Externalities: When Is a Potato Chip Not Just a Potato Chip?

An “externality” occurs when a transaction between two people affects a third person without that person’s permission. Professor Michael Munger illustrates a simple externality problem with potato chips. If Art sells potato chips to Betty, Art and Betty are both better off. However, if Betty crunches her chips loudly enough that it annoys Carl, then Carl has to bear a cost (in the form of annoyance), despite not receiving any benefit from the potato chip exchange. In this example, the volume of Betty’s eating is an externality Carl has to endure.

Because negative externalities represent a cost that is not included in the price of a transaction, it seems like the solution would be to try to adjust price so it coincides with the total cost. Many people believe that means the problem should be fixed with taxes, but Professor Munger shows several alternatives. For example, if Carl asked Betty to eat more quietly, she probably would. Alternatively, Betty could share some of her chips with Carl in exchange for her munching.

Even if these solutions don’t work, it may be difficult for government action to resolve the externality. Even A. C. Pigou, the original scholar who proposed fixing externalities with taxes, recognized that it would be very difficult for a government body to obtain sufficient knowledge to solve this problem. The government has a knowledge problem just like everybody else, and poor policy can lead to negative unintended consequences.

4 Comments

  1. taschrant

    Cool video on externalities.  I’ve never heard of that term until now!  But it does make sense.

  2. sid1138

    One problem not address by taxes is quite obvious.  Art and Betty pay more in taxes, but Carl still has to deal with the problem and gets nothing out of the exchange.  Maybe, if the taxes were designed so that Carl received all of the funds, then the politician could get an accurate read on the true costs and everyone (well, except the politician) would be happy. 

    That never happens.  Consider, for example, the taxes levied on a large number of companies to clean up pollution (the so-called super fund).  Very little of the super fund money collected over the years has actually gone towards pollution.  Of also consider the many billions in fines and taxes the government has received from smokers and tobacco companies.  Almost none of that money has gone to smokers or families damaged by tobacco.

    The bottom line – externalities are difficult to determine, but the government never helps makes the problem better.

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