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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.

Dilbert on Workplace Externalities [comic]: Dilbert tries to internalize the cost of a coworker's externalities

Introduction to Economic Analysis [online textbook]: A textbook introduction to Coasian bargaining

Law and Property: The Best Hope for Liberty? [article]: Article in The Freeman explains how common law can solve externalities

Thank You Ronald Coase [article]: A Property and Environmental Research Center piece on Coase and Pigou

The Pigovian Tax [blog post]: An ethics blogger's argument in favor of Pigovian taxes

When is a potato chip not a potato chip? When it’s an externality.

An externality is when a transaction between two people—call them Art and Betty—has an effect on a third person, Carl, without Carl’s permission.

Suppose Art sells Betty some potato chips. Now Betty really likes potato chips. She opens the bag; she’s looking forward to eating the chips. As she eats them, she makes “yum, yum, yum” sounds. Just look at her. She loves it. But no matter how loud she is, there is no externality unless someone, like Carl, is there to hear it. Obviously Art benefits from selling the product, and Betty benefits from buying the product since this exchange was voluntary.

But Carl’s affected by a negative externality. He’s harmed. He didn’t get anything, but he has to listen to all that crunching and yum-yumming. It really annoys him. So it takes three to have an externality: a seller, a buyer, and at least one additional person who is not voluntarily a participant in the transaction.

In a previous video, I claimed that prices can tell people the right thing to do. But if there are externalities, do prices tell us everything we need to know? The answer must be no, because with externalities, the price of something and its actual cost are different. The price is the amount Betty paid to Art, but the cost is the amount Betty paid to Art plus the cost to Carl of having Betty munch potato chips in his ear during class.

The problem with externalities is that prices do not capture all of the costs of the transaction. Instead, some of the costs are borne by people who never gave their permission. It seems like the solution would be to try to adjust price so that it coincides with the total cost. For many people that means “fix it with taxes.” In other words, impose a tax equal to the difference between the market price and the true cost to force the buyer and the seller to bear the full cost of their transaction. This is what economists call internalizing the cost.

We may not need to resort to government action, of course. One way we solve externality problems is called manners. If Carl tells Betty her crunching is bothering him, she’ll probably apologize and stop.

Then there’s bargaining, a solution proposed by R. H. Coase. If Carl complains, Betty might make a side payment sharing her chips with Carl. Once Carl’s crunching too, there are no externalities, only chips. Even if these solutions don’t work, it may not be easy to fix it with taxes through state action. Remember, the problem is information. Prices don’t contain the full information about cost. But where can accurate information be attained? How can the state be expected to acquire more accurate information and then act on it effectively?

The most interesting answer to these questions came from the original scholar who proposed fixing it with taxes, A. C. Pigou. Pigou was a really smart guy and understood that guessing at the correct tax would be very difficult. Back in 1920, Pigou said, “It is not sufficient to contrast the imperfect adjustments of unfettered enterprise with the best adjustment that economists in their studies can imagine, for we cannot expect that any state authority will attain or even wholeheartedly seek that ideal. Such authorities are liable alike to ignorance, to sectional pressure, and to personal corruption by private interests. A loud-voiced part of their constituents, if organized for votes, may easily outweigh the whole.”

The “fix it with taxes” solution often has unintended, bad consequences. The government has a knowledge problem just like everybody else. Every economics student learns about externalities and Pigouvian taxes, but professors rarely mention how hard Pigou himself thought it would be to get those taxes exactly right.

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  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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