Externalities

A second type of inefficiency arises when there are spillovers or externalities, which involve involuntary imposition of costs or benefits. Market transactions involve voluntary exchange in which people exchange goods or services for money. When a firm buys a chicken to make frozen drumsticks, it buys the chicken from its owner in the chicken market, and the seller receives the full value of the hen. When you buy a haircut, the barber receives the full value for time, skills, and rent.

But many interactions take place outside markets. While airports produce a lot of noise, they generally do not compensate the people living around the airport for disturbing their peace. On the other hand, some companies which spend heavily on research and development have positive spillover effects for the rest of society. For example, researchers at AT&T invented the transistor and launched the electronic revolution, but AT&T's profits increased by only a small fraction of the global social gains. In each case, an activity has helped or hurt people outside the market transaction; that is, there was an economic transaction without an economic payment.

Externalities (or spillover effects) occur when firms or people impose costs or benefits on others outside the marketplace.

Governments are generally more concerned with negative externalities than positive ones. As our society has become more densely populated and as the production of energy, chemicals, and other materials increases, negative externalities or spillover effects have grown from little nuisances into major threats. This is where governments come in. Government regulations are designed to control externalities like air and water pollution, damage from strip mining, hazardous wastes, unsafe drugs and foods, and radioactive materials.

In many ways, governments are like parents, always saying no: Thou shalt not expose thy workers to dangerous conditions. Thou shalt not pour out poisonous smoke from thy factory chimney. Thou shalt not sell mind-altering drugs. Thou shalt not drive without wearing thy seat belt. And so forth. Finding the precisely correct regulations is a difficult task that requires complex science and economics and is subject to heavy political pressure, but few today would argue for returning to the unregulated economic jungle where firms would be allowed to dump pollutants like plutonium wherever they wanted.

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