When Markets FailExternalities
List the costs and benefits that land on people outside the deal, because nobody prices them in.
When two parties strike a deal, they weigh their own costs and benefits. Effects on bystanders, such as noise, pollution, congestion or the benefit of a neighbour's well-kept garden, are left out. Costs to others get overproduced and benefits to others get underproduced, because nobody in the deal pays for or is paid for them.
How to use it
- Describe the activity and the parties who directly agree to it.
- List everyone else it affects, for better or worse.
- Estimate the size of each effect, even roughly.
- Ask how the effect could be brought into the decision: a charge, a payment, a rule, a negotiation between the parties.
- Choose the least costly mechanism and check whether behaviour changes.
Example
A hypothetical software team ships features fast, leaving operations to deal with the support load. Making each team carry a share of the support hours its releases create leads to more careful launches without any new rule.
Watch out
- Treating every side effect as a reason to intervene. Small externalities may cost more to fix than they do harm.
- Forgetting positive externalities. Activities that benefit others are often underdone too.
Related: Public Goods, Tragedy Of The Commons and Gains From Trade.