Externality is an Economic concept that arises whenever private parties fail to perceive some implicit cost or benefit due to the decisions they make. Is one of the forms of “Market Failure” that we encounter in our daily lives (i.e. situations in which market allocation won’t result in a socially optimal result), and the main reason for it is society as a whole can perceive those costs and/or benefits, but the economic agents actually responsible for the decision making process can’t.
As we think about planting trees for example, one tree has a particular cost to be planted, and this cost is paid by the one planting it. This person gets the benefit of a new tree, but so does everyone else who breathes. They get to enjoy this benefit for free. As a society, we see that when it comes to trees, ‘the more, the merrier’. But how many of us are actually willing to go through the cost of planting a tree?
What we end up with is less trees than socially desirable. But it doesn’t end there. Let’s look at things from the other side too. When we were born, our planet had already a wide endowment of trees. Not only are we not planting them as much as we should, but we are also cutting them faster than we are replacing them. Why is that so? For the exact same reason, but shaped as the ‘Tragedy of the Commons’. The benefit of cutting a tree (wood value, medicinal properties, etc.) are private (the one who cuts gets to keep the value), but costs are public (the one who cuts isn’t just diminishing the availability of trees and oxygen for oneself, but to everyone). Therefore, there is a tendency of over cut trees.
The image above brings up an interesting concept, which has some underlying economic concepts. Every consumer’s problem is to maximize utility (welfare) subject to a budget constraint. Because oxygen is free, even though it is necessary, the average person doesn’t think about the cost of consuming it (which is reducing the availability of that oxygen molecule for everyone else). Wifi on the other hand, we all pay a fee to have access to it. Having trees emit wifi would reduce the amount people pay for having access to wifi, which would encourage people to be willing to pay for it. Whereas if you ask them to pay to increase the availability of oxygen, which is already free, they won’t. The key here is the lack of forward-looking behavior for the average economic agent when making decisions. That’s the externality, the future lack of oxygen as a cost which isn’t perceived in everyday decision making, generating market-failure. I would like to encourage you to think as to how we may make people perceive such costs, and lead us back to social-optimum solutions.