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.
Table of Contents
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 businessmodel, 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.
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.
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’sfounder — 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.
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.
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.
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 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.
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.
When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation.
Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.
An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage. Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.
In simplistic terms, the circular flow model describes the mutually beneficial exchange of money between the two most vital parts of an economy: households, firms and how money moves between them. The circular flow model describes money as it moves through various aspects of society in a cyclical process.
Trade deficits occur when a country’s imports outweigh its exports over a specific period. Experts also refer to this as a negative balance of trade. Most of the time, trade balances are calculated based on a variety of different categories.
A market type is a way a given group of consumers and producers interact, based on the context determined by the readiness of consumers to understand the product, the complexity of the product; how big is the existing market and how much it can potentially expand in the future.
Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.
The peer-to-peer (P2P) economy is one where buyers and sellers interact directly without the need for an intermediary third party or other business. The peer-to-peer economy is a business model where two individuals buy and sell products and services directly. In a peer-to-peer company, the seller has the ability to create the product or offer the service themselves.
The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.
In a command economy, the government controls the economy through various commands, laws, and national goals which are used to coordinate complex social and economic systems. In other words, a social or political hierarchy determines what is produced, how it is produced, and how it is distributed. Therefore, the command economy is one in which the government controls all major aspects of the economy and economic production.
How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.
The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”
Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.
Market fragmentation is most commonly seen in growing markets, which fragment and break away from the parent market to become self-sustaining markets with different products and services. Market fragmentation is a concept suggesting that all markets are diverse and fragment into distinct customer groups over time.
The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth. The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.
Comparative advantage was first described by political economist David Ricardo in his book Principles of Political Economy and Taxation. Ricardo used his theory to argue against Great Britain’s protectionist laws which restricted the import of wheat from 1815 to 1846. Comparative advantage occurs when a country can produce a good or service for a lower opportunity cost than another country.
The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.
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 organizationscale further.
In Economics, a Diseconomy 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 can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
