Externalities and the Production of Widgets
by Gabriel Cross
A company makes widgets. The community that the company is located in loves widgets, and buys them as fast as they are produced. Every household, in fact, has one or two widgets at any given time. Some brilliant manager, realizing that this was the case, convinced the owners to make widgets that would break faster, so that the community would end up buying widgets more often, and the company would make much more money. It worked very well.
The above is a snapshot model of industry in the later half of the 20th century, but that’s a boring story so let’s muck it up a bit (complications are what make stories interesting, after all). There is a river that runs through the community, and the widget producing factory is next to the river outside of town. It is located there for good reason: the factory uses water from the river for various widget-related processes. Unfortunately, the water that they use comes out somewhat dirtier than when it came in. The dirtier water is not safe to swim in, and damages the local fish populations.
Furthermore, the factory being out of town means that they have to truck the widgets in, and the workers have to drive back and forth to get from work to home. All those cars and trucks pollute the air in the community. The polluted air increases cases of asthma, intensifies symptoms of allergies, and increases occurrences of cold and flu cases.
As stated above, the people in this community love their widgets, but they also love fishing, swimming, and not having asthma. They pay for the widgets, but nobody pays for the air or water. The result is that, although there is an economic cost to the community for the company’s activities (in lost fish dinners and increased doctor visits), the company is not required to pay for it in any way.
This is a classic example of an externality: using or damaging a resource without paying the cost that that use or damage generates for others. It is repeated again and again in every economics class that there is no such thing as a free lunch, yet we seem reluctant to extend this rather basic principle to natural resources. A river is not just a pretty water feature; rivers create measurable economic value in terms of recreation, food supply, water for cities, and (if the river is big enough) transportation. Furthermore, a number of less economically measurable ecological services are provided by any body of water. When the flow, clarity and purity of a river is altered or degraded, some or all of those services will be diminished or eliminated.
When costs are externalized, someone pays for them. In the example above, if the community buying the widgets is downstream of the factory, they pay. If the community knows that the company is making them pay, they may pressure the company to change the way it does business, to move the factory, or to pay themselves in some other way.
If the factory is downstream, however, then it is the next community downstream from the factory that pays, and they may not even be aware of why the water is dirty. What’s more, they may not even like widgets. If they complain, the company will just raise its hands and say “the people want widgets, who are we to deny them?” Another argument might be “paying to clean up the water or change our widget-making procedures will make the widgets so expensive, nobody will be able to afford them.” Of course if the latter argument is true, then they have been trying to eat lunch on everyone else’s tab for a long time.
And that is ultimately the point of an externality. It keeps the widget prices artificially low and generates an unfair, unbalanced, biased market. This is not a free market, but one in which costs are hidden and shuffled around to the benefit of one group. In a sense, when a company externalizes the costs of degrading a natural resource, they are holding the market hostage. In economic terms, this is no different from stealing.
What is worse, however, is that the degradation often takes years, even decades to undo. While we are devising ever more ingenious ways to make widgets last even less time before breaking, we have not discovered many ways to speed up the restoration of natural resources. In other words, we have been steadily picking up the pace at which we damage our ‘free’ resources without doing enough to help protect or preserve them. It also means that the value of the widgets produced today must be weighed against the potential value of the natural resources for years to come.
Currently, there is no easy way to account for externalities. Many intelligent people have come up with clever ways to value ecosystems (The Value of the World’s Ecosystem Services and Natural Capital, Robert Costanza et. al., 1987), but there is no set, widely accepted rubric for valuing a single river, or one ton of CO2 emitted, for that matter. Even when we can value these things, it is extremely difficult to get companies to internalize costs that they have successfully externalized to date; they view such efforts (and understandably so) as an assault on their way of business. They have been eating lunch without paying for quite a while, however, and it is high time that they paid their bill.