On Austrian highways you can sometimes find a sign that says “Schnell ist laut!” or “Fast is loud!” in English. The caricature of Homo Economicus (the rational person, often interpreted as highly self-centered) upon reading this would probably react by thinking “Thank you for the warning. But it is no problem. I can just turn up the radio.”
I guess that this is not the reaction that people who placed the sign there were looking for. And I also guess that most people understand perfectly what this sign is asking them to do: Drive more slowly, so that others, i.e., those who live here, don’t have to suffer so much from the noise that you otherwise create. Whether or not this sign makes them slow down is yet another question.
In economic terms, when you drive fast you create an “externality”, in this case harm, to other people not involved in your decision or activity. In this post I want to consider what happens when economic activity imposes negative externalities on others. We will see that this creates problems to the extent that market allocations are no longer even Pareto efficient (recall this post).
Let me begin by trying to convince you that externalities create a problem. I will take up an example I have found in Dani Rodrick’s “Economics Rules”. Suppose that you are in charge of a company producing running shoes. Suppose that, at the moment, you have profits of 10 million euros a year. Assume that, at the moment, you are not advertising in a big way. But you are now considering a bigger advertising campaign. Assume that this would cost you about one million euros a year, but would raise profits (without considering the advertising costs) by 30%. Should you do it?
Well. The answer seems pretty straightforward. Of course, you should do it. The advertising campaign would bring in profits of 13 million a year (before considering the cost of the campaign), which then leaves net profits of 12 million a year. That is 2 million a year more than without advertising. So yes, you should do it.
But now imagine that this extra profit that you get is mostly because people, seeing your adverts, buy your running shoes instead of some other company’s running shoes. Assume that this is the main effect of advertising in the running shoe business. Then your decision to advertise poses a negative externality on your competitors, i.e., other running shoe producers. But then couldn’t your competitors do the same thing? Suppose, for the sake of simplicity, that you have only one major competitor. They could also start advertising. Will they? And what if they do?
The following table describes the “game” that these two companies play with each other, perhaps not even knowingly. Each company, you and your competitor, could advertise or not do so. The cell entries are then the profits the two companies would generate in all 4 possible cases. Note that I am assuming that your competitor is in many ways just like you.
So, if you both don’t advertise you both have profits of 10 million euros a year. If you advertise and the other does not, it is exactly as I described above, you get profits of 12 million euros a year. Suppose that you do. Then let us put ourselves in the shoes of your competitor. What would they then do? They can refrain from advertising and get 7 million a year (because you “stole” 30% of their business) or advertise and get 9 million a year (to restore their market share). Clearly, they should advertise. Note that the competitor may not even realize the actual source of their reduction in profits (although they probably would know) and simply contemplate advertising to raise their profits in any case. In this example it is completely true that advertising raises a company’s profits. But, and this is here the negative externality, this has negative consequences for the other company. In fact, if they both advertise, as we would probably expect, they are actually worse off than if they had both not advertised. By the way, the game I described here is a version of the so-called prisoners’ dilemma. Google it if you want to know why it has this name.
One could say that the two companies are caught in this logic and “forced” to advertise which in the end is worse for both of them. Note by the way that it is not clear that this is bad for the consumers. It is, thus, not clear whether this high-level advertising equilibrium is bad for the economy overall. But it is clearly bad for the two companies. You might say that surely the two companies can avoid this bad situation. Well, you might be right. If they both understand the logic of this situation and if they are indeed the only two running shoe producers, they would probably try to communicate and agree not to advertise. You can learn more about this in courses on “game theory”. But if there are actually many running shoe producers this might not be so easy. Also companies talking to each other about things like this is often considered illegal (against anti-trust legislation).
In any case I wanted to use this as an example of the effect of a negative externality. Here advertising causes a negative externality on other companies. If companies aim to maximize their own profits then they end up advertising too much. With too much I mean that in the end, paradoxically, the two companies have lower profits than they would have had if none of them had advertised.
In the case of advertising it is not clear how we should feel about this from a societal point of view. But the same logic applies whenever there are negative externalities, and then we would often consider the presence of negative externalities a societal problem. The perhaps most pertinent example these days is the problem with CO2 emissions. It seems more and more clear now that CO2 emissions pose a huge negative externality by affecting the climate in a way that adversely affects the average person in this world. If I drive a car or run a factory, I produce CO2 and this CO2 does not only harm me (a little bit) but probably harms almost everyone a little bit too, and a little bit times millions or billions of producers of a little bit may well be a very large amount. Of course, I driving a car also gives me (and perhaps some others) a benefit. And one shouldn’t forget about that. But people usually don’t worry too much about the harm they impose on others with their activity and therefore, from a societal point of view and given the negative externality of their actions, pursue these activities too much. This doesn’t usually mean that they should stop altogether, but just that they drive or fly too much or generally do too much of whatever produces CO2 emissions. In the next post I want to address how negative externalities can often be tackled relatively simply and will also explain why these same solutions don’t help with CO2 emissions.