Externalities

This article on externalities might help clarify this concept.

http://en.wikipedia.org/wiki/Externalities

"Externalities" and "effects" are not the same thing. "Externalities" are a subgroup of "effects." Every transaction has effects. We discussed this earlier in the context of opportunity cost. In a free market, the parties who agree to the transaction only do so if they belief that they will be better off. However, their can also be consequences for those who are not a party to the transaction. It is the effects of the transaction on people who are not parties to the transaction, which we call externalities.

Normally, if you are talking about a firm, the entire firm (all of its officers, employees, etc. are considered to be the firm. Thus, externalities are normally exterior to the firm itself. The exception to this rule is when you are talking specifically about different parts or the firm. For example, if a CEO negotiates a deal to accept a bribe in exchange for a deal, which is not in the interest of the firm, and this deal causes employees to lose their jobs, their loss of employment is an externality, but it is because the CEO is functioning in his own interest and not in the interest of the firm as a whole.

Why do we care about externalities? Markets are efficient, because the parties to an agreement are free to act in their own interest. Thus, they normally negotiate win-win agreement that result in a net creation of wealth. However, to the extent that third parties are affected by the decisions of others (good or bad), markets are inefficient. It the externality is positive, then society as a whole would benefit if more was produced than decision makers acting in their own interests will decide to produce. The opposite is true for negative externalities. Thus, the trick is to minimize externalities and bring them into the decision making process.

Granting people property rights can be a way to minimize externalities. For example, law can be used to create a property right which allows a certain amount of a pollutant to be released into the atmosphere. Those creating the pollution must purchase the property right. Thus, they must pay must pay the full cost of their activity. This increase in costs will cause them to produce less.

There are practical limits to this approach. It is true that we all pay for the choice that others make. We pay when we have to look at another person who purchased clothes that don't match or we sit by a person who at a meal high in garlic. We could use law to force them to pay for these bad choices. But, you can see that trying to fine tune markets in these ways creates a threat to personal liberty.

Thus, if a factory is taking years off of people's lives, we will want to use the law to force the factory to reduce its pollution or pay for the effects to third parties. We may decide that it is worth it to use law and taxpayer's money to encourage more education. But, aside from very significant externalities, the cure is worse than the disease.

		October 23, 2005 *Externalities - When Someone Else Pays the Price*
	This article on externalities might help clarify this concept. http://en.wikipedia.org/wiki/Externalities "Externalities" and "effects" are not the same thing. "Externalities" are a subgroup of "effects." Every transaction has effects. We discussed this earlier in the context of opportunity cost. In a free market, the parties who agree to the transaction only do so if they belief that they will be better off. However, their can also be consequences for those who are not a party to the transaction. It is the effects of the transaction on people who are not parties to the transaction, which we call externalities. Normally, if you are talking about a firm, the entire firm (all of its officers, employees, etc. are considered to be the firm. Thus, externalities are normally exterior to the firm itself. The exception to this rule is when you are talking specifically about different parts or the firm. For example, if a CEO negotiates a deal to accept a bribe in exchange for a deal, which is not in the interest of the firm, and this deal causes employees to lose their jobs, their loss of employment is an externality, but it is because the CEO is functioning in his own interest and not in the interest of the firm as a whole. Why do we care about externalities? Markets are efficient, because the parties to an agreement are free to act in their own interest. Thus, they normally negotiate win-win agreement that result in a net creation of wealth. However, to the extent that third parties are affected by the decisions of others (good or bad), markets are inefficient. It the externality is positive, then society as a whole would benefit if more was produced than decision makers acting in their own interests will decide to produce. The opposite is true for negative externalities. Thus, the trick is to minimize externalities and bring them into the decision making process. Granting people property rights can be a way to minimize externalities. For example, law can be used to create a property right which allows a certain amount of a pollutant to be released into the atmosphere. Those creating the pollution must purchase the property right. Thus, they must pay must pay the full cost of their activity. This increase in costs will cause them to produce less. There are practical limits to this approach. It is true that we all pay for the choice that others make. We pay when we have to look at another person who purchased clothes that don't match or we sit by a person who at a meal high in garlic. We could use law to force them to pay for these bad choices. But, you can see that trying to fine tune markets in these ways creates a threat to personal liberty. Thus, if a factory is taking years off of people's lives, we will want to use the law to force the factory to reduce its pollution or pay for the effects to third parties. We may decide that it is worth it to use law and taxpayer's money to encourage more education. But, aside from very significant externalities, the cure is worse than the disease.