The Problem

Externalities plural of \ex·ter·nal·i·ty\ (Noun)
A side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost.

Most of us are painfully aware of the problem...


environmental degradation, record rates of species extinction, climate change and ocean acidification. We also face increasing social pressures from uneven economic growth, rising rates of income and asset inequality and an economy that too often lurches from one financial crisis to the next.

But few are aware of the root cause of these problems. Many of our core social and environmental problems stem directly from incomplete information about the costs of producing goods and services and the exclusion of certain assets (natural, human, and social) from the mainstream of the economy. Economists call these imbalances externalities – pollution for example. To address these imbalances, we employ palliative measures to “fix” systemic design issues. These patches include: regulations, taxes, artificial markets (like cap & trade), and the work of non-profits.

Unfortunately, these approaches are simply outgunned. There are not enough resources that can be transferred or donated to counteract the damage being done by flaws in our economic foundation. With our best efforts, we are simply slowing down the rate of decline while failing to address the root cause of the problems.

Is it us or the system?

If asked 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.”

If asked if it was okay to have textile sweatshops with polluting, dangerous working conditions, again 90% or more would say, “No, it is far from okay.” 

By the way, poll after poll indicates the overwhelming majority of people support a clean environment and safe, equitable working conditions.

But it is almost certain that 99% of us will go out and purchase gasoline and expect it to be as inexpensive as possible. When gasoline prices spike, there is always a loud cry of complaint for politicians to do something. When we buy clothes, we expect the same inexpensive goods.

A recent study at the University of Michigan offered consumers a choice of two socks for purchase. One clearly labeled as coming from a factory with safe working conditions and and environmental standards, the other without those standards. 50% of consumers chose the "good" socks.  When prices rose just 5%, the percentage dropped to 37%, a 25% decrease.  When prices rose 30%, now only 24% of customers chose the "good" 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, non-polluting 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, and society as a whole, 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 "good" socks cost less — how many would choose the safe working condition socks? Imagine if the clean socks were cheaper and the dirty socks 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 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, principles become harder to put into action. Life is hard enough already without having to be an environmental and social crusader and product sleuth as well. 

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 simply 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 glaring flaw in our current system is that it does not count all costs and excludes certain values. In the Ecuadorian rainforest example, 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 the damage from 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 can also leave out the 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, creates and 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 have traditionally resorted to taxes and regulation. And of course, the entire engine of our economy bridles at this restraint, as it is force-fed pricing information through this inefficient political process. 

The result of these artificial corrections is that those things we care about can be labeled the enemies of job and wealth creation. Those assets we otherwise value become liabilities because they are singled out for 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 adopt regulations that “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, ethic, or fashion. 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.