Here in Singapore, we are currently in the so-called haze season. It’s a time of year when corporate and some small farmers in Indonesia use fire to clear oil palm fields for planting. The smoke from the fields – and other non-farm areas where the fire spreads – blows across the water to mainly Singapore and Malaysia, leading to significant air pollution. For example, as I write this, a measure of air quality called PSI is reading 239. One hundred is considered the top of the safe range.
The countries in southeast Asia have debated how to fix the problem for decades. The talks are a complex mix of national economic interests, national sovereignty, and national pride. While I wish it would get resolved once and for all, at least the haze provides an opportunity to highlight what I think is one of the more powerful ideas in economics: externalities.
No, no, come back! Stick with me. It’s more interesting than it seems.
Externalities crop up when people besides the participants in an economic exchange either benefit or are harmed by that exchange. In other words, the costs or benefits end up being separate from – external to – the people who made the deal.
When a third party benefits, it’s called a positive externality. One example is when parents pay to get their children inoculated against contagious diseases. The parents pay the direct price, but everyone benefits from having a healthier community. Another example is college education. The student (or more likely the parents, again) pays the price, but everyone benefits to some degree from having a well-educated workforce. There are plenty of other important examples, like public K-12 education and roads.
But for this post, I want to focus on negative externalities. That’s when someone else bears the cost of an exchange two other people make. The haze we’re living under right now is a perfect example.
The oil palms grown in Indonesia are processed into palm oil (oddly enough), which is used in a wide variety of products, from pizza dough and ice cream to lipstick and shampoo. The profits made from selling these products go, in part, to the palm oil producers. However, nobody is paying me as I run our portable air cleaner to keep the air in our condo free of haze particulates. No one is paying me as I wipe particulates off the flat surfaces in our kitchen that the air cleaner doesn’t capture. No one is paying me for the hassle of being stuck inside, unable to enjoy the day.
Does that sound like whining? Okay, let’s think of the Indonesians themselves, who are living right next to the fires and bearing the brunt of the pollution. PSI levels in one of the effected areas almost hit 2,000 recently. Remember, 100 is the top of the safe range. The health problems they will suffer now and in the future are bound to be significant. Who will pay for the medical care?
In a world without externalities, the corporate and small farmers and all of the food and personal care product companies and their customers would. But that’s unlikely. Instead, the people themselves will pay. Or the cost will be picked up by government, which is covered by everyone paying taxes. It’s privatized profits, but socialized costs. In other words, an unaddressed externality.
This dynamic, by the way, is the logic behind some taxes and regulation. If the market won’t capture the costs, the government has to step in with a system for doing so. It’s one way government makes capitalism function properly.
So, that’s externalities. Once you know about the idea, you start seeing it everywhere. Just the like the haze.