What Is A Negative Externality In The Digital World?

A negative externality is a phenomenon that happens when the negative impact and consequences of a transaction are dumped on a third party. Third parties might bear those costs in an economic transaction where the manufacturer produces goods for consumers, including other individuals or society.

Breaking down negative externalities in the digital era

Back in the late 1990s, the web looked pretty much like the Wild West; anyone could grab a piece of digital land, put a name on it and start catching the attention of millions of users at the time, with a very lean team of people.

This is how it started when the Netscape team, after having released their browser, made it available to millions of people in, at the time, the nascent web.

Netscape later IPOed and clarified to the world that the Web was much more than just a few connected computers.

Ever since, new entrants have learned to dominate the scene, yet, over the years, one thing has become clear.

The most important asset on the web is people’s attention.

Thus, web companies learned how to grab it and manipulate it until the Web became a meme machine.

If there is one thing our brain is good at is at creating and passing on memes.

And the web became its maximum expression.

The meme machine didn’t just represent the Web. The Web was also driven by a business model, which we’ll call “attention merchant.”

The era of attention merchants

In an asymmetric business model, the organization doesn’t monetize the user directly, but it leverages the data users provide coupled with technology, thus having a key customer pay to sustain the core asset. For example, Google makes money by leveraging users’ data, combined with its algorithms sold to advertisers for visibility. This is how attention merchants make monetize their business models.

At the core, an attention merchant is a business that makes money by monetizing the attention of its people.

More specifically, the attention merchant usually offers a free service, a frictionless experience, and releases it to the masses.

Those masses share and spread their “social experiences,”

This model is, by nature, asymmetric, hidden from the eyes of its distracted users, and abundant. The maximum expression of it it is the newsfeed.

A slot-machine-like mechanism that allows people to spend hours scrolling through their screens without conscious effort and no understanding of what goes on behind the scene.

This process can’t be conscious, as it needs to be entirely driven by a willingness to show up no matter what.

This content-generating machine is mostly grassroots-based, ready to be consumed by anyone, anywhere. Gossipping, once an essential tool for socializing, all of a sudden becomes an end for its own sake.

The company that most depicts this business model is Facebook.

A blue logo with a white “F” generated almost forty billion dollars in 2017, thanks to its unlimited, frictionless money-making machine. This money-making machine is advertising-driven.

Hidden ads or what its founder calls “targeted ads,” can be so subtle to be taken for real content.

This we call innovation, and we admire it as business people.

Indeed, that innovation has been generating “engagement” for marketers and businesses worldwide at a high price and high margins. This is a pure business genius.

Move fast with stable infrastructure

For years, Facebook’s founder — Mark Zuckerberg– motto has been “move fast and break things.”

This motto helped the company scale from a single computer in a dorm room to one of the largest tech companies in the world.

Yet, in 2017, that motto changed to “Move fast with stable infrastructure.” This is a paradigm shift from both a technical and business standpoint.

From a technical perspective, as Facebook has grown among the most popular sites on earth, it soon realized that its moving fast was also becoming too costly.

Indeed, a bug that once was not risky and inexpensive- in a platform where billions of people interact each day — that bug would have meant days and teams of people to fix it!

Thus, from a business standpoint, this would have also caused large expenses and missed opportunities.

However, there is a third and critical point — I argue.

As those tech companies have such a reach, a simple bug can carry such a significant negative externality that any benefit they have created would be swept off in a matter of minutes.

Negative externalities in the era of FAANG

FAANG is an acronym that comprises the hottest tech companies’ stocks in 2019. Those are Facebook, Amazon, Apple, Netflix and Alphabet’s Google. The term was coined by Jim Cramer, former hedge fund manager and host of CNBC’s Mad Money and founder of the publication TheStreet.

A few tech companies have become so ubiquitous and present in our daily lives that we also have an acronym for their combined effects: FAANG.

Those are Facebook, Apple, Amazon, Netflix, and Alphabet’s Google, which now have their own index on Wall Street.

It’s easy to measure their positive impact on society by looking at the number of interactions on Facebook, Google’s searches each day, Amazon’s transactions, Netflix’s watch time, and Apple’s iPhones sold.

It’s also easy to compute their growth and the wealth generated for their investors by looking at their financial statements.

However, what’s hard yet truly important is the understanding of the negative externalities those companies might carry.

A negative externality happens when the social marginal costs exceed the marginal social benefits.

In short, a company produces a net loss for society overall. This concept is well known, especially in the industrial world, where a few companies pollute the environment and create a negative net balance for society overall.

In those cases, there are two main routes, either we live with it, or the Government places a tax on those polluters.

What if we tax attention? The Pigovian tax on attention polluters

While pollution can be detected, negative social externalities tied to people’s “polluted attention” are hard to measure, let alone track. However, that should not discourage us from attempting.

Companies that lock us into their platforms to monetize our attention might be entertaining us but also creating a military of zombies.

We might also argue that Facebook is an excellent tool for keeping us from thinking about the things that matter the most.

Just like Roman Emperors used the formula of panem et circenses (bread and circuses) to distract the masses with ample food and entertainment. Facebook is pretty useful, and politicians might love it as it distracts us from their real agenda.

Yet, not when it is used as a tool for political propaganda. Many might not like the Government intervention, but can the market do it on its own?

What if the market takes care of itself?

Another possible scenario is letting things go and letting the market take care of itself.

As companies like Facebook trade attention for profit, that attention is evaluated from time to time by businesses that trade it for dollars.

For instance, if I buy a hundred clicks on Facebook, as a business owner, I also measure its conversions and if and how much it’s worth. So willingly or not, I’m creating a marketplace for attention.

So far, Facebook has been pretty good at marketing its metrics (impressions, clicks, likes, and shares).

Yet, what if businesses will soon realize those metrics aren’t good enough to justify a dedicated marketing budget?

What if people are taught what happens in the “business backend?”

There is a part of any business that anyone can see. Usually, this is the customer-facing side of a company. Everything that deals with customers, from its segments, channels relationship, and how a value proposition and perception about a product or service is delivered. While this side is important, there is an even more critical part, the back-end business. The back-end business is anything hidden from the eyes of customers. Things like the key activities and resources an organization has in place to make its product and service valuable in the eyes of its customers.

Education (not schooling) is a critical ingredient for people’s freedom.

On my own blog, I spend hours dissecting companies’ business models to understand what “motivates those companies.”

I’ve been surprised in the last two years to see how many people don’t know how the companies that influence their daily lives make money.

It’s almost like taking medicine from a doctor, to realize after you’ve become addicted, that person wasn’t a doctor but a drug dealer who in the process of making you an addict, has become a millionaire.

How would you react to that?

Other negative externality examples

Unemployment in the financial sector

In the fintech industry, increased competition and the adoption of technology have caused unemployment to rise in the past few years. 

In the Spanish banking sector, for example, almost 100,000 jobs were lost over 2018 and 2019 (or around 37% of the total workforce).

What’s more, the number of bank branches in the country declined from 31,000 in 2015 to 22,600 in 2020. 

Unemployment caused by the digitization of banking services is a worldwide trend, with a study commissioned by Self Financial predicting that bank branches will be extinct by the year 2034.

This trend is also spreading beyond traditional banking services to other areas of the financial sector such as asset management and insurance. 

When a branch closes, the company is reluctant to relocate employees because of the intense competitive pressures of the industry.

For the branches that do remain open, their functions are reduced since there are fewer workers and fewer remaining branches. 

To increase efficiency, the bank then forces the consumer to carry out many of the services and processes that would have once been handled by an employee.

This practice is especially detrimental to those with low financial literacy or access to financial services.

Money laundering and cryptocurrency

Despite the benefits and attractiveness of the cryptocurrency space, criminal organizations and individuals with nefarious intent have found a way to exploit it.

The very function and structure of cryptocurrency and blockchain make it difficult for authorities to verify the identities of those behind unlawful transactions.

Exacerbating this problem is the explosion in different types of cryptocurrency.

Digital wallet providers and other companies now use tools that were initially devised for law enforcement.

Many can now ascertain whether funds originated from a dark web marketplace or determine the proximity between a crypto transaction and its ultimate source.

Others have evolved to focus on the nature of transactions or whether such transactions comport with the wallet holder’s profile.

In any case, criminal intent has caused increased regulatory oversight of an industry whose decentralization and anonymity are its main selling points.

This may be welcomed by consumers who have lost money to fraud, for example, but traditionalists may rue the unwanted attention that money laundering has brought to the industry.

There may also be added costs related to compliance or extra security that wallet providers and crypto platforms choose to pass on to the consumer.

While there are still many safe harbors and grey areas in which criminals can operate, cryptocurrency may more closely resemble traditional financial sectors in the future and lose some of the traits that made it appealing.

Energy use and cryptocurrency

As an addendum to negative externalities in cryptocurrency, consider the impact that energy-intensive mining has on society and the environment.

According to the University of Cambridge, bitcoin mining consumes around 0.6% of global electricity consumption, equivalent to the CO2 emissions of a small country such as Jordan or Sri Lanka.

While some of this electricity is generated via sustainable sources, consumption is rising because of an increase in miners and also an increase in the computational power of mining hardware. 

In a recent study published in Scientific Reports, researchers calculated that for every dollar of Bitcoin value produced by miners, the process itself caused 35 cents worth of damage to the environment.

In other words, a 35% reduction in bitcoin’s market value. Compare this to the impact of beef on climate change (33 cents) and crude oil (44 cents).

Considering there are only 1 million bitcoin miners in the world and 106 million bitcoin users, the negative implications of environmental damage and climate change for the remaining 99% of the world’s population are profound.

Related Business Concepts

Economies of Scale

In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

In Economics, Diseconomies of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That might happens for several reasons, such as coordination and management costs and communication inefficiencies as the company becomes too big.

Platform Business Models

Linear business models create value by selling products down the supply chain. Platform business models create value by enabling exchanges among consumers.

Network Effects

A network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining.

AI Supply Chains

A classic supply chain moves from upstream to downstream, where the raw material is transformed into products, moved through logistics and distributed to final customers. A data supply chain moves in the opposite direction. The raw data is “sourced” from the customer/user. As it moves downstream, it gets processed and refined by proprietary algorithms and stored in data centers.

Bullwhip Effect

The bullwhip effect describes the increasing fluctuations in inventory in response to changing consumer demand as one moves up the supply chain. Observing, analyzing, and understanding how the bullwhip effect influences the whole supply chain can unlock important insights into various parts of it.

Supply Chain

The supply chain is the set of steps between the sourcing, manufacturing, distribution of a product up to the steps it takes to reach the final customer. It’s the set of step it takes to bring a product from raw material (for physical products) to final customers and how companies manage those processes.

Data Supply Chains

In a data supply chain the closer the data to the customer the more we’re moving downstream. For instance, when Google produced its own physical devices. While it moved upstream the physical supply chain (it became a manufacturer) it moved downstream the data supply chain as it got closer to consumers using those devices, so it could gather data directly from the market, without intermediaries.

Last Mile Delivery

Last-mile delivery consists of the set of activities in a supply chain that will bring the service and product to the final customer. The name “last mile” derives from the fact that indeed this usually refers to the final part of the supply chain journey, and yet this is extremely important, as it’s the most exposed, consumer-facing part.

Backward Chaining

Backward chaining, also called backward integration, describes a process where a company expands to fulfill roles previously held by other businesses further up the supply chain. It is a form of vertical integration where a company owns or controls its suppliers, distributors, or retail locations.

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