Defining Externalities: Social Entrepreneurship and Externalities, Part 2

In the first post in this series, we looked at the definition of social entrepreneurship. In this post, we’ll look at the definition of externalities. Before we get into the post, I wanted to let you know that when I copied part of the paper into this post, the footnotes reset and started at 1. However, as we know from yesterday’s post the first footnote from Pigou is actually footnote #10.

Defining Externalities

The process for defining externalities is as muddled as the process for defining social entrepreneurship. Since the term ‘externalities’ came first,[1] it might be more accurate to say that the process for defining social entrepreneurship is as muddled as the process for defining externalities. The first appearance of a definition of externalities comes in the early 1900s from Pigou,[2] a British economist, who comes from the field of ‘welfare economics,’ which focused on maximizing the well being of society. The general understanding of externalities hasn’t changed too much since then, leaving us with the following definition: “An externality is a cost or benefit that is experienced by someone who is not a party to the transaction that produced it.”[3]

This definition of externalities leaves us with the possibility for positive (benefit) externalities or negative (cost) externalities. An example of a negative externality could be the pollution to the air (or water) caused by a factory. An example of a positive externality could be the honey caused by the natural process of bees. Those two examples of positive/negative externalities are simple ones, but there are many more. Some cite traffic congestion as a negative externality[4] and some cite immunization as a positive externality.[5] The concept of externalities came out of economic theory and as such, we can highlight (through economic theory) some of the results that come from negative/positive externalities. “Negative externalities cause overproduction of the good in a competitive market, while positive externalities cause underproduction of the good in a competitive market, in both cases leading to a deadweight loss.”[6]

There is another kind of externality: positional externalities. “A positional externality occurs when new purchases alter the relevant context within which an existing positional good is evaluated.”[7] An example of this could be said to be when a job candidate starts to wear really expensive suits. The side effect of this is that other job candidates don’t make as good an impression upon the interviewer. From the perspective of the other candidates, it would be most beneficial to go out and purchase expensive suits, so as to make a favorable impression on the interviewers. “But this outcome may be inefficient, since when all spend more, each candidate’s probability of success remains unchanged.”[8] The last kind of externality of this similar vein (positive, negative, and positional) is a network externality. This is also referred to as a network effect and is most often seen in technology. Think about your cell phone. The value of your cell phone is somewhat dependent upon the number of other people [network] who also have cell phones. There is a further way to distinguish between different kinds of externalities: ‘internal’ and ‘external’ externalities.[9] Internal externalities are those externalities that are external to the contractual relationship, but internal to those parties within the contract. External externalities are those externalities that are external to both the contractual relationship and the parties within the contract.

At this point, we have talked about the various kinds of externalities (positive, negative, positional, network, internal, and external). To solidify the understanding of externalities, I’d like to provide an example of the creation of externalities by externalities:[10]

Jacksonville, Florida requires apartment complexes to provide 1.75 parking spaces per one-bedroom apartment – despite the fact that 16% of Jacksonville’s renter households even own one [sic] car . . . Most American cities require office buildings to provide four parking spaces per 1000 square feet of office space. Because four parking spaces consume about 1200 square feet of space, this means that a commercial landlord must allocate the majority of his land to parking.

Minimum parking requirements reduce population and job density, because land that is used for parking cannot be used for housing or commerce. Residents of low-density areas tend to be highly dependent on automobiles for most daily tasks, because they are less likely to live within walking distance of public transit and other amenities.

Minimum parking requirements indirectly discourage walking, by encouraging landowners to surround their building with parking. Where shops and offices are surrounded by a sea of parking, they are unpleasant places for pedestrians, because pedestrians must waste time walking through parking lots and risk their lives dodging automobiles . . .

By increasing the number of parking lots, minimum parking requirements may increase pollution from stormwater runoff. Rainstorms cause stormwater to fall on parking lots, collect metal, oil and other pollutants lying on the ground, and then run off into nearby waters, thus making those waters dirtier and more dangerous.

As one can see, this never-ending string of externalities seems to keep going. All of this stems from the initial action of a policy seemingly trying to do well by its citizens. Now that we have talked about some of the different kinds of externalities and explored a concrete example of how externalities can quickly multiply, let’s look at some of the proposed solutions to these externalities. But just before we move into the description of some of the solutions to externalities, I thought it a good place to add a note from Coase, who is often part of the conversation of externalities: “The traditional approach [to externalities] has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is; how should we restrain A? But this is wrong . . . The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A?”[11] Coase is absolutely right in his critique of the framing of the question. Even in today’s discussion (Coase wrote this in the 1960s) about externalities, rarely is the question framed in the way that Coase has suggested.

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Note: when we next pick-up this series, we’ll look at some solutions to externalities.