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externalities  plural of ex·ter·nal·i·ty (Noun)

  1. A side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost.
  2. The fact of existing outside the perceiving subject.

The Problem

I would bet that if I were to ask the question: should we destroy a virgin rainforest in Ecuador to drill for oil? — 90% or more of you would say, “No, we should preserve the rainforest because it is too valuable to destroy.”

If I asked you if it was okay to have textile sweatshops with dangerous working conditions like those in the recent tragedy in Bangladesh, again 90% or more would say, “No, it is far from okay.” 

By the way, poll after poll back up my bet in both examples.

But it is almost certain that 99% of us will go out and purchase gasoline and expect it to be as inexpensive as possible. Recall the uproar when gasoline prices spiked during the spring of 2012. We will buy clothes and expect the same cost savings. A recent study at the University of Michigan showed that when prices rose just 5%, a third of consumers would not buy socks designated as coming from factories having safe working conditions. When the price increased 20-50%, 75% of subject shoppers bought the cheaper socks.

The sock example is a controlled experiment and the researchers made it easy to see the price difference and reason for it: one sock was more expensive, one less and the reason was stated — the factory employees who made the more expensive socks had a safer working environment. Consumers had a clear choice. In the real world it is so much harder. Most products are not labeled. Some come with labels such as “fair trade,” which means something, but other labels, like “natural,” are more difficult to interpret.

Even the clear-cut research example tells only half the story. Labeling goes just so far. Although the experiment made the choice clearer, it still offered one pair of “cheaper socks” and another more “expensive pair.” In reality, though, that cheaper sock is actually tagged only with a partial price derived from a limited set of costs. The rest of the price includes social and environmental costs that someone else pays involuntarily: not you or the factory or the store. The price tag gives us false information and a false choice. 

If we performed the experiment again and the socks cost exactly the same — how many would choose the safe working condition socks? Maybe 90% or more. Imagine if the socks that were cheaper in the example above were now twice as expensive because the price factored in safe working conditions, fair wages and environmental costs? Well, that might leave a bin full of the now more expensive “cheaper socks” for the wealthy, pathologically indifferent or economically irrational — a distinct minority of the population and a distinct niche market. It should be this easy to live and buy things consistent with our values and economic self-interest.

Some might argue, and they have, that experiments like the one with the socks show that we are morally flawed, that we are bad people for not caring. In a perfect world where we have all the resources and time to care — maybe — but in fact it shows that it is really difficult to translate social and environmental values into day-to-day actions, despite our best intentions. You have to be a crusader, hyper-vigilant and willing to be economically penalized to keep up: “fair trade,” “organic,” “bird friendly” and “natural,” “cage free,” “local” — yikes. 

The contradiction of what we say we want and what we are able to do underlies a long battle by the environmental, economic and social movements. We want a healthy economy, clean air and water, abundant wildlife, full employment, and we believe in treating each other fairly. The problem arises when we have to act according to those principles. When we get up in the morning and do the things we have to do in order to eat, have a home, and raise a family, those principles become harder to put into action. Life is hard enough already without having to be an environmental and social crusader or sleuth as well. 

But why do we have prices that reflect only partial costs anyway? The truth is that we have a massive design flaw built into our economic system. It is not our moral or ethical failing. Our hearts and minds are in the right place, but our wallets are not. And, unfortunately, our wallets are a lot more powerful than our good intentions in the system in which we live today.

The Problem.jpg

The glaring flaw in our current system is that it does not count all costs and excludes certain values. In the Ecuadorian rainforest example above, we are able to say that there is probably $20 billion worth of oil sitting under that forest. But what we cannot state is the value of the rainforest itself. What is a rainforest worth? What about the long term services that forest provides? Those numbers do not exist or they are found only in academic white papers: $20 billion in oil versus the unknown worth of the forest and all the natural capital it represents. It is hard to make decisions when we have only half the facts. Just like the cheaper socks, the $20 billion right there for the taking is pretty hard to resist.

Then we get to the cost side. It will cost a certain amount to build roads, drill wells, transport the oil and pay royalty fees to the government and/or landowners. That is the traditional way of accounting. If the cost is less than the value of the oil the project goes forward. But like the sock example, these costs do not include the destruction of the forest, the loss of forest services for decades to come, increased pollution, oil spills, and loss of genetic capital. These represent the misapplication of capital for a project that would be uneconomical if the real costs were tallied.

This problem of incomplete accounting has been recognized for a long time. Economists have an arcane term for the incomplete accounting: externalities. Negative externalities are the costs that someone else pays involuntarily. When children get asthma from air pollution, for example, we do not find a charge for “Children’s Asthma” on our monthly fuel bill. Nor does it include the cost of sitting in traffic wasting time and polluting the air in the first place. Nor all the costs of extracting oil or coal, and on and on down the line. 

These costs are borne by others and constitute a hidden tax that often makes it economical to do things one way when a more inclusive cost accounting would make it completely unaffordable. 

The lack of valuing or more accurately pricing natural and social assets are positive externalities. These are benefits you get without paying anything. An example is fireproofing a home. If your neighbor does that, your home is protected from spreading fire even if you do not fireproof your own home. Your neighbor pays and you reap the reward for free. Most of the services nature provides are positive externalities — a forest pumps out clean air, pure water, reduces flooding, provides wildlife habitat, captures carbon, stores genetic capital and creates recreational opportunities. 

The costs of negative externalities are real and those natural capital values are also not free, they are just inefficiently priced. To make up for the incomplete accounting process we use a Rube Goldberg approach to force the economy to recognize those uncounted costs and un-priced values.

When things get bad — when we have terribly dirty air, unsafe food, hazardous workplaces, high health care costs and chronic unemployment — we resort to taxes and regulation. And of course the entire engine of our economy bridles at the restraint as it is force-fed pricing information through this inefficient political process. 

Those things we care about can be labeled the enemies of job and wealth creation because you can single out those instances when people are hurt by a tax or told they cannot do something and are denied a permit to build this or that or when they shoulder the administrative costs of regulation. But you cannot see the tax and the loss of wealth and well-being from all the hidden costs and lost opportunities. 

Like the sock and forest drilling choices, the deck is stacked. You have to be a tree-hugger or bleeding heart to make uneconomic choices and hurt the economy. 

Advocacy groups do their best to raise awareness and influence the incredibly inefficient political process to force a poorly designed economy to take on some of these costs, but they operate with a tiny fraction of the resources of the rest of the economy. 

We can keep on doing what we have been doing. We can try to regulate once the problem is severe enough to cause outrage. We can hope that caring about the environment catches on as a religion of ethics. We can hope that human potential, children’s education, and social capital will be captured in a new government program; but the last hundred-plus years of experience would suggest that doing the same thing and expecting a different result is, well, a bit crazy. 

It should not be so hard to live our lives and have the quality of life we and all other living things deserve. We can keep pumping energy into fixes that have never solved the problem or we can come to terms with the real problem, get to the root cause of most of our social and environmental ills, and begin to solve, not just ameliorate them. If we do not find a way to include negative and positive externalities in the mainstream economy, we will always have a system that is out of step with our desire to have a healthy economy, a healthy environment and optimal human well being.

The Solution.jpg

That is why we created The Intrinsic Value Exchange [IVE]. We want to create a mechanism for our economy to recognize hidden costs and un-priced values efficiently. We want to allow the incredibly powerful and pervasive market economy to work with natural and societal capital and make it simple for the average person to make a living, enjoy life, AND support society’s social and environmental values.