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.
| Aspect | Explanation |
|---|---|
| Definition | A Negative Externality is an unintended and adverse side effect or consequence of an economic activity that affects parties who did not choose to be involved in that activity. It is a situation where the production or consumption of a good or service imposes costs on third parties who are not part of the transaction. Negative externalities can lead to market inefficiencies and social costs. They are often associated with environmental pollution, noise, traffic congestion, and other harmful impacts on society. |
| Key Characteristics | – Unintended Consequences: Negative externalities are typically unintended and arise when the full social costs of an activity are not borne by the individuals or businesses involved in that activity. – Costs Imposed on Third Parties: These costs are imposed on parties who are not part of the original transaction. For example, air pollution from a factory affects nearby residents. – Market Failure: Negative externalities can lead to market failure because they result in overproduction or overconsumption of goods or services that have harmful effects on society. – Need for Intervention: In many cases, government intervention through regulations, taxes, or subsidies is required to internalize the external costs and correct market outcomes. |
| Examples | – Air Pollution: The emissions from industrial factories or vehicles can lead to air pollution, affecting the health of nearby residents and the environment. – Noise Pollution: Construction activities, airports, or loud music events can create noise pollution that disturbs the peace and well-being of nearby residents. – Traffic Congestion: Excessive use of private vehicles on crowded roads can lead to traffic congestion, increasing commute times and fuel consumption for all drivers. – Deforestation: The logging of forests for timber production can have negative externalities, such as soil erosion and loss of biodiversity, affecting ecosystems and communities. |
| Economic Impact | – Market Distortions: Negative externalities can lead to market distortions, such as overproduction and overconsumption of goods with external costs. – Social Costs: They result in social costs that are not reflected in market prices, causing resources to be misallocated. – Inefficiency: Market outcomes with negative externalities are often inefficient, as they do not maximize overall social welfare. |
| Mitigation Strategies | – Regulation: Governments can impose regulations and standards to limit or control activities with negative externalities. For example, emissions standards for vehicles reduce air pollution. – Pigouvian Taxes: Taxes can be levied on goods or services that generate negative externalities, such as carbon taxes on greenhouse gas emissions. – Cap and Trade: Cap-and-trade systems set limits on emissions and allow trading of emission permits among businesses, encouraging pollution reduction. – Subsidies: Governments can provide subsidies for cleaner technologies or practices to incentivize positive externalities. |
| Real-World Impact | – The awareness of negative externalities has led to increased environmental regulations, such as limits on carbon emissions and stricter standards for industrial pollution. – Efforts to internalize external costs through taxation or emissions trading aim to reduce the social and environmental impact of economic activities. |
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
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
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?”
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?
Advantages:
- Market Efficiency: Negative externalities highlight instances where markets fail to allocate resources efficiently. By identifying the costs imposed on third parties not involved in the transaction, negative externalities provide valuable information for policymakers and regulators to intervene and correct market failures.
- Incentive for Regulation: Negative externalities create a rationale for government intervention through regulation or taxation to internalize the external costs. By imposing taxes or setting regulations that mitigate the negative effects, policymakers can align private incentives with social welfare and promote more socially responsible behavior.
- Environmental Protection: Negative externalities often arise in the context of environmental pollution and resource depletion. By recognizing the external costs associated with pollution and overexploitation of natural resources, society can implement measures to protect the environment, conserve resources, and promote sustainability.
- Public Health Improvement: Negative externalities such as air pollution, secondhand smoke, and noise pollution can have detrimental effects on public health. By addressing these externalities through regulations, public health initiatives, and behavioral interventions, society can mitigate health risks and improve overall well-being.
- Social Equity: Negative externalities disproportionately affect vulnerable or marginalized communities, exacerbating social inequalities. By addressing externalities and their associated social costs, policymakers can promote social equity and ensure that the burdens and benefits of economic activities are distributed more fairly across society.
Disadvantages:
- Regulatory Burden: Government intervention to address negative externalities through regulation or taxation can impose administrative burdens and compliance costs on businesses and individuals. Excessive regulation may stifle innovation, economic growth, and entrepreneurial activities, leading to inefficiencies in the market.
- Unintended Consequences: Policies designed to mitigate negative externalities may have unintended consequences or create new externalities elsewhere in the economy. For example, imposing emissions standards on vehicles may incentivize the use of alternative energy sources but could also lead to increased energy costs or job losses in certain industries.
- Rent-Seeking Behavior: Regulatory measures aimed at addressing negative externalities may be susceptible to rent-seeking behavior by special interest groups seeking to influence policy decisions in their favor. This can distort policy outcomes, undermine regulatory effectiveness, and lead to regulatory capture by vested interests.
- Compliance Costs: Businesses may incur significant costs to comply with regulatory requirements aimed at mitigating negative externalities. These costs can be passed on to consumers in the form of higher prices for goods and services, reducing consumer welfare and purchasing power, particularly for low-income households.
- Economic Distortions: Government intervention to internalize negative externalities may lead to economic distortions, such as deadweight loss, market inefficiencies, and resource misallocation. Taxes or regulations designed to address externalities may alter production and consumption patterns in ways that are not socially optimal, leading to allocative inefficiency in the market.
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.
Key Highlights
- Negative Externalities in the Digital Era:
- Negative externalities occur when the negative impact of a transaction affects a third party.
- Digital platforms have become adept at monetizing people’s attention, creating a business model known as “attention merchants.”
- The attention merchant model involves providing free services and capturing users’ attention to generate profits through advertising.
- This model is asymmetric, often hidden from users, and characterized by the manipulation of people’s attention, exemplified by the newsfeed mechanism.
- FAANG Companies and Negative Externalities:
- FAANG companies (Facebook, Apple, Amazon, Netflix, Google) have a massive impact on society, evidenced by their interactions, growth, and financial statements.
- However, it’s important to consider potential negative externalities associated with their operations.
- Negative externalities occur when the social costs outweigh the benefits produced by a company, leading to an overall net loss for society.
- Pigovian Tax on Attention Polluters:
- Comparisons are drawn between pollution and “polluted attention,” which represents negative social externalities from attention-grabbing platforms.
- Companies monetizing attention might entertain but also create a population distracted from important matters.
- Governments could intervene with taxes on attention, similar to taxing polluters to mitigate negative externalities.
- Market Solutions and Education:
- A market for attention exists where businesses trade attention for dollars, but metrics like impressions, clicks, etc., might not fully justify marketing budgets.
- People’s lack of awareness about how companies make money from their attention is highlighted.
- Education is emphasized as a critical factor in fostering people’s understanding and freedom.
- Negative Externalities Examples:
- The digitization of the financial sector has led to unemployment, especially in traditional banking services.
- Cryptocurrency has attracted money laundering activities due to its anonymity, leading to increased regulatory oversight.
- Cryptocurrency mining contributes to significant energy consumption and environmental damage.
Case Studies
| Context | Description | Negative Externality | Examples and Impact |
|---|---|---|---|
| Air Pollution | Industrial emissions and vehicle exhaust. | Air pollution harms public health and the environment, leading to respiratory problems, climate change, and decreased air quality for communities. | The burning of fossil fuels by factories and vehicles results in smog, greenhouse gas emissions, and health problems for nearby residents. |
| Noise Pollution | Excessive noise from transportation or industries. | Noise pollution disrupts sleep, causes stress, and reduces overall quality of life for nearby residents, affecting their well-being and productivity. | Airports, highways, and construction sites can generate significant noise pollution for surrounding communities. |
| Secondhand Smoke | Exposure to tobacco smoke in public places. | Secondhand smoke harms non-smokers by increasing the risk of respiratory diseases and other health issues, leading to higher healthcare costs. | Bans on smoking in indoor public spaces aim to reduce the negative health effects of secondhand smoke on non-smokers. |
| Deforestation | Clearing forests for agriculture or development. | Deforestation contributes to loss of biodiversity, climate change, and disruption of ecosystems, affecting global climate and wildlife. | The clearing of rainforests in the Amazon basin for agriculture leads to biodiversity loss and carbon emissions, impacting the environment globally. |
| Noise from Urban Development | Construction and urban development activities. | Noise from construction sites and urban development disrupts residents’ peace and quiet, affecting their well-being and property values. | Large-scale construction projects in urban areas can create noise pollution that negatively impacts the quality of life for nearby residents. |
| Littering and Pollution | Improper disposal of waste and pollutants. | Littering and pollution in public spaces, water bodies, and oceans harm ecosystems, wildlife, and tourism industries. Cleanup and restoration costs are incurred. | Plastic waste in oceans, for example, damages marine life and fisheries, affecting both the environment and industries dependent on aquatic resources. |
| Smoking in Multiunit Housing | Smoking in shared residential buildings. | Secondhand smoke can infiltrate neighboring units, causing health problems for non-smoking residents. It can also increase maintenance and cleaning costs. | Smoking in apartment buildings or condos can result in health issues and increased expenses for landlords and non-smoking residents. |
| Industrial Waste Disposal | Improper disposal of hazardous industrial waste. | Contaminated groundwater, soil, and air quality near industrial sites can harm local communities and ecosystems, resulting in health risks and cleanup costs. | Irresponsible disposal of toxic waste from industrial facilities can lead to environmental contamination and harm to nearby communities. |
| Light Pollution | Excessive artificial lighting at night. | Light pollution disrupts natural night skies, harms nocturnal wildlife, affects human circadian rhythms, and wastes energy. | Bright city lights and poorly designed outdoor lighting can contribute to light pollution, affecting both urban and rural areas. |
| Traffic Congestion | Excessive traffic and gridlock in urban areas. | Traffic congestion leads to wasted time, increased fuel consumption, air pollution, and stress for commuters and impacts overall productivity. | Heavy traffic in urban areas results in lost work hours, increased fuel costs, and environmental pollution due to idling vehicles. |
Connected Economic Concepts
Positive and Normative Economics
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