A Look at Externalities

George Rebane

'We know best what's good for the people.' -  from the Central Planning Bible

Lately several readers have been discussing the whys and wherefores of (economic) externalities.   It’s a slippery concept to apply as may be deduced from its definition.

An externality is “a consequence of an economic activity that is experienced by unrelated third parties. An externality can be either positive or negative.”  - Investopedia.

If a producer (Agent A1) provides a quantity (Q1) of goods/services to a customer (Agent A2) willing to pay price P1 for them, then we have the costs of production and price driven demand represented by the classical producer-demand curves showing the market realities arrived at by A1 and A2 – that is, Q1 exchanged for $P1.  In this situation each agent has satisfied his own utility for money and goods.

Now enters agent A3 who is neither a producer nor consumer, and he determines that there are people out there negatively impacted by such production/consumption transactions.  By fiat A3 (usually the government) has the power to assess, attribute, and allocate what it determines is the ‘social cost’ of such unhampered transactions.  It attributes such a cost to a given industry (economic activity) and, in its wisdom, allocates a portion MEC (marginal external cost) to A1 - as a tax, tariff, license fee, imposed purchase of, say, carbon credits, etc – that A3 claims is a negative externality.  But in reality A1 experiences MEC as an added cost of production to his existing MPC (marginal private cost) of production.  This yields a new MSC (marginal social cost) production curve experienced by A1.  And the new price point now shifts to P2 at which price A2 is willing to buy only quantity Q2. (See my modified figure below from Environmental Economics.)

The details of what all the lower case letters mean are very interesting, and the reader is invited to study them (only one page of reading required).  But the clear point is that when A3 comes in and imposes some arbitrary MEC on A1, the production cost curve jumps up as indicated (blue dotted arrow) thereby shifting the new market equilibrium point so that A2 buys a lesser quantity Q2 at a higher price P2.  A1 now can only sell Q2 < Q1 which means that workers who contribute to his profit (wealth generation) must be reduced.  The liberal will argue that ‘well, A1 may have to hire/shift workers to satisfy the new A3 imposed regulations that cost MEC, so perhaps the employment situation is not all that bad.’

But the situation really is bad from a number of perspectives.  First and foremost is that A3 enters the picture with the power of the gun, and mandates an arbitrary increase in production costs.  Doing so allows A3 to immediately pocket the cash in area b+c+f and take it out of the cost-benefit calculations of A1 and A2.  You see, the arbitrariness of A3’s actions are that A3 has his own ‘social utility’ which invariably is something cooked up by bureaucrats who do not understand production, consumption, and the market that joins them – in short, their utility is much different from that of A1 and A2, and throws out the brown number MEC by which both A1 and A2 must now live.  No one is allowed to look behind the curtain to see how that brown number was arrived at, it came down from God.

The result is that less of the product (Q2) is made and sold at a higher price (P2) to customers who demonstrated their need and willingness to buy more of it (Q1) at price (P1).  So now it is up to the rest of us to determine whether we are getting our money’s worth by buying less for more.  The ‘we know best what’s good for you’ central planners will argue from behind their impenetrable bureaucratic fortress that, since we have imposed ‘social justice’ in this market, everyone now benefits.  Now just move along.

In the GDP figure below (explained here), it is the dollar amount (b+c+f) taken by government that will at best create wealth consumption and/or destruction, and such loss is indicated by the wiggly ‘poof’ line that just sucks money out of the economy.

The interested reader is also directed to a very lucid discussion of externalities at the Von Mises website. 

Comments

[Gregory]

Now, let's get with some specifics... just where else Frisch wants to go with "internalizing the externalities" besides raising massive revenues from the likes of carbon taxes and fees on all groundwater used right down to having meters on rural residential wells... flush the toilet, send ten cents to Sacramento.

The rent seeking will continue until OPM runs out, and Frisch's refusal to even acknowledge that recent paper showing scary decreases in solar activity is bound to that reality, squealing in delight in response to cartoon 'deniers' presented by the FUE.

I saw Pelliine in the Bonanza market parking lot with that brandspankingnew truck a couple days ago. A 4x4, those Duke boys would have loved it... how does a warmist like jeff justify such a massive carbon footprint?

[Steven Frisch]

Of course what you guys are missing is the 1) social costs exist without the actions of any A3, and 2) positive externalities exist without any A3, that are not compensated for. George's graph is correct, but his definition of A3 is wrong. As a matter of fact if one clicks through to the Environmental Economics graph one finds that George added A3 and A2 to the graph (without telling us so). Nice move George, but as a reader of Environmental Economics I suspected an alteration.

Second Greg is incorrect, I do not support a carbon tax, which is a direct tax, I support Cap and Trade, which is a trading system that allows the producer to reduce emissions any way they choose, and allows them to benefit from doing so by selling any credits they accumulate. This is a classic example of what i meant when I said sometimes the reason internalizing the externalities is more efficient is because it avoids other less favorable alternatives.

The alternative to Cap and Trade in California would not have been no action, the law requiring a reduction in emissions had already passed. The task that the ARB took on was HOW to reduce emissions, and choose a market based mechanism over a direct tax.

Finally, I am not sure what Jeff's truck has to do with any of this and would point out that it is a violation of the rule against injecting extraneous unrelated information into the topic.

But more on that when I can send George my monograph. .

[Steven Frisch]

By the way George, when I submit my monograph what is the best way for me to embed graphs and charts in order to ease your posting? I am not very html proficient. Would sourced links be enough?

[Gregory]

"I do not support a carbon tax, which is a direct tax, I support Cap and Trade, which is a trading system that allows the producer to reduce emissions any way they choose, and allows them to benefit from doing so by selling any credits they accumulate."

Yet another distinction without a difference, perhaps Frisch's favorite fallacy. They are both taxes on fossil fuels, one direct, one indirect. Both raise the costs of goods, services and the ability to keep warm, driven by faulty, politically funded, groupthink science.

[George Rebane]

StevenF 532pm - Are you implying that I was attempting to defraud my readers? All I did was use a convenient figure from the web and augment it correctly identifying the agents that Environmental Economics would have found a bit embarrassing to include in a more complete definition of negative externals. My additions would have been obvious for anyone going to the link I supplied. I'm not sure I understand the purpose of your insinuation. In any event I have inserted the word 'modified' into the figure's introduction.

And the identification of A3 is precisely correct. For example in California's attempt to internalize environmental externals through AB32, the California Air Resources Board is A3. If you don't understand these obvious (agents) players, I'm not hopeful for any resolution here.

The best way for you to submit your monograph is by sending me the Word document of the piece with its embedded figures. I can take these out, reformat them, and reinsert them where you had placed them.

[Todd Juvinall]

Did I see somewhere that "cap and trade" is almost exclusively done by the utilities? If so, isn't that special? They don't care how much the tax is because they go in front of the PUC and get a raise in the taxes or fees or costs. What a incredible scam. The little folks of California are being hosed and Steve Frisch and his support for it are hosing them. Those little old ladies in LA, they are unable to use their AC because they can't afford the SCE bills. Proud of that Steve Frisch? All lives matter, even little old ladies.

[Steven Frisch]

Posted by: George Rebane | 02 July 2015 at 06:26 PM

I merely correctly identified that the graph you submitted was not the graph from EE, it was altered. I am glad you altered your post to indicate that the original authors did not include A3 and A2.

And yes, I content the idea that externalities are social costs identified by government. They are social costs that exist whether they are identified by the government or not, thus your identification of A3 is incorrect. Social costs simply exist. It just so happens that sometimes one function of government is to identify them. In the case of Cap and Trade yes, you are correct, the intervener is the government, although it was legislatively decided, and we live in a democratic republic, thus the intervener is THE PEOPLE who are represented by the government.

Thanks for the info regarding the monograph.

[Steven Frisch]

Should read "...I contest the idea that externalities are social costs identified by the government."

[Steven Frisch]

I wish people really understood what they critiqued. It would be so much more efficient. Todd, Utilities receive their cap and trade allowances fro free, are required to sell all of them at every auction, and buy back the amount that they need for their emissions. If the emit less, they make money. If they emit more the have to buy them, but the revenue derived from buying them is rebated to the customers. This the little old lady in LA is not paying any more for her electricity because of cap and trade.

http://www.wsj.com/articles/how-cap-and-trade-is-working-in-california-1411937795

[Todd Juvinall]

Thanks for confirming the utilities are paying those fees. The little people are getting hosed and your support for that is breathtaking.

[Steven Frisch]

Posted by: Todd Juvinall | 02 July 2015 at 07:30 PM

The new rules require I reply by saying, "“He uses statistics as a drunken man uses lamp-posts... for support rather than illumination.”

[Jon]

I believe most of us feel that one should have a basic, at least a rudimentary grasp of a particular subject matter before commenting on these threads. This subject is particularly technical, requiring some experience in the matter. So given that desirable goal for this forum, can someone please help me-

why is Todd Juvinall commenting on this subject?

[Bonnie McGuire]

Many years ago during an income tax class the teacher mentioned that the Gov used internal revenue stats to dtermine what areas of industry needed to be encouraged, or restrained....

[Gregory]

"I wish people really understood what they critiqued."

Perhaps you can then relate the issues many of us have with the scientifically ignorant lot including you
Jon, Pelline, Ahnna and the rocket scientists in Sacrameno who think their priests are the only voices who should be heard on climate issues.

[Todd Juvinall]

Jon 7:35 PM

The reason I am here is to keep the trolls in check. Since you are unknown and have not released your expertise to the readers, I would suggest you are the one who does not belong here. Based on your answers and views here, I would suggest you try say, Sesame Street's blog. Regarding the rules, I am following them just fine it is the Truckee troll breaking them.

A return to the halls of education is in order for them.

[Steven Frisch]

Posted by: Todd Juvinall | 02 July 2015 at 07:43 PM
Posted by: Gregory | 02 July 2015 at 07:37 PM

Life is full of irony and hubris.

[Steven Frisch]

Posted by: Jon | 02 July 2015 at 07:35 PM

The incest thread has been pretty quiet.

[Bill Tozer]

Hey, if you want to externalitize the internalities, pull my finger. Might as well since some elistist PC control freaks have been pulling my chain for a long time.

[Russ]

The externalities of prolonged global cooling.

One of the externalities that Steven Frisch refuses to consider is the increasing probability that we will see a significant global cooling in the next 20-30 years, which will have a negative impact on the world's food supply. These externalities are driven by processes that we have no control over.

Solar activity is declining during Solar Cycle 24 and sunspots maybe extinguished during Solar Cycle 25, reaching a level last seen during the Maunder Minimum, when the sun spots vanished for long periods. This period is know as the Little Ice Age, a period that extended from the 14th through the 19th Centuries.

Between the early 14th and late 19th centuries, a period of cooling chilled the planet. Europe bore the brunt of its ill effects, experiencing harsh and fickle weather for several centuries and especially from 1560 to 1660. Beginning in the spring of 1315, cold weather and torrential rains decimated crops and livestock across Europe.

The North American breadbasket in Canada and the United States had not been developed yet. Studies have shown that extended cold periods would significantly shorten the breadbasket's growing season, making some grain crops impractical, if not impossible. Many traditional crops would have to be moved farther south, replacing existing crops. More food would have to be imported from Central American countries, that do not currently have the necessary agriculture infrastructure.

For the last 30 years the Atlantic has been in a warm phase and it starting to cool, entering a 20-30 year period called the Atlantic Multi-decadal Oscillation (AMO). Atlantic cooling can impact the climate for decades, according to researchers, on timescales from 20 to 30 years. This means cooler global temperatures and changing weather patterns could unfold over the next two to three decades. According to Joe Bastardi a cool PDO, which is currently the Pacific phase and a cool AMO will produce winters like current US generations have never seen.

The ocean phases and solar energy decline are externalities that humans have no control over. We can only adapt.

[Gregory]

"Life is full of irony and hubris"

Like the CA legislature and Arnold Schnizengruben installing AB32 in order to remake the state's economy to lead the world into the new century and make Xmas dinner at Uncle Teddy's more pleasant? Fail on all accounts.

By satellite and radiosonde measures, no warming for 18+ years; it will eventually break one way or the other.

Some of us have a clue, others studied rhetoric and polisci.

[Steven Frisch]

Posted by: Russ | 02 July 2015 at 08:26 PM

I have an idea, how about if we want to debate whether global warming is really happening or not we do it on another thread.
George can start one and we can debate it, or not, as the case may be.

This thread is about economics. It is about the concept of externalities. Cap and Trade was an EXAMPLE, it was brought up a classic case of an economic externality and a third party player in an economic system imposing a calculation of a social cost. We could just as easily used cigarette taxes or child labor laws, or even a positive externality like vaccinations or entrepreneurship. We are talking about an idea here, and the examples are intended to illustrate the idea and further the understanding of it, not act as a derivative.

That way if people want to hear Russ and Greg call me a rent seeker, or pontificate about how much smarter they are because they went to Harvey Mudd University, or how much more they know because they are some sort of scientists esconsced on the back porches of Nevada County, or argue over how big Jeff's truck is, or laugh when Bill tell fart jokes, or stay quiet while Todd cites anecdotal media reports that he appears to have not even read or watched himself, there is a place for it.

The "sandbox" is where your freak flags can fly my friends. It is designed for exactly such ephemera.

[Todd Juvinall]

What is it about these liberals that are into the apocalypse? There is global nothing and never was. Only weather and climate as it has always been. But the hubris of liberals to control their fellow humans knows no bounds. The issue is simply political not science (they tell us the sun has nothing to do with it). However, a gravy train of tax dollars has found its way into the pockets of liberals and their shameless "scientists" so the beat goes on. If the money was stopped my guess is the lies would stop and we could finally live in peace on the planet. As the reader can see, the supporters of the hoax of AGW are relentless because their whole livelihood is at stake.

[Barry Pruett]

This is not a conversation strictly about economincs. That argument is a complete fallacy for those that think. When A3 determines the externalities arbitrarily, we are talking about the confluence of social policy and economics. If you change the players on Mr. Rebane's graph, it becomes a model for the state planners (i.e. a communist model).

[Steven Frisch]

Posted by: Barry Pruett | 03 July 2015 at 07:26 AM

Barry, this is not a new idea, it is a standard theory of neoclassical economics accepted by almost all economists from Karl Marx to Milton Friedman, and including people like Hayek and Laffer. I am sure all of these economists would love to hear how the concept of externalities is a complete fallacy for those who think, because externalities are critical to understanding how markets work.

As stated above, externalities, whether positive or negative, exist regardless of government or regulation.

Although it may be about both social policy and economics, my post was intended to say lets discuss the theory and its practice and not get sidetracked by Climate Change.

But in your example who decides what is 'arbitrary'?

We created and elect governments to create social order and ensure stability for rights.

For us those governments act on the will of the people through a democratic republic. (Happy 4th of July)

The representatives of that democratic republic establish regulation through due process.

Those regulations affect everything from what drugs we take to extend our lives, to whether a pig farm can move in next to your house, to how old people need to be to work dangerous jobs, to who can pollute and how much. All of these actions are acts of intervention to encourage a social purpose or avoid social costs.

So in short, I agree with you that economics is a social system; what I reject is that conservatives seem to forget that they regulate, that they make arbitrary decisions, that they favor certain activities over others, that they are also engaged in the dance of externalities.

I am a little surprised with your comment Barry because you know better than most of us that Law is the underpinning of individual rights and that it is Law that governs our markets and makes them work; from contracts, to regulating competition, to securities regulation; law is the arbiter.

Would we say that 'communism' is at work when the local government says the pig farm can't open next to your house? Some would consider that a restriction on property rights. How about if the pig farm opened 5 miles away but the prevailing winds sent the stench plume over your house using the 'commons' (the air)? Should we or could we regulate that because the externality is unacceptable?

[George Rebane]

Administrivia - as requested above, the segue thread into climate change dilutes the discussion of externalities here. For that purpose the 3jul15 sandbox is now open for business and invites readers to discuss climate change.

[George Rebane]

re StevenF 803am - We have to always remember that it is also the Law by its absence that makes a large and important part of the markets work. When Law begins to interfere with the communication function of market price for a good/service, bad things often begin to happen. And therein lies the debate between a conservatarian and a collectivist.

Not sure what circling the 'pig farm next door' will contribute. Communities have existed next to pig farms, feed lots, and paper mills for centuries when the economic benefit required it. Even in gold country the 24/7 din of stamping mills was accepted as the cost of doing business, which was job one for every community until cash began to imported over great distances by Leviathan. Then NIMBY took over, and Leviathan grew more to accommodate that sentiment.

Finally citing that the likes of Hayek, Friedman, and Laffer recognized the existence of externalities should not be taken by the naïve reader as their having endorsed unfettered participation (as, say, today by the EPA) of A3 in private transactions. HFL well understood the evils of such arbitrary allocations and assessments.

[Steven Frisch]

Posted by: George Rebane | 03 July 2015 at 08:52 AM

I will get back to this in the afternoon after going to the store this morning to avoid the crowds in Truckee, and while watching a baseball game :)

[Gregory]

The 1:48AM mudball made quite a splat. Feel better getting that out of your system?

As Frisch mentions, the economics is standard stuff; I'd add that we've already exhausted the topic unless there was a five page paper due in our macro econ class and we were all trying to figure out what POV the prof would require for a decent trade,as if we cared.

Yes, Steve, I also took econ with polisci majors.

The reason for the segue into the climate is that "externalities" is the battle cry for those wishing to price conventional energy sources into oblivion, and politically determined "externalities" are the ticket for both a moral authority for such an intervention and a fig leaf to avoid calling it a major shift in taxation, which is what it is.

In short, without the climate scare we'd not care about externalities outside of Econ 101. We already have sin taxes, 'taxing things that are bad for you' has always been popular but taxing you for driving to work or daring to keep your home above 50F in the winter is a hard sell.

[Steven Frisch]

Posted by: Gregory | 03 July 2015 at 09:22 AM

No mudball in there Greg, and if you wish to debate climate change go to
the new Sandbox :)

[George Rebane]

re Gregory 922am - Greg's point is well made on externalities - for the progressives managing their gruberized constituencies, assessing arbitrary externalities is exactly a new method of taxation. In my post I call out the precise monies taken out by government in such assessments. But for those who see government as the final solution upon which no limits of power and taxation should be placed, comprehensive application of externalities to all items of commerce is just the ticket for complete control. The sheeple have no more understanding of how externalities were calculated than they do of Al Gore's calculation of temps and sea levels a century from now.

[Todd Juvinall]

I read somewhere that more businesses are going out of business than being created/started in America. When the government imposes so many rules and regulations and demands a person pay everything upfront to even start a business, then we see the "ghosts" of government affecting the economy and it is not pretty. I would suggest that creating a business avoidance number is in order. How many billions are not in the economy because the "risk" of government interference is at work. Kind of like the government not counting the 93 million Americans who gave up looking for work and who are not counted in the "unemployment" numbers. It is all smoke and mirrors.

[Bonnie McGuire]

Mr. Rebane you're so right regarding where people live in order to earn a living. Our travels to Alaska (and Arctic) to the southwest and Mexico, and the accompanying sights and history was a real education regarding human survival. Our grandfather had a mine in Mogollon, New Mexico, a real Wild West enviroment where outlaws liked to roam. It's interesting how the quest for gold and silver inspired improvement and efficiency. The dust at one mine caused the death of many until they used water with the drills. http://www.mcguiresplace.net/Stories/Mogollon Dawson, Alaska was Amazing. The mines were very advanced with electricity and able to make and repair equipment. The entire town benefitted. However, I'm sure the noise from the dredges was something else.

[Russ]

[email protected]:48am

I do not want to debate climate change, climate is a cycle and we are on the cusp of the next cooling cycle which is forecast to be the coldest cycle in recent history. The point I was making is that this will be an externality that humans cannot control, with a huge economic impact. More people die from cold and hunger, than heat and drought. Preparing for a warmer world by spending billions to control CO2 has an economic impact, when history and science tells us that we are going to live in a much cooler world. Spending billions in the foolish notion that humans can control the climate is an externality that we could control, but lack the political will to address in the real world, preferring to wallow in failed computer models. Now to the Sandbox for the climate change debate.

[Gregory]

The ephemera is not the climate issue; it will be remembered and revisited long after the current cause celebre of "internalizing the externalities" is forgotten, and as climate IS the reason we are discussing externalities I think this is a fine venue; George's 9:45 seems to agree.

Over the last couple of days Frisch has cited the same video as his retort to any claim of a warming pause. The video, by the climate blogger Peter Sinclair (an artist with no science education) is six years old, with seven year old data from the activist NASA/GISS office that eschews data from NASA satellites in favor of heavily modified terrestrial instrumental records, many of which are from poorly sited screens, like the one for Reno, sitting between the two huge runways on their major airport.

The two main keepers of satellite datasets are Remote Sensing Systems and the UAH and both support "the pause":
http://www.remss.com/research/climate
Don't miss fig 1, Steve

And here:
http://www.drroyspencer.com/wp-content/uploads/UAH_LT_1979_thru_June_2015_v6.png

The problem with having politicians determining science, especially when it comes to the mother of all externalities is that their lips are moving and most of us know what that means.

[George Rebane]

re Gregory 1221pm - When we leave climate change externalities and get on to the merits of AGW and climate change per se, I recommend taking that discussion, already ongoing, to the 3jul15 sandbox opened specifically for that purpose.

[Steven Frisch]

Climate is most certainly not the reason I am discussing 'externalities'. I have been discussing and doing work related to internalizing costs of production for more than 20 years. Cap and Trade was an EXAMPLE.

[Gregory]

Since the IPCC is 27 years old it is certainly possible Steven Frisch has been considering CO2 externalities for the entire two decades, omitted nicely by his implied claim that he wasn't.

Just for fun I dug out my old econ text... Paul A Samuelson thought externalities worth only a page of text with no figures or quantitative treatments. With CO2, the stuff of life itself, available for taxation, I'm sure that would have changed but in the early 70's the scare was cooling, not warming and co2 was merely a possible salvation.

[Gregory]

It's worth a direct question: Steve, when did you first consider CO2 as an externality that should be accounted for?

It's an example. A really huge example. Is there an example that rivals it in sheer size?

[George Rebane]

My post here was to explain the details of externalities on a market in sufficient detail to support the discussion we are having. I didn't want to extend this piece with what I consider are the evils of mandated externalities (added arbitrary taxes injected to gain additional govt revenue under false pretenses). In the above piece I only wanted to point out without dwelling the arbitrary and often gratuitous way such taxes are levied on a product, which then in no way go to assuage the supposedly external costs that the product's manufacture and consumption entail to society.

This judgment is clearly ideologically motivated, for were I progressive I would celebrate added tax revenues to the state, no matter their source or putative justification. So now that we all know how and where externalities are accounted, I look forward to how their amounts are developed and justified, because even progressives must pay some lip service to the increasing tax burden they place upon the people.

My own observation is the an externalities tax (ET) is regressive on ALL parties in its very nature. And any attempted palliating just grows Leviathan, and serves to increase the power of special interests. That, of course, why the large corporations don't really mind increased ETs - they pass the costs on to the distribution channel and ultimately the consumer, and they have yet one more dimension through which to game the system. And it's all done for the little guy in the name of 'social justice' which has been drilled into his head as a universal raison d'etre by his Great Society teachers. Cognitively, he's no more capable of protest than he is of identifying Afghanistan on the map, especially when accompanied by yet another govt check along with the news that 'the rich' are going to pay for it all.

In the past such views have invoked the CCC being called to respond. One can only hope that this discussion has raised itself to a higher level worthy of such considerations by both sides.

[Gregory]

"No mudball in there Greg, and if you wish to debate climate change go to the new Sandbox :)" -Frisch

Then go to the garbage thread and find Frisch has no interest in discussing it there, either. Really, no surprise.

It's Let's Make A Deal for warmists in Sacramento and that will continue for some time. However, if public employee unions lose the case for mandatory dues taken up by the SCOTUS the one party state will lose its mojo; if cooling becomes so noticable that even Frisch feels it in his bones the one party state will lose its mojo; and, when the people of California notice they are paying way more than all but Hawaii for energy of all flavors, the warming party will lose its mojo.

[George Rebane]

Looks like no one listened to moving their climate change debate to the 3jul15 sandbox. Extraneous comments have been unpublished.

[Steven Frisch]

Posted by: George Rebane | 03 July 2015 at 03:35 PM

Funny, I followed the rules George, how about a shout out :)

[George Rebane]

Praise is shallow and fleeting, by their works shall they find favor in the eyes of God and Man.

[Todd Juvinall]

LOL!