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Economic Benefits of Education Investment, Measurement

ECONOMIC BENEFITS OF EDUCATION INVESTMENT, MEASUREMENT


The concept of the rate of return on investment in education is very similar to that for any other investment. It is a summary of the costs and benefits of the investment incurred at different points in time, and it is expressed in an annual (percentage) yield, similar to that quoted for savings accounts or government bonds.

Returns on investment in education based on human capital theory have been estimated since the late 1950s. Human capital theory puts forward the concept that investments in education increase future productivity. There have been thousands of estimates, from a wide variety of countries; some based on studies done over time and some based on new econometric techniques. All reaffirm the importance of human capital theory.

The rise in earnings inequality, and the subsequent increase in the returns on schooling experienced during the 1980s and 1990s in many countries, led to renewed interest in estimates of returns on educational investment. The literature suggests that systematic changes in the production process brought about by changes in technology and the growth of the knowledge-based economy whereby product cycles become shorter and flexibility is needed, led to changes in the demand for skilled labor.

An Illustration

For illustrative purposes, assume that an eighteen-year-old secondary-school graduate is driven only by monetary considerations in deciding whether or not to invest in a four-year university degree. Such a student will have to contemplate and compare the costs and benefits associated with going to college. The cost per year for tuition and other related expenses ($10,000 in this hypothetical case) is the direct cost. In addition, the student will incur an indirect (or opportunity) cost because he or she will not be able to work while attending college. This cost is approximated by what the average student with a secondary school diploma earns in the labor market, perhaps $20,000 per year. On the benefits side, the student expects to be making, on average, approximately $15,000 more than a secondary school graduate over his or her lifetime after graduating from college.

A rough way to summarize the above costs and benefits is to divide the annual benefit of $15,000 by the lump-sum cost of $120,000, yielding a 12.5 percent rate of return on investment in education. The logic of this calculation is similar to that of buying a $120,000 bond giving an annual coupon of $15,000. The yield of the bond is 12.5 percent.

Private Versus Social Costs

A very important distinction in rate of return calculations is whether one evaluates the private cost or the social cost of an education. The example given above refers to a private rate of return, where the costs are what the individual actually pays in order to receive an education. A social rate of return calculation includes, on the cost side, the full resource cost of one's education. That is, it includes not only what the individual pays, but also what it really costs society to educate one person. In most countries education is heavily subsidized, so the social cost is much higher than the private cost. The social rate of return, therefore, is typically less than the corresponding private rate of return.

Beyond the above monetary calculations used to arrive at a private rate of return, the social rate of return should ideally include the externalities associated with education. This is, of course, extremely difficult to measure, and the issue of externalities has remained a qualification accompanying rate of return estimatesin the sense that such rates, as conventionally computed on the basis of monetary earnings and costs, must underestimate the true social return on investment in education.

The earnings of educated individuals do not reflect the external benefits that affect society as a whole. Such benefits are known as externalities or spillover benefits, since they spill over to other members of the community. They are often hard to identify and even harder to measure. In the case of education, some studies have succeeded in identifying positive externalities, but few have been able to quantify them. If one could include externalities, then social rates of return might well be higher than private rates of return on education.

Empirical Findings

Typically, returns on educational investment are higher at lower levels of schooling and also higher for countries at lower levels of economic development. The scarcity of human capital in low-income countries provides a significant premium to investing in education. The high returns on primary education provide an added justification for making education a priority in developing countries.

In low-income countries, the returns are high, as can be seen in Table 1, which presents an illustrative summary of typical rates of return. Estimates of rates of return over a range of country types show the usual pattern most researchers find. For low-income countries, rates of return can be as high as 12 percent or more. In middle-income countries similar estimates can be found. In many eastern European transition economies, returns are relatively low, but rising. In high-income countries, rates of return on education tend to be lower than in lower-income countries. However, during the 1980s and 1990s returns on schooling increased in these countries, especially in the United States.

Private rates of return are higher than social returns. This is because of the public subsidization of education and the fact that typical social rate of return estimates are not able to include social benefits. Nevertheless, the degree of public subsidization increases with the level of education, which has regressive policy implications. Illustrative rates of return for a variety of countries are shown in Table 2. Higher education remains a profitable investment for individuals in high-income countries, as represented by the private rate of return. There is an even greater private incentive to invest in education in middle- and low-income countries. In these countries the social returns on education are particularly high, signaling a priority investment for society.

Overall, women receive higher returns on their schooling investments, though the returns on primary education are much higher for men (20%) than for women (13%). Women experience higher returns on secondary education (18% versus 14%, respectively).

The highest returns on a per-country basis are recorded for low- and middle-income countries. Overall, the average rate of return on another year of schooling is about 10 percent. From 1990 to 2002, average returns on schooling have declined by 0.6 percent. At the same time, average schooling levels have increased. Therefore (and according to human capital theory), everything else being the same, an increase in the supply of education has led to a slight decrease in the returns on schooling. That is, if there are no "shocks,"such as changes in technologythat increase the demand for schooling, then an increase in overall school levels should lead to a decrease in the returns of schooling. Over the recent decades the returns to schooling have declined in many low income countries, while the technological revolution has increased demand for skilled labor in developed countries and the returns to schooling have increased.

Estimation Issues

Ideally, a rate of return on investment in education should be based on a representative sample of a country's population. But in reality this is the exception rather than the rule. It is problematic when the estimated rates of return are based on a survey of firms (rather than households), because firm-based samples are highly selective. In order to control survey costs, such samples focus on large firms with many employees. Second, the questionnaire is typically filled out by the payroll department rather than by the individual employee. This approach leads to the use of samples concentrated only in urban areas.

Another problem occurs when rate-of-return estimates are based on samples that include civil servants, since public-sector wages, in most cases, do not reflect market wages. Of course, in many countries (although fewer than in the past) the majority of graduates end up in public-sector employment.

The concentration of graduates in public-sector employment is identified as a problem in major growth studies. However, rate-of-return estimates based on civil-service pay are useful in private calculations regarding the incentives set by the state to invest in education.

A less serious problem occurs when wage effects are confused for returns on investment. Jacob Mincer has provided a great service and convenience in estimating returns on educational investment by means of the well-known earnings function he first put forward that explains differences in earnings among individuals according to their differences in schooling attainments and work experience.

Another methodological limitation is that many researchers feel obliged to include in the regression whatever independent variables they seem to have in the data set, including occupation. In effect, this procedure leads to those other variables taking away a significant part of the effect of education on earnings that comes from occupational mobility.

Perhaps the returns on education estimates that stem from the work of Ashenfelter and colleagues using twins, and other natural experiments, are the most reliable of all. According to this work, the overall private rate of return on investment in education in the United States is of the order of 10 percent, and this figure establishes a benchmark for what the social rate of return would be (a couple of percentage points lower, if not adjusted for externalities), or what the rate of return should be in a country with a lower per capita income than the United States (several percentage points higher, as based on the extrapolation of the noncomparable returns on education presented earlier).

Extensions

More research on the social benefits of schooling is needed. For developing countries, there is a need for more evidence on the impact of education on earnings using a quasi-experimental designfor example, looking at the earnings of different groups, say those exposed to a special training program and those who are not; or children who received early interventions such as nutrition and those who did not. There are more opportunities in the early twenty-first century for this type of research. Moreover, this research needs to be used to create programs that promote investment and reform financing mechanisms.

TABLE 1

There is a concern in the literature with social rates of return that include true social benefits, or externalities. Efforts to make such estimates are numerous, but the estimates vary widely. If one could include externalities, then social rates of return may well be higher than private rates. Richard Venniker's 2000 review found that empirical evidence is scarce and inconclusive, providing some support for human capital externalities (though this support is not very strong and has been disputed). These studies estimate externalities in the form of an individual's human capital enhancing the productivity of other factors of production through channels that are not internalized by the individual (similar to Lucas's 1998 theory). As Venniker states, the evidence is not unambiguous. In fact, some estimates give negative values, while others give very high estimates.

A few studies in Africa have focused on estimating external benefits of education in agriculture using the education of neighboring farmers. A one-year rise in the average primary schooling of neighboring farmers is associated with a 4.3 percent rise in output, compared to a 2.8 percent effect of one's own primary education in Uganda. Another study found that neighboring farmers' education raises productivity by 56 percent, while one's own education raises productivity by only 2 percent in Ethiopia; however, the 56 percent figure seems rather high. Overall, the results are inconclusive.

TABLE 2

Not only has the academic literature on returns on schooling increased, both in quantity and quality, but the policy implications have changed as well. Returns on education are no longer seen as prescriptive, but rather as indicators, suggesting areas of concentration. A good example is the impact of technology on wage differentials, which has led to a huge literature on changing wage structures.

At the same time, the importance of returns on education is seen in their adoption as a key indicator by the Organisation for Economic Co-operation and Development (OECD) in their annual Education ata Glance series and other policy documents. Increasingly, governments and other agencies are funding studies of returns on education, along with other research, to guide macro-policy decisions about the organization and financing of education reforms. This was the case in the United Kingdom higher education reforms as well as the Australian highereducation financing reforms.

Innovative use of rate-of-return studies is being used to both set overall policy guidelines and to evaluate specific programs. Examples include the Indonesia school building program, India's Operation Blackboard project, and Ethiopia's major sector investment program.

Above all, returns on investment in education are a useful indicator of the productivity of education, and they serve as an incentive for individuals to invest in their own human capital. As such, they can play an important role in the design of policies and the crafting of incentives that both promote investment and ensure that low-income families make an investment in education.

See also: Decision-Making in Developing Nations, Applying Economic Analysis to; International Education Statistics.

bibliography

Appleton, Simon. 2000. "Education and Health at the Household Level in Sub-Saharan Africa." Center for International Development Working Paper No. 33. Cambridge, MA: Harvard University.

Ashenfelter, Orley, and Krueger, Alan B. 1994. "Estimates of the Economic Return on Schooling from a New Sample of Twins." American Economic Review 84 (5):11571173.

Ashenfelter, Orley, and Rouse, Cecilia E. 1998. "Income, Schooling, and Ability: Evidence from a New Sample of Twins." Quarterly Journal of Economics 113:253284.

Becker, Gary S. 1964. Human Capital: A Theoretical and Empirical Analysis. New York: National Bureau of Economic Research.

Card, David. 2001. "Estimating the Return on Schooling: Progress on Some Persistent Econometric Problems." Econometrica 69 (5):11271160.

Duflo, Esther. 2001. "Schooling and Labor Market Consequences of School Construction in Indonesia: Evidence from an Unusual Policy Experiment." American Economic Review 91 (4):795813.

Haveman, Robert H., and Wolfe, Barbara. 1984. "Schooling and Economic Well-Being: The Role of Non-Market Effects." Journal of Human Resources 19 (3):128140.

Krueger, Alan B. 1993. "How Computers Have Changed the Wage Structure: Evidence from Microdata, 19841989." Quarterly Journal of Economics 108 (1):3360.

Lucas, Robert E. 1988. "On the Mechanics of Economic Development." Journal of Monetary Economics 22:322.

Murphy, Kevin, and Welch, Finis. 1992. "The Structure of Wages." Quarterly Journal of Economics 107:285326.

Organisation for Economic Co-operation and Development. 1997. Human Capital Investment: An International Comparison. Paris: Organisation for Economic Co-operation and Development.

Organisation for Economic Co-operation and Development. 2001. Education at a Glance: OECD Indicators 2001. Paris: Organisation for Economic Co-operation and Development.

Organisation for Economic Co-operation and Development. 2001. Education Policy Analysis 2001. Paris: Organisation for Economic Cooperation and Development.

Pissarides, Christopher A. 2000. Human Capital and Growth: A Synthesis Report. Paris: OECD Development Centre.

Psacharopoulos, George. 1973. Returns on Education: An International Comparison. Amsterdam: Elsevier.

Psacharopoulos, George. 1985. "Returns on Education: A Further International Update and Implications." Journal of Human Resources 20 (4):583604.

Psacharopoulos, George. 1994. "Returns on Investment in Education: A Global Update." World Development 22 (9):13251343.

Psacharopoulos, George, and Patrinos, Harry Anthony. 2002. Returns on Investment in Education: A Further Update. Washington, DC: World Bank.

Weisbrod, Burton A. 1964. External Benefits of Education. Princeton, NJ: Princeton University, Industrial Relations Section.

World Bank. 1998. Ethiopia: Education Sector Development Program. Report No. 17739-ET. Washington, DC: World Bank.

internet resource

Venniker, Richard. 2001. "Social Returns on Education: A Survey of Recent Literature on Human Capital Externalities." A CPB (Netherlands Bureau for Economic Policy Analysis) Report. <www.cpb.nl/eng/cpbreport/2000_1/s3_4.pdf>.

Harry Anthony Patrinos

George Psacharopoulos

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Externality

Externality

BIBLIOGRAPHY

The term externality originated in economics, but it is now widely used in the social sciences and the popular press. In economics it is defined as: (1) benefits or costs of an economic activity that spill over to a third party (e.g., pollution is a negative spillover, while a positive spillover would occur when neighborhood property values are enhanced by the restoration of a rundown house; (2) an incidental effect produced by economic activities, but that does not enter the cost or benefit decisions of either buyer or seller; (3) uncompensated benefits (costs) to others as a result of an action taken by an economic unit; (4) any cost or benefit generated by one agent in either production or consumption activities that also affects another agent in the economy.

The economist Ronald Coase (1960) suggests that externalities are reciprocal, and that it is a case of selective perception to say that A harms B rather than B harms A. Hence, the idea that pollution is a spillover and an incidental outcome seems misplaced. Take the production of steel for example. The recipe for steel includes iron ore, coke, labor, and blast furnaces. Also necessary is a place to put the waste, either on the land or in the atmosphere as a pollutant, as well as a warehouse to store the steel until it is to be used. One of these items is no more incidental than another, and any industrial engineer would know all the ingredients. Is the cost of the waste storage accounted for by the market? How is the cost of labor accounted for? The steel producer would not pay for labor if there were not a prohibition against slaverythat is, if people did not own their labor power. If a producer does not own a necessary ingredient to its production, it must be bought in the market. If it is already owned, the owner will consider its opportunity cost, or what it could be sold to others for. This is true of iron ore and labor as much as for a place to put the waste. An owner of the atmosphere, whether it be a steel company or the general public, may submit a bid to the company, and if the bid does not exceed its value in use for producing steel, the company will use it. This is how any resource input is accounted for.

Does the action to use an owned resource taken by the steel company produce an uncompensated cost (or benefit) for others? None could be expected if the resource is owned by the steel company. Thus, if the steel company uses its land for a blast furnace, farmers could not expect to be compensated for the land not being used for agriculture. If a farmer has a better use for the land, then a bid can be made for the resource. The issue then boils down to who owns the resource. To own is to deny opportunities to others who need the resource; to own is to coerce and visit uncompensated lost opportunities on nonowners; and to own is be the recipient of bids, not the payer of compensation to others. The ability of an owner to withhold what others need is the source of all income.

In a world of scarcity, any production or consumption activity affects another agent in the economy. The policy issue concerns who is the buyer and who is the seller of any contested economic opportunity. In the words of Coase, externalities are reciprocal. If A owns, it harms B, but if B owns, it harms A. Externalities are ubiquitous. They are the stuff of human interdependence. The term externality might be usefully replaced by interdependence, with nothing inherent in the term implying who should own or who should do without if they cannot make an attractive bid to the owner.

What about transaction costs? Given resource ownership, there may be buyers who are willing to meet the reservation price of sellerowners. Their potential bids may nevertheless be overcome by transaction costs and therefore rejected by the owners. The opportunity for a mutually beneficial trade may be lost. The most common example of transaction costs defeating a potential bid occurs in the case of high exclusion cost goodsthose goods which if they exist for one person are available to all. This is sometimes called a market failure, and the inefficiency is often used to justify public taxation (or regulation), perhaps to buy out owners now using the atmosphere as a place to put waste. Those opposed to a role for government in such goods argue that governments may also fail to do the right thing (if that can be agreed on).

New interconnections in the economy are constantly being brought to peoples attention through new technology. No one worries whether a person has a particular opportunity to use or exchange an opportunity when that person does not have the ability to affect others. For example, no one worried about air rights before the Wright brothers. But then the issue arose as to who owned the air above the land. The interdependence between landowners and airlines became evident, and the question of ownership arose. Each wanted to be declared the owner, and to be entitled to compensation for any lost opportunity. The effect of each persons use on the other is not incidental. Who should compensate whom is the issue. There is nothing in nature or economics that dictates the outcome of this contest. Cost is not independent of rights when the willingness to pay and the willingness to sell differ. Nations gave ownership to the airlines, and the landowners could not enjoin their use. If this had not been the case, the airline industry would have followed a different growth path. Later, as noise became as issue, regulations set a maximum for noise near airports. These regulations in effect gave ownership of some aspects of the atmosphere to those living near airports. Public choice of ownership, whether implemented by taxes, fees, or liability rules, determines what kind of world we live in.

Externality just points to the interconnections in any economy that might be better understood by referring to the connections as interdependencies, without any presumed policy conclusion. The interdependencies are sorted out by formal and informal institutions serving as property rights (ownership) and determining use or exchange opportunities (who has to buy what from whom). Changing ownership can change what is efficient.

SEE ALSO Overfishing; Tragedy of the Commons; Transaction Cost

BIBLIOGRAPHY

Coase, Ronald H. 1960. The Problem of Social Cost. Journal of Law and Economics 3 (1): 144.

Samuels, Warren J. 1992. Essays on the Economic Role of Government. Vol. 1. New York: New York University Press.

Schmid, A. Allan. 2004. Conflict and Cooperation: Institutional and Behavioral Economics. Oxford: Blackwell.

A. Allan Schmid

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Externalities

EXTERNALITIES


Externalities are economic benefits or costs that affect people who are not directly part of an economic activity. In a way externalities can be thought of as economic "black holes" that have economic effects that are hard to determine because so many people are affected indirectly. For example, if a chemical company has to store all its manufacturing waste in metal drums, it will incur the cost of buying the drums, putting the waste into the drums, and allocating the land to store the drums. Because this will be expensive the company may have to cut back on its production to keep its waste disposal costs under control, thus losing profits. If the company simply dumps its waste into a nearby river, however, its waste disposal costs would be smaller. From the standpoint of the company there is greater economic incentive to pour the waste into the river than to store it in drums, but to the people who live along that river, the company's waste will become a major environmental hazard. This is a "negative externality": a collision of the "private benefit" of one party (the company that pollutes) with the "public cost" to society. To prevent the company from polluting the river, the people must force it to do something detrimental to its profits. Since the company has an economic incentive to continue polluting, the people must convince the company to change its policy by boycotting its products or by passing legislation against pollution.

An example of a "beneficial externality" is a company that hires and trains unskilled workers when it would be more efficient and profitable to hire trained workers. The company incurs a "private cost" (the expense of training unskilled people) and provides society with a "public good" (employed people learning new skills). Since society gains more skilled and employed workers at the company's expense, it is an externality that is beneficial to the economy as a whole, but it is difficult to measure.

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externality

externality, externalities In economic theory it is generally recognized that some of the costs and benefits of economic activities (production, exchange, and the like) are not reflected in market prices. So, for example, air pollution caused by the activity of a company may be experienced as a cost by local residents or by society as a whole, but since clean air does not figure in the costs of production as calculated by the company, the latter has no incentive to reduce its polluting activity. Such costs and benefits which are not expressed in market prices are termed ‘externalities’. Policy problems implicit in social and environmental externalities in market economies are conventionally addressed by economists in the form of strategies for assigning market values to non-market variables and so ‘internalizing’ them, for example through taxation of pollution or scarce-resource use. Recent developments in environmental economics tend to exhibit the limitations of the concept of externality in the face of the systemic character of environmental-economic interactions (see, for example, E. B. Barbier Economics, Natural-Resource Scarcity and Development, 1989
).

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Externality

Externality


Most economists argue that markets ordinarily are the superior means for fulfilling human wants. In a market, deals are ideally struck between consenting adults only when the parties feel they are likely to benefit. Society as a whole is thought to gain from the aggregation of individual deals that take place. The wealth of a society grows by means of what is called the hidden hand of free market mechanisms, which offers spontaneous coordination with a minimum of coercion and explicit central direction. However, the market system is complicated by so-called externalities, which are effects of private market activity not captured in the price system.

Economics distinguishes between positive and negative externalities. A positive externality exists when producers cannot appropriate all the benefits of their activities. An example would be research and development, which yields benefits to society that the producer cannot capture, such as employment in subsidiary industries. Environmental degradation , on the other hand, is a negative externality, or an imposition on society as a whole of costs arising from specific market activities. Historically, the United States have encouraged individuals and corporate entities to make use of natural resources on public lands, such as water, timber, and even the land itself, in order to speed development of the country. Many undesirable by-products of the manufacturing process, in the form of exhaust gases or toxic waste, for instance, were simply released into the environment at no cost to the manufacturer. The agricultural revolution brought new farming techniques that relied heavily on fertilizers, pesticides, and irrigation , all of which affect the environment. Automobile owners did not pay for the air pollution caused by their cars. Virtually all human activity has associated externalities in the environmental arena, which do not necessarily present themselves as costs to participants in these activities. Over time, however, the consequences have become unmistakable in the form of a serious depletion of renewable resources and in pollution of the air, water, and soil . All citizens suffer from such environmental degradation, though not all have benefited to the same degree from the activities that caused them.

In economic analysis, externalities are closely associated with common property and the notion of free riders . Many natural resources have no discrete owner and are therefore particularly vulnerable to abuse. The phenomenon of degradation of common property is known as the Tragedy of the Commons . The costs to society are understood as costs to nonconsenting third parties, whose interests in the environment have been violated by a particular market activity. The consenting parties inflict damage without compensating third parties because without clear property rights there is no entity that stands up for the rights of a violated environment and its collective owners.

Nature's owners are a collectivity which is hard to organize. They are a large and diverse group that cannot easily pursue remedies in the legal system. In attempting to gain compensation for damage and force polluters to pay for their actions in the future the collectivity suffers from the free rider problem. Although everyone has a stake in ensuring, for example, good air quality , individuals will tend to leave it to others to incur the cost of pursuing legal redress. It is not sufficiently in the interest of most members of the group to sue because each has only a small amount to gain. Thus, government intervention is called for to protect the interests of the collectivity, which otherwise would be harmed.

The government has several options in dealing with externalities such as pollution. It may opt for regulation and set standards of what are considered acceptable levels of pollution. It may require reduced lead levels in gasoline and require automakers to manufacture cars with greater fuel economy and reduced emissions, for instance. If manufacturers or social entities such as cities exceed the standards set for them, they will be penalized. With this approach, many polluters have a direct incentive to limit their most harmful activities and develop less environmentally costly technologies. So far, this system has not proved to be very effective. In practice, it has been difficult (or not politically expedient) to enforce the standards and to collect the fines. Supreme Court decisions since the early 1980s have reinterpreted some of the laws to make standards much less stringent. Many companies have found it cheaper to pay the fines than to invest in reducing pollution. Or they evade fines by declaring bankruptcy and reorganizing as a new company.

Economists tend to favor pollution taxes and discharge fees. Since external costs do not enter the calculations a producer makes, the producer manufactures more of the good than is socially beneficial. When polluters have to absorb the costs themselves, to internalize them, they have an incentive to reduce production to acceptable levels or to develop alternative technologies. A relatively new idea has been to give out marketable pollution permits. Under this system, the government sets the maximum levels of pollution it will tolerate and leaves it to the market system to decide who will use the permits. The costs of past pollution (in the form of permanent environmental damage or costly cleanups) will still be borne disproportionately by society as a whole. The government generally tries to make responsible parties pay for clean-ups, but in many cases it is impossible to determine who the culprit was and in others the parties responsible for the pollution no longer exist.

A special case is posed by externalities that make themselves felt across national boundaries, as is the case with acid rain , ozone layer depletion , and the pollution of rivers that run through more than one country. Countries that suffer from environmental degradation caused in other countries receive none of the benefits and often do not have the leverage to modify the polluting behavior. International conservation efforts must rely on agreements specific countries may or may not follow and on the mediation of the United Nations.

See also Internalizing cost; Trade in pollution permits

[Alfred A. Marcus and Marijke Rijsberman ]


RESOURCES

BOOKS

Mann, D., and H. Ingram. "Policy Issues in the Natural Environment." In Public Policy and the Natural Environment, edited by H. Ingram and R. K. Goodwin. Greenwich, CT: JAI Press, 1985.

Marcus, A. A. Business and Society: Ethics, Government, and the World Economy. Homewood, IL:. Irwin Press, 1993.

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Externality

Externality

What It Means

An externality is a side effect of any market activity (an activity related to the buying and selling of goods and services) that either harms or benefits a third party not involved in that particular activity. For instance, a paper mill may pollute the air around its site, but this is not factored into the price of the paper that is ultimately sold. Neither the producer nor the buyer of the paper bears the costs related to the pollution. Instead, the people who live near the paper mill bear these costs, some of which may be economic costs (doctor’s bills for lung ailments) and some of which may be difficult to quantify in terms of money (an unpleasant smell that disrupts children’s outdoor playtime). Such pollution would be called a negative externality.

Economic activity also frequently results in positive externalities. When one person in a neighborhood renovates her home, for example, she obviously increases the market value of her own property. But she also increases, to some degree, the value of other homes in the neighborhood and the feelings of well-being that neighborhood residents experience because of the improved appearance of the house and area.

Externalities that harm a third party are called negative externalities or third-party costs; externalities that benefit a third party are called positive externalities or third-party benefits. The phrase “spillover effect” is also frequently used interchangeably with “externality,” because an externality spills over the boundaries of a buyer-seller transaction to affect uninvolved people.

For economists, both positive and negative externalities represent market inefficiency and are thus potential flaws in the theory, widely accepted in the world of economics, that markets generally achieve maximum economic efficiency. There is no single answer, however, as to how or whether externalities should be addressed.

When Did It Begin

The positive and negative side effects of business activity have no doubt always existed, but negative externalities in particular began increasing exponentially in the nineteenth century as a result of the Industrial Revolution.

The Industrial Revolution was the dramatic shift (made possible by new technologies such as coal-burning steam engines and new techniques for manufacturing textiles and steel) in Western Europe and North America from societies dominated by agriculture and manual labor to societies dominated by mechanized industrial production. In addition to reshaping society at every level, the industrial advances of this time enabled businesses to produce goods on a much larger scale than ever before. The greatly increased production benefited people in countless ways and made possible the development of modern capitalism (a system in which private individuals, not the government, own businesses). It also led, however, to a dramatic increase in negative externalities such as pollution and the depletion of natural resources. These externalities multiplied during the twentieth century, as populations grew and new technologies made possible ever-greater increases in production.

The British economist Alfred Marshall (1842–1924), author of the most widely used economics textbook of his time, Principles of Economics (1890), first theorized that there might be externalities (or external costs) that are not accounted for by the price system. One of Marshall’s students at the University of Cambridge, Arthur Pigou (1877–1959), developed Marshall’s idea further in his book The Economics of Welfare (1920).

More Detailed Information

The fundamental concept of all economic theory is the notion that supply, demand, and prices work together to coordinate economic activity. The law of demand dictates that as the price of a given product rises, consumers become less and less likely to buy that product; and the law of supply dictates that as the price of a product rises, sellers will be willing to sell more and more of that product. In a market, where buyers and sellers freely interact with one another, these opposing laws will result in a balancing of the desires of each side. By trial and error, the price of any product eventually reaches an equilibrium point, a point at which sellers will provide exactly as much of a given product as buyers want to buy. According to economic theory, such efficiency is most easily produced by markets.

Consider the example of the paper mill again. The paper company and its consumers, according to the laws of supply and demand, would (after a process of trial and error) collectively arrive at the equilibrium price for paper, the price at which the forces of supply and demand are equal. Exactly the amount of paper that consumers require is produced, and exactly the amount of paper that the company is willing to supply is produced. This process represents the most efficient allocation of resources possible, according to supply-and-demand theory.

But in actuality, society at large will have to bear the costs of the pollution (for instance, as medical bills, as loss of property value, and as the natural resource of clean air), so the price that society pays for the paper is actually higher than what the paper company is charging. By failing to take into account the externalities of their transaction, the paper mill and paper consumers have arrived at a false equilibrium price. A correct determination of the equilibrium price would have taken the potential costs of pollution into account, but the pricing system alone cannot do this.

This situation, in which a market has failed to produce maximum efficiency, is called market failure. Economists believe that market failure also occurs when positive externalities are not integrated into the pricing system. In the case of renovating properties, the woman who improves her property increases the value of her neighbors’ properties without being directly compensated for this service; although she might have strong motivations for continuing to keep her property in good condition, she would be more likely to do so if the market supplied her with a direct economic incentive. Likewise, her neighbors are less likely to maintain their own houses than they would if they had a clear economic incentive for doing so. The market supplies no reliable mechanisms for encouraging people to maintain their houses’ appearance, so there will always be more demand for this activity than there will be residents willing to supply it.

Economists sometimes speak of the presence of externalities in terms of the private cost vs. the social cost of a good. If, for example, you buy a car, the purchase price of your car, together with your gasoline and other maintenance costs, represent the car’s private cost. The total cost to society of your car-related purchases, however, is greater than the price you pay to the dealer and service-station owners. Driving your car results in pollution that can cause health problems for people uninvolved in the purchase of your car, and that contributes to global warming, which scientists and economists expect to impose severe costs on society and the economy. Cars also cause traffic. Traffic imposes costs on the government (such as increases in the size of the police force), and traffic also cuts into the profits of businesses whose delivery drivers and office workers spend time in traffic jams instead of using that time to generate revenue for the company. A more general cost of traffic is that it decreases the well-being of all the individual drivers who endure it. These negative externalities represent real costs to society, even though they can be hard to calculate in dollar amounts. Adding the external costs of your car (the costs of the externalities) to the private cost of your car yields the overall price paid by you and society for your car. This total price is called the social cost.

Arthur Pigou, who pioneered the concept of social vs. private costs, argued that governments should intervene to correct the gap between these costs. In the case of negative externalities, such as pollution, Pigou recommended that the government tax the industries involved. In the case of positive externalities, he recommended that the government subsidize (or pay part of the manufacturing costs of) the industries involved. This would promote social well-being, but it would do so, in theory, by increasing economic efficiency.

Recent Trends

In the case of both negative and positive externalities, part of the reason that market solutions are not readily available is that it is often difficult, if not impossible, to estimate the cost that negative externalities inflict on people and the gains that people enjoy because of positive externalities. The court system today is full of individual citizens demanding payment for the costs (some economic and some harder to quantify) of negative externalities. Likewise, governments often try to correct the market inefficiencies created by externalities; they can do so by taxing activities that generate negative externalities (which increases companies’ production costs and therefore theoretically spurs cuts in supply), subsidizing activities that generate positive externalities (money to help cover expenses, which decreases production costs and therefore theoretically spurs increases in supply), and putting in place other laws.

The U.S. government, for instance, regulates pollutants expelled by factories by imposing fines if pollution rises above certain levels. The effectiveness of these regulations is often contested, however. Some of the worst air polluters in the country find it less expensive to pay the fines imposed by the government than to update their equipment and thus cut pollution. Their payments of fines may technically bring about a balancing of supply and demand by factoring in the costs of externalities, but their actions arguably do little to repay the public for the costs they must bear as a result of the pollution.

Meanwhile, some economists question whether government intervention can ever rectify market inefficiency, because government workers are not able to process nearly as much information as can decentralized markets governed by the laws of supply and demand. Further, these economists argue, even the most efficient government involvement results in added costs (of hiring regulators, processing paperwork, and enforcing new rules, for instance) that might ultimately outweigh any balancing out of supply and demand.

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