Externalities

8 Economics Lessons #5

All transactions that take place in a free market are, in effect, voluntary by the parties involved in the transaction. People choose to enter a transaction and they accept the consequences of that transaction. If I go into a car dealership and purchase an automobile, it is my choice to purchase a car and it is the choice of the dealership to sell me that car. When I go to the grocery store, I choose to buy groceries and the grocery store chooses to sell them to me. This is free market economics at its most basic.

Of course, there are often effects on people who are not directly involved in a transaction. The people who are involved in the transaction consider the costs to themselves ... they don't tend to think of any external costs involved. If you purchase a huge, gas guzzling, air polluting SUV, there is an environmental cost that neither you nor the dealership have to pay. These costs, and the failure to consider them, is a failure of the free market. These costs are called externalities.

In Naked Economics, Charles Wheelan defines an externality as "the gap between the private cost and the social cost of some behavior". These effects can be positive, but there are many negative effects from externalities. These effects can threaten our safety. They can threaten our security. They can threaten the very survival of our planet. How are externalities dealt with then?

Well, the existence of negative externalities is one of the best arguments for government involvement. People choose to buy cell phones, but people who use them when driving pose a danger to other drivers. What is the only entity that can work to ensure safety when using cell phones? People choose to smoke cigarettes, but second smoke can be deadly. What is the only entity that can work to minimize an individuals exposure to second hand smoke? Many of us choose to purchase automobiles that use gas and put pollution into the air. What is the only entity that can work to force car manufacturers to create more environmentally friendly cars?

The answer is, of course, the government. The government can tax behavior that it would like to see limited. The government can issue regulations to force better behavior. The government can outlaw that which it deems dangerous. These are the necessary functions of government, and contrary to so many Republican talking points, they are in no way inconsistent with the concept of freedom in a capitalist economy.