*** Long Post ***

*** This post defines and clarifies the nature of an economic
externality ***

--

Dear Amanda,

Thanks for your response. I appreciate your attempt to clarify these
issues.

Jurgen’s note reminds me that I planned to respond with respect to
Michel Callon’s work. It’s not possible to use Callon or
Actor-Network Theory for economic analysis. The problem is that Michel
Callon does not understand what externalities are. 

Callon writes: “What economists say when they study externalities is
precisely that this work of cleansing, of disconnection, in short of
framing, is never over and that in reality it is impossible to take it
to a conclusion. There are always relations which defy framing. It is
for these relations which remain outside the frame that economists
reserve the term externalities” (Callon 1999, 188).

Economists do not speak of externalities in this way. Externalities are
not outside the frame of economic analysis. Externalities are situations
where a transaction imposes a cost or delivers a benefit to a third
party who was not part of the transaction that caused the problem.

Here is an example. The manufacturer of Hi-Tech Zing locates a factory
near the border of Laissez-Fair Nation, a country with lax pollution
controls. The factory is located on the Zeeb River, a river that flows
into Responsible Country, an environmentally aware nation where all
manufacturers must bear the costs of environmental responsibility. The
Hi-Tech Zing plant produces an astonishing array of fabulous,
high-priced products that sell extremely well. The plant grows far
beyond its original capacity, and releases tons of pollutants. These
pollutants do not go upstream into Laissez-Faire Nation, but downstream
where they wreak havoc, causing health problems, and destroying the
once-prosperous fish industry. Responsible Country did not grant
permission for Hi-Tech Zing’s operations, and this would not be
permitted in Responsible Country. Nevertheless, the citizens of
Responsible Country are forced to pay the price for a series of
transactions taking place to the benefit of people in Laissez-Faire
country. This is an externality.

Externalities often occur at the borders of jurisdictions, when, for
example, one nation dams a river to the disadvantage of another nation
downstream.

Economists know what externalities are, and externalities lie within
the frame of economic modeling. The problem is that externalities occur
where parties to a transaction exploit the border of legal or political
frames. In some cases, of courses, externalities occur when people cause
unplanned effects. This can also happen within jurisdictions, and this
is when economists are called on as expert witnesses in the effort to
determine who should pay for what. 

There is an ambiguity in the selection you have taken from Callon, of
course. If you read it one way, Callon seems to say that there are
always externalities, suggesting that economists agree with this and
accept that this is the price of economic analysis. It was this reading
that you seemed to apply in your earlier post with the comment that
economists seem to “decontextualize, dissociate, detach and
disentangle.” The other reading is that economists work to create
better models, and in doing so, they continually engage in the work of
framing. In that reading, of course, the purpose is quite different: to
do this, an economist must place things in context, associate them
properly, link them in relevant models, and engage them in clear
relations while disentangling confusing or irrelevant data.

This is what economists do when they create economic models. The point
of an economic model is to demonstrate and explain the phenomena we
observe. If we observe adverse effects that we cannot explain, we’ve
got to reframe the model to account for the effects. Economists are
always trying to account for new phenomena, or trying to account for
phenomena in more robust ways, the work of framing is never done.

But an externality is not a black box that lies outside the frame. An
externality is something we can account for. It occurs when someone who
is not party to a transaction is forced unwillingly or unwittingly to
pay part of the price of a transaction that benefits the willing
parties. Economists describe and analyze externalities to bring them
within the frame.

Now there is one technical aspect of economic description that
sometimes puzzles people, and this is the relation of externalities to
markets and prices.

The Oxford English Dictionary defines economic externality this way:
“A side-effect or consequence (of an industrial or commercial
activity) which affects other parties without this being reflected in
the cost of the goods or services involved; a social cost or benefit.
Cf. ”

What this really means is simple. 

Let’s imagine that the manufacturer in our example in our example
makes a product they can sell direct to each customer so that the only
costs are production and delivery. Because Hi-Tech Stuff is located in
Laissez-Faire Nation, they have nearly no costs for environmental
protection. As a result, it costs $75 per unit to make and deliver a
product they sell for $500. The profit is huge, $425 per unit. Hi-Tech
Stuff sells 100,000 units a year for a profit of more than $42,500,000.

If Hi-Tech Stuff were located in Responsible Nation, the costs of
sustainable manufacturing and environmental protection would double the
per unit cost to $150. Let’s say that the market will nevertheless pay
no more than the same $500 per unit. This would mean $300 profit per
unit. On annual sales of 100,000 units, the company would make
$30,000,000 profit.

In this example, the difference of $12,500,000 is profit to Hi-Tech
Stuff. But this profit to the company is not reflected in the cost. This
profit is therefore an externality “which affects other parties
without this being reflected in the cost of the goods or services
involved.” There are other costs as well – the health costs in
Responsible Nation go up, the costs to the fishing industry are immense.
Individuals, businesses, and government in Responsible Nation pay these
costs. Given the nature of pollution, this may mean that total costs far
exceed the cost of environmental protection. If the company were in
Responsible Nation, everyone would agree that the $12,500,000 in
environmental safety is a lower cost than the cost to health,
environmental damage, and the loss of the fishing industry. The problem
is that Hi-Tech Stuff is located upstream.

Problems such as externalities and spillovers are problematic precisely
because it’s cheaper to off-load high costs onto someone else than to
accept a responsible low cost to prevent the externality. 

Let me give you an example of a classic spillover effect. Many
organizations in the era of high telephone costs placed tight limits on
long-distance telephone usage. In some cases, of course, the limits were
too tight, and these prevented people from making necessary calls. When
the first telefax machines came into use, people soon discovered that
every fax machine had a handset. Because telefax machines were nearly
always used for long-distance transmission, fax lines were not subject
to long-distance restrictions. As people discovered this, the telefax
machine became the de facto long-distance phone booth for employees who
had a difficult time getting a line. Other spillovers followed from
this. Employees who use their own phones for long distance calling
generally demonstrate responsible usage patterns. From the telefax,
however, no one could know who it was that was calling. The first
spillover often led to a second spillover, and employees in many firms
began using the telefax machine for personal long-distance calling that
could not be traced to them without far higher investigation costs on
every call. This is another kind of externality.

In this case, the firm bears the costs of a personal transaction
unrelated to company business. We also see this phenomenon when
executives with access to the corporate jet use the jet for private
vacation trips. This range of externalities is related to the Tragedy of
the Commons, where an individual profits by forcing others to bear the
costs of a market transaction. It is less expensive for the individual,
despite the fact that it ultimately destroys the very basis on which the
market is built, at least in local terms. One of the problems of a naïe
belief in “the magic of the market” is that powerful businesses
often find ways to exploit externalities, and some even find ways to
create externalities for the purpose of exploiting them. When this
happens, price mechanisms do not recognize or signal true costs. This
leads to magical markets for those who expropriate the positive effects
of an externality and damaging costs for those who are exploited.

This is why externalities are important to economists. The Economist
defines an externality as: “An economic side-effect. Externalities are
costs or benefits arising from an economic activity that affect somebody
other than the people engaged in the economic activity and are not
reflected fully in . For instance, smoke pumped out by a factory may
impose clean-up costs on nearby residents; bees kept to produce honey
may pollinate plants belonging to a nearby farmer, thus boosting his
crop. Because these costs and benefits do not form part of the
calculations of the people deciding whether to go ahead with the
economic activity they are a form of , since the amount of the activity
carried out if left to the free market will be an inefficient use of
resources. If the externality is beneficial, the market will provide too
little; if it is a cost, the market will supply too much.” 

For most economists, externalities represent serious problems. An
economist who fails to understand and attend to externalities is
incompetent. 

Serious economists do not “maintain their ‘claims to truth’ by
treating all the problematic bits as externalities - they
‘decontextualize, dissociate, detach and disentangle’.” To be
do serious economics, one must place things in context, associate them
properly, link them in relevant models, and engage them in clear
relations while disentangling confusing or irrelevant data. This is the
foundation of good economic modeling.

You can’t use Actor-Network Theory to understand economic models. ANT
theorists just don’t understand economists. This isn’t to say that
economists get everything right. There are problems with many approaches
to economic analysis, and we’ve also made a lot of progress in
modeling over the past few centuries.

To respond to the final section in your note, I have been trying to get
the Bagwell article to look at it again. Now I’m experiencing a
glitch. I’ve asked the library to get me a hard copy, and when it
does, I will respond. It is possible to do responsible economic analysis
without worrying about what we sometimes call the laws of the market. We
are speaking of three very different kinds of laws: 1) the law-like
phenomena that economists attempt to understand when they examine the
properties of human economic behavior, 2) the political and legal market
structures that legislators create to govern the markets in various
jurisdictions, and 3) the loose colloquial phrase used to indicate or
describe market mechanisms.

Yours,

Ken

Professor Ken Friedman, PhD, DSc (hc), FDRS | University Distinguished
Professor | Dean, Faculty of Design | Swinburne University of Technology
| Melbourne, Australia


—snip—

.....Some well-known social science positions, for example those
attributed to actor-network theory, take the view that economic analyses
maintain their ‘claims to truth’ by treating all the problematic
bits as externalities - they ‘decontextualize, dissociate, detach and
disentangle’.  This process is necessary to make anything into a
marketable commodity.  As Michel Callon points out, in order to a
conceive of a market, its necessary to first ‘frame’ agents and
goods as distinct from one another.

“What economists say when they study externalities is precisely that
this work of cleansing, of disconnection, in short of framing, is never
over and that in reality it is impossible to take it to a conclusion.
There are always relations which defy framing. It is for these relations
which remain outside the frame that economists reserve the term
externalities” (Callon 1999, 188).

It may be that Bagwell’s chapter exemplifies this process, although I
couldn’t say, not having read it. However, from the abstract it
appears to me to supply a very useful pro-forma for constructing an
economic rationale by framing the relations necessary to an advertising
market (for which we could substitute ‘product design’). If we want
to construct a market for product design, then we need to follow the
laws of the market......

—snip—