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It looks like externality is the situation when the frame of reference used by the actors is deficient and outcomes extend to the other metrics (spillovers).
These literatures treat the concept of externality uncritically. Thus it is natural for a reader encountering a paper discussing network externality to look for the association most commonly made with externalities: that the market fails. And the reader is not disappointed. But another problem is that the government intervention might not provide the desired effect and make the market failure even more pronounced.
This argument, carried to its logical conclusion, actually might indicate that most markets fail standard economic tests of efficiency, and are behaving in a different way then their economic abstractions. This conclusion is too important to pass without careful scrutiny. One such thing is over-consumption of luxury goods. The commonly known terms such as "keeping up with the Joneses," the status treadmill" the "arms race of consumerism, Consumer Fetishism," and Velben's "Conspicuous Consumption". But we will try to analyze it not from a moralistic standpoint, but from economic and particularly sociological standpoint. Out hypothesis is that this the imbalance in USA population spending patterns may be viewed as a market failure caused by consumption externalities: by the fact that greater consumption by some people imposes significant costs on others.
An important advantage of this explanation is that it is grounded in the very same theoretical framework that animates the beliefs of the most ardent defenders of the status quo. Thus, as even conservative economists have long recognized, when one family's spending decisions impose negative consequences on others, Adam Smith's invisible hand simply cannot be expected to produce the best overall spending pattern. Greed alone is not really responsible for the USA relentless desire to have flashier household appliances, big sport-utility vehicles, and fancy 4 bedroom suburban houses with just one or two occupants; rather it is the ongoing behavior of social peers which ultimately determines how much average Joe Consumer should spend and how he spend it. In Russian this phenomenon is called "Ella-man-eater syndrome" from the heroine of the famous novel "Twelve chairs". Author Robert H. Frank's thesis is that runaway consumption of extravagant luxuries is a major problem in American society. This concept may have seemed more valid in 1999, at the height of the dot-com bubble, when the book first rolled off the presses, than it does in 2004. The intervening recession has done a lot to rearrange household consumption priorities. Yet one need only look at the houses, cars and home entertainment systems on the market to recognize that the thesis has not entirely lost all merit. For the more muscular theoretical foundation of this premise, readers are referred to the superior 100-year-old classic Even in the shadow of that light, Frank's observations about the pressures to consume - especially the evidence that he marshals for an evolutionary compulsion to "keep up with the Joneses" - merits notice. While the author's proposed remedy of a consumption tax is controversial, we believe this book deserves to be read and appreciates its unusually stimulating, accessible writing on economics.Behavioral science now provides additional grounds to question the wisdom of our current spending patterns. Scores of careful studies show that we would be happier and healthier if we spent less on luxury goods.
But this raises an obvious question: If we'd be better off if we spent our money differently, why don't we? In her essay (and in her recent book, The Overspent American), Juliet Schor surveys a variety of possible explanations. Communitarians cite a decline in social capital, noting that affluent Americans sequestered in gated communities are increasingly insulated from the consequences of our neglected public sphere. Social theorists emphasize the imperatives of class and identity, which drive many to proclaim their superiority over others through the purchase of costly goods. Other critics stress the influence of sophisticated marketing campaigns, which kindle demands for things we don't really need. Professor Schor especially favors this marketing explanation, and she argues forcefully on its behalf, as did John Kenneth Galbraith more than forty years ago in The Affluent Society.
Despite its distinguished pedigree, however, the marketing explanation also has a drawback: although it can account for a bias toward luxury consumption spending, it does not seem to explain why things have gotten so much worse. Television advertising has been with us since the early 1950s, after all, and salesmanship in various other forms since before the dawn of the industrial age.
Why, then, are the apparent distortions so much larger today? In my recent book, Luxury Fever, I suggested that one reason may lie in a simple change in the economic incentives we face. This change is rooted in a fundamental shift in the distributions of income and wealth in America that began in the early 1970s.
Whereas incomes grew at about 3 percent a year for families up and down the income ladder between 1945 and 1973, most earnings growth since 1973 has gone to families at the top. For example, the top 1 percent of earners have captured more than 70 percent of all earnings growth during the last two decades, a time during which median real family income has been stagnant and the incomes of the bottom fifth have declined about 10 percent. Reinforcing these changes has been a parallel shift in the distribution of wealth, much of it driven by the spectacular run-up in stock prices.
Increasing inequality has caused real, unavoidable harm to families in the middle-class-even those who now earn a little more than they used to-by making it more difficult to achieve balance in their personal spending decisions. The problem stems from the fact that the things we need so often depend on what others have. As Nobel laureate Amartya Sen has pointed out, a middle-class Indian living in a remote mountain village has no need for a car, but a middle-class resident of Los Angeles cannot meet even the most minimal demands of social existence without one.
When those at the top spend more on interview suits, others just below them must spend more as well, or else face lower odds of being hired. When upper-middle-class professionals buy 6,000-pound Range Rovers, others with lower incomes must buy heavier vehicles as well, or else face greater risks of dying. Residents in a community in which the custom is to host dinners for twelve need bigger dining rooms than if the custom were dinners for eight.
So when top earners build larger houses-a perfectly normal response to their sharply higher incomes-others just below them will have greater reason to spend more as well, and so on all the way down. Because of the growing income gap, the size of the average American house built today is roughly 2,200 square feet, up from 1,500 square feet in 1970.
The middle-income family that buys this house must carry a significantly larger mortgage than the buyer of the average house in 1970. And because public school quality is closely linked to local real estate taxes, which in turn are closely linked to average house prices within each school district, families must buy an average-priced house or else send their children to below-average schools. So even the middle-income family that doesn't want a bigger house may feel it really has no choice but to buy one.
Yet because this family has no more real income than in 1970, it must now carry more debt and work longer hours to do so. Little wonder, then, that despite the longest economic expansion on record, with the unemployment rate at a 29-year low, one American family in 68 filed for bankruptcy last year, almost seven times the rate in 1980. Our national savings rate is now negative, which means that we are currently spending more each month than we earn.
Luxury Fever: Why Money Fails to Satisfy in an Era of Excess is a serious examination of the long-term costs associated with our society's ever-accelerating spiral of conspicuous consumption, followed by a far-reaching remedy that will intrigue anyone concerned with related fiscal issues. Robert Frank, a Cornell University professor of economics, ethics, and public policy, who previously coauthored The Winner-Take-All Society, believes neither foolishness nor greed is really responsible for our relentless desire to own flashier household appliances, bigger sport-utility vehicles, and fancier suburban houses; rather, he contends, it is the ongoing behavior of our peers which ultimately determines how much we spend and how we spend it. Frank goes on to claim, however, that this knowledge alone may actually point us toward an alternative that is both acceptable and practical. "By a simple and easily achieved rearrangement of our current consumption incentives," he writes, "we can effectively enrich ourselves by literally trillions of dollars a year." He then goes on to discuss the recent boom in luxury spending, its potential implications for those at all income levels, his suggestions for altering current consumption patterns, and the reasons that redirecting these funds could benefit everyone. --Howard Rothman
From Publishers Weekly
Frank, a professor of economics at Cornell and the author of The Winner-Take-All Society, castigates Americans for wasteful spending and offers reasonable, if unexciting, policy proposals to remedy the problem. Our homes, cars and even our watches are flashier than ever. But although the rich have the money to indulge their whims, the rest of us finance our spending sprees either by decreased personal savings or by increased debt: Frank reports that total household debt grew from 56% of disposable income in 1983 to an astonishing 81% by the beginning of 1995. Most economists accept that conspicuous consumption merely reflects Adam Smith's dictum that the sum of individuals seeking their own interest adds up to the greatest good for all. But Frank argues that our notions of self-interest are skewed, that all this getting and spending doesn't even make us happy (if your neighbor didn't buy the new Lexus, you wouldn't feel the need for the newer Beemer, and you'd both work less and spend more time with the kids). The problem, Frank believes, is that American society has a glut of individual incentives and a dearth of group incentives. To protect us from our greedier selves, Frank lobbies for a tax exemption for savings and a progressive consumption tax. If Americans spent less on luxury items, he writes, there would be more money available "to restore our long neglected public infrastructure and repair our tattered social safety net." Frank's diagnosis of American luxury fever is hard to dispute, but his remedies, sensible in the abstract, take insufficient account of the political and cultural obstacles that need to be overcome to implement them.
Copyright 1998 Reed Business Information, Inc.
A very good discussion. PUBLIC GOODS AND EXTERNALITIES. Cached with notes internally.
Inducing Market-FailureBy Kevin
I must agree with Don Boudreaux. From my perspective the most critical economic function of a government is not its ability to correct externalities and market-failures, but its ability to induce them. The institutions that governments maintain can either sustain and enrich or feed off and combat economic activity.
As a result of geographical monopoly and historical accident, a range of governmental forms--and resulting economies--can be found. After a cursory analysis, it becomes absurdly clear that the power to induce and sustain market failure is most often found in the poorest countries.
I could be pursuaded otherwise, but I hold fast because of two charts that Don asked me to quickly assemble a few months ago--plotting Economic Freedom and Freedom to Trade vs. GNI per capita:
Thus, for externalities, and for other market. failures, issues of values ...
Market failures include. externalities due to an imperfect world oil market, ...
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But with externalities, as in market failure analyses,. gains fromtrade failtobe
realized ... market failure occurs and externalities exist when in real- ...
MY CLAIM, in a nutshell, is that the imbalance in our current spending patterns may be viewed as a market failure caused by consumption externalities: by the fact that greater consumption by some people imposes costs on others.
Thus, as even conservative economists have long recognized, when one family's spending decisions impose negative consequences on others, Adam Smith's invisible hand simply cannot be expected to produce the best overall spending pattern.
The other issue relates to market failure or rather more specifically government failure. Market failure refers to a situation where the forces of demand and supply do not, for some reason, allocate resources efficiently. In this case we could look at the concept of allocative efficiency. This refers to a situation where individuals cannot be made better off through a reallocation of resources without making someone else worse off. In more simple terms, firms are producing goods and services that people want. Allocative inefficiency implies that resources could be reallocated to make individuals better off without making others worse off.
In the case of Exeter, it could be argued that the fall in the number of people wanting to do chemistry at A' level and university would suggest that resources should be moved from providing chemistry to something that students do want to do, for example, media studies.
Under normal circumstances, however, education could be regarded as being immune from market forces. It could be argued that chemistry, being a core subject is something that ought to be provided regardless of the demand for places; it could even be argued that there would be significant external benefits in so doing in terms of the benefits from research and development in university chemistry departments as well as providing well qualified chemists to increase the stock of quality human capital.
... ... ...
Whilst the funding mechanism is meant to be fair, the chances are that it will distort resource allocation and in turn cause market failure. By intervening in the 'market', the government might have actually created more problems than it intended. This is what we mean by market failure and government failure.
This Problem Based Learning (PBL) exercise focuses on the issue of non-renewable resources and externalities in production. There is conflicting evidence about just how much damage the remorseless progress of production and economic growth is imposing on the Earth's natural resources and arguments about the potential methods to tackle this damage.
A recent report from the Millennium Ecosystem Assessment suggested that the human race is using up resources at an alarming rate and are destroying many others. Can 1,300 experts from 95 countries be wrong and if they are not what can we do to help reverse this trend?
Our Guide for Educators provides advice on how to use this resource with both HE and FE students.
4.2 Instances of Market Failure in Energy Markets
The types of market failure likely to be found in energy markets can be briefly set out as follows:
The presence of monopoly. Electricity and gas networks are largely natural monopolies. Their operation will be determined by the regulatory framework in which they operate rather than by competitive forces. Regulatory intervention may be necessary to encourage use of renewables and CHP.
More broadly there may be international monopolies on fuel supply. Dependence on OPEC for oil and on a few exporters for natural gas supply by pipeline may raise concerns about future exposure that would not exist with a more competitive upstream market.
Taxation. Taxes may distort prices and so affect resource allocation. Some forms of energy are heavily taxed and so, considering this dimension alone, too little energy may be consumed compared with that required for maximum theoretical economic efficiency. However, other tax distortions may encourage excess consumption. For example, VAT on residential energy is applied at a lower rate than VAT on insulation materials and other goods.
Principal agent problems The person who is responsible for carrying out a certain activity may not be the one who incurs the costs. This will lead to a mismatch of interests if it is difficult for the party bearing the costs to provide the right incentives to the agent, or to monitor their behaviour. For example, employees may not attempt to save energy in the workplace because their employer incurs the costs, or tenants may find it difficult to ensure the optimal rate of investment by landlords who do not incur the costs of heating the building.
Capital market distortions. It may be difficult to make investments because capital markets do not adequately reflect the value of the investment. For example, mortgages may be awarded on a simple multiple of salary. This may limit the affordability of an energy efficient house with higher capital costs, even if the lower running costs would lead to lower total costs
Verification of purchases. In energy markets it is often difficult to determine what is needed or whether it has been effective once bought. For example, it will be difficult for a householder to judge the appropriate level of insulation for their home or to measure by exactly how much their energy use has changed as a result of upgrading their insulation.
Underprovision of public goods. Markets tend to underprovide goods, such as national defence, where it is difficult to exclude people from benefitting (making it difficult to secure payment and encouraging free riding) and where consumption by one does not reduce availability to others (implying very low marginal costs and so a very low price for optimal consumption). The main examples of such circumstances in energy markets are provision of information and fundamental research and development.
Public goods can be provided by private institutions. The necessary role of the state, or other body acting on behalf of the public, is to ensure the optimal amount of such goods is procured.
Externalities. The value of things which are not priced is not recognised by the market so consumption decisions do not take into account the full costs and benefits.
- Negative externalities occur where costs are not priced. For example, emissions to the atmosphere may impose costs via climate change but this is not normally priced.
- Positive externalities exist where a good or service provides a benefit the value of which the producer can not appropriate. For example, education and training may benefit not only the firm or individual but also the wider economy.
Recognising the cost and value of externalities which will not be fully recognised by conventional pricing is closely related to ensuring sustainable development.
Social Goals. Markets may fail to provide adequate warmth and other basic energy services for all. Measures to address market failures other than the underpricing of environmental externalities are sometimes referred to as "no regrets" measures because they are worthwhile even in the absence of environmental considerations.
Network externality, the concept that a product's value to a consumer changes as the number of users of the product changes, has become increasingly influential in economic thought. In this paper we elaborate a claim that, in spite of the popularity of the concept, several important aspects of network externalities have been neglected or misunderstood. We argue that many 'network externalities' are not externalities in the modern sense of causing market failure. Some are not sources of market failures because they are pecuniary externalities, which is a class of externality that does not constitute market failure. Other supposed instances of network externality are incorrectly classified as externalities because they are internalized through market mechanisms.
We also argue that the new technologies that are thought to have spawned these externalities have been improperly modeled. The seemingly relentless decreases in costs that are associated with many new technologies are due not to economies of scale so much as rapid technological progress. And the decreased costs associated with technological progress is not a new phenomenon. We conclude that the empirical importance of network externalities, as externalities, has been greatly overstated.
Every new age is enamored of its own advances. In this "age of technology," our focus is on such highly visible technologies as computers, fax machines, and new methods of communication. So taken are we with these new technologies that we tend to treat these new inventions as sui generis, so different in essentials that we cannot even speak of them in the same terms as we have used in the past. To discuss the advances of this age of technology, the economists has invented a new concept: network externality. Network externality has been defined as the change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes. It is argued that network externality is endemic to new, high-tech industries, and that such industries experience problems that are different in character from the problems that have, for more ordinary commodities, been solved by markets (Katz and Shapiro 1985, Farrell and Saloner 1985).
The concept of network externality has been applied in the literature on standards, in which a primary concern is the choice of a correct standard (Farrell and Saloner 1985, Katz and Shapiro 1985, Liebowitz and Margolis 1994a). The concept has also played a role in the developing literature of path dependency, which maintains that the explanation for many market outcomes is mere happenstance (Arthur, David).1 While the path dependency literature has focused on technologies, the reasoning of path dependency arguments has also been extended to the choice of social institutions (Binger and Hoffman, North).
These literatures treat the concept of network externality uncritically. Thus it is natural for a reader encountering a paper discussing network externality to look for the association most commonly made with externalities: that the market fails.2 And the reader is not disappointed: papers in this literature have found market failure. As we will show below, this argument, carried to its logical conclusion, would indicate that most markets fail standard economic tests of efficiency, and thus might be thought to call for government intervention into most markets. This conclusion is too important to pass without careful scrutiny.
This paper elaborates a claim that network externalities are not well understood. We demonstrate that one class of phenomena identified as network externalities is actually pecuniary in nature, and not a cause of welfare loss. We also argue that many of the remaining network externalities are not externalities at all, but are better thought of as network effects that are resolvable by the familiar mechanisms of ownership and contract that internalize these effects. Further, we discuss the mischaracterization of technology that has been offered to justify network externalities and we elaborate upon the technical features of models that have led other authors to conclusions that differ from ours. In sum, it is our argument that, notwithstanding the enthusiasm that has greeted this literature, the concept of network externality has, in important respects, been improperly modeled, incorrectly supported and inappropriately applied.
To put the public goods and externalities problems in perspective, you may recall from Lecture Five that perfect competition provides an efficient allocation of society's resources. However, you may also recall that when one or more of the assumptions of perfect competition are not met, a market failure results.
So far, we have examined the market failure of imperfect competition in our discussions of monopoly, monopolistic competition, and oligopoly. Now we turn to public goods and externalities-two market failures that provide the rationales for a large part of our government's expenditure.
For example, each year the United States government spends almost $300 billion dollars on one public good alone: national defense; and this defense expenditure represents a full 15 percent of the total federal budget. At the same time, billions more are spent on other public goods ranging from parks, roads, and bridges to our criminal justice system, flood control programs, and even our lighthouses on the high seas. In this lecture, we will explain why it is the government rather than the private marketplace that has to provide for all these public goods.
Similarly, we shall see that the externalities market failure helps explain not only the existence of many of our environmental protection laws but also many government health services. In analyzing this important problem, we will want to come to understand the many different ways a government can address it-from liability rules, lawsuits and direct controls to the use of taxes to discourage "negative externalities" and subsidies to encourage "positive externalities."
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