The concept of externalities is critically important but often ignored in the field of economics.  I believe that the lack of focus on externalities is a primary reason that economics fails to produce optimal outcomes.

Under true capitalism, consumers have a range of choices and are able to accurately judge the costs and benefits of each and thus make the best decision for themselves.  For this to happen producers have to know and charge all the costs of producing and using the product and consumers have to know and be willing to pay those costs plus a reasonable profit.  As long as all the costs are accounted for and paid for by the two parties involved in the transaction capitalism will likely lead to the most efficient outcome.

One way that cheating leads to less efficient outcomes is when some of the costs are paid by people not directly involved in the transaction and who do not receive any of the benefits.  The costs paid by those outside the transaction are known as externalities.  Sometimes externalities occur because a product has costs that are unknown.  Other times the costs are known and intentionally ignored to provide a competitive advantage.

A classic example of an exterality is pollution.  For instance PCB’s are a class of chemical once commonly used as coolants.  In time it became known that they are a very strong carcinogens and their use was discontinued.  Sadly they are also persistent and thus they still exist in the environment.  The people with the highest loads of PCBs are Canadian Inuit who presumably have very little need for coolants and thus have received little benefit from societies use of PCBs yet they are payng the highest cost.  This occurs because PCBs do not degrade quickly and thus they  eventually all end up in the ocean.  There is a principal in biology known as bioaccumulation which states that concentrations of toxins increase 10 fold for each level in the food chain.  For instance PCBs in people would be expected to be 10x higher than the cow that they eat and the cow would have 10x as much as the grass.  Eskimos eat very high on the food chain as they often eat seals that eat big fish, that eat smaller fish, that eat shrimp, that eat plankton, etc.  Thus they suffer from pollution despite being far removed from both its source and its benefit.

In this example it could be argued that the costs associated with PCB pollution were unknown when they were produced, however in many cases the costs of pollution are known and imposed on persons in other countries or on future generations.  For instance when a company moves to another country to avoid environmental regulations in the USA the costs of the pollution do not disappear.  Those costs are merely transferred to persons external to the transaction as the residents of the new country pay the cost of the pollution.  As a result the price charged by the company is artificially low and consumers make inefficient decisions.

Another example is when governments provide some type of subsidies that enable producers to charge less for their products.  In this case the costs are spread across all taxpayers and are unrelated to their use of the product.  This results in inefficiencies as heavy users receive more benefit and lighter users pay more of the costs resulting in incentive to use more.

Lets look at the price of gasoline.  Under true capitalism the price charged for a gallon of gasoline would include:

  1. The cost of pumping it out of the ground.
  2. The cost of transporting it.
  3. The cost of refining it.
  4. A reasonable profit.
  5. The cost of military action required to ensure stable supplies.
  6. The costs of terrorism which is largely the result of #5.
  7. The costs of pollution on health.
  8. The costs of global warming.

In fact the price we pay only includes 1-4.  While the costs of 5-8 are spread out among taxpayers, other members of our health insurance groups, persons in other countries, and future generations.  The result is economic inefficiency and lack of incentive to conserve.  While we could argue and split hairs about what should fairly be charged for items 5-8 and who the money should go to and how it should be managed, it is a fact that ignoring them results in the price of gasoline being artificially low and leads to poor economic decision making among consumers.

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