Market Inefficiencies (Part 1): Externalities

"The free market can fix any problem".

This is a powerful saying. It's beautiful, elegant, and -best of all- requires no government intervention. If you wait long enough, the market should be able to fix any problem that young, hungry entrepreneurs set their eyes on.

There is a issue, though. Economists have known about the issue for many years. But the explanation is longer than the sentence "the free market can fix any problem", so it's easy to ignore. But if you have a few minutes and want to know hear one reason (among a few still to come), continue reading.

This is an externality. He's a pain in the ass. He shows up to parties uninvited.

Here's my definition of externalities: stuff not included in the price of a product.

Stuff is a pretty general term, so we'll get 5% more specific.

An externality is a "cost or benefit that affects a party that did not choose to incur that cost of benefit" (that's from wikipedia).

Let's think of some common examples.

• People who drive their cars up snowy mountain passes without tire chains
• Smog

Let's start something simple and common. The last one seems like a good place. Smog.

Let's imagine a world where a gallon of gas costs $2.00 (clearly not California). That's the market price. It includes all the efforts it took to drill the well, pump the oil up, refine it into gasoline and deliver it through an elaborate supply chain to your local gas station, plus a little profit for the companies involved.



As a consumer, I look at the price of a gallon of gas and ask myself "Am I getting at least $2.00 in benefit from this gallon of gas?". If the answer is yes, I go ahead and buy it. If the answer is no, I don't. And the market works efficiently because of millions of these decisions.

In this imaginary example I choose to live in a city like LA (but not in California, for consistency), where various meteorological forces cause the exhaust from my car to linger in the air around the city. Most people would agree that smog and air pollution cause lots of diseases. Let's assume the smog gets so bad that my friend Larry eventually gets unlucky and is diagnosed with lung cancer as a result of breathing in terrible air for 30 years. That sucks, hardcore.

And now Larry - or Larry's health insurance company - has to shell out $100,000 in treatments.

If the smog didn't exist, Larry might never have gotten lung cancer. So there was an EXTERNAL COST (not included in the original price of gas) to other people that I never paid when I bought my gallon of gas.

If you totaled up all the cases of lung cancer that were a result of smog in the city and then divided it by the total gallons of gas that were burned to create the smog, you might end up with a total healthcare cost per gallon of $0.02 (completely fake number, just to illustrate the idea). So if I were to pay for the benefit I got AND set aside money for Larry's future medical bills (the cost I imposed by benefitting from the gasoline),  I should have paid $2.02 for that gallon of gas.

But I didn't. Someone else ended up paying the $0.02. It doesn't sound like a lot of money. But when you see that 384,000,000 gallons of gasoline are used in the United States per day, and that the environmental costs could be much higher than $0.02 per gallon, it adds up real quick.

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Ok, so this can be hard to imagine because there's a lot of INDIRECT externalities that are hard to track. So what if we take a really short, really tangible example?

Tire chains can be bought for $10 per pair. They are required in snowy passes in the mountains to maintain traction. In a free market, the owner of a two-wheel drive Honda Civic should have the right to either buy the tire chains ($10) or suffer the consequences of getting stuck: it's up to him if he wants to take that risk.

If you've ever gotten stuck behind a Honda Civic that can't get up a snowy mountain pass, you know that the owner of the Civic's stupid decision to not buy tire chains affects more than just him. It affects you and the long line of cars behind you.



There are very tangible costs to everyone waiting for this Civic to get unstuck. Lost wages, missed meetings, lost free time, gas wasted idling, lost hours skiing, immense frustration. That person's "free market" decision to take the risk affected a huge group of people and cost the collective group much more than $10 in mental serenity. The $0 he paid was not the actual social cost of his decision (i.e. his decision wasn't cost-free just because he chose the $0 option).

In an ideal market, all of those individuals would then have a claim on the owner of the Civic for the costs imposed on them. But it is neither practical or efficient for everyone in their cars to sue him for (for example) $15 each. The government, recognizing these costs and the failure of the market to compensate, steps in and regulates the road: Use tire chains or face a $100 fine. That $100 fine, in some ways captures a portion of the external (negative) value imposed on society by the inefficiency (or non-existence) of the market for snowy hill lawsuits and tire chains.

The list of activities that include externalities is essentially endless. Here's a few more:

• Not wearing your seatbelt in a car (added healthcare costs in the event of an accident)
• Playing loud music at night (annoys your neighbors)
• CO2 emissions (effects of global warming)
• Nuclear plant being built in your neighborhood (decreases the value of your home)
• City building a park in your neighborhood (increases the value of your home)
• Littering (costs associated with city beautification)
• Smoking (second-hand smoke, among others)
• Microbeads