# Intro to Econ: Eleventh Lecture – Negative Externalities

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.

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.

$\begin{tabular}{c|cc} & not advertise & advertise \\ \hline not advertise & 10,10 & 7,12 \\ advertise & 12,7 & 9,9 \\ \end{tabular}$