Externality as a Big Concept in Economic Analyses - Research Paper Example

Introduction When any transaction in an economy happens such that it impacts somebody other than transacting parties, in either positive or negative manner, then the influence on the other parties is called as externality. Externality is a significant concept in economic analyses. Externality is a source of market failure which warrants government’s intervention to maintain equilibrium and achievement of economic goals. When the cost generated by a transaction is higher than the private cost, then the excess cost is borne by the society and is called negative externality. On the other hand, when the benefit generated by a transaction is more than the benefit enjoyed by the transacting parties, then the excess of benefit is passed on to society and is called as positive externality. Negative and positive externalities influence a producer’s production decision. If there is negative externality generated, then a producer will produce more. However, making the producer compensate the society, through taxes etc would induce lower output. For example when government puts taxes on pollution, the tax will increase the cost to the firm and the firm may reduce its production. In case of positive externality, the firm may be induced to restrict production unless compensated for the social benefit it generates. For example, if a firm is aware of the fact that its product innovations can be enjoyed by other firms also by imitating it product prototype, then the firm will be discouraged from investing in R&D. Thus the government has to compensate the firm through tax benefit, legal protection like copyright, patent etc so as to motivate firms to spend on R&D. Some examples of positive and negative externality are Positive Externality – Innovation, which has not been patented, allows other firms also to enjoy the newer knowledge without paying for it. Figure 1 shows Positive externality situation. Negative Externality – There are many types of negative externalities in an economy. For example pollution caused by factories, Smoking, drunk driving accidents, crimes, tax evasion etc. Figure 2 Negative Externality Markets, without government intervention will not be able to deal with externalities. For instance without government intervention patenting rights can not provided and pollution taxes can not be enforced. Thus the government has to intervene and correct the externality problem to restore equity in the economy. Smoking as an externality Smoking has been a problem to the society, for a very long time. Until 1980s, smoking had been considered as an irrational behaviour and smokers were thought to be behaving without rationally weighing its merits and demerits. Becker and Murphy (1988) argued that since smoking was a rational behaviour and thus government’s intervention to ban or tax smoking was unreasonable. He mentioned that the smokers fully internalize the costs in their, rationally made, smoking decisions. Nevertheless, government and other social agencies do consider smoking an externality. The next section will briefly discuss on this issue. Smoking is essentially a negative externality on the society. Albeit, the exact degree of it has been a matter of debate among economists, philosophers, sociologists etc, however no authoritative study has been able to deny that smoking is a negative externality. Although, discussions on positive side smoking externality can be found but the amount of such positive externality through smoking will be very small in relation to the negative externality that it pushes on the society. Why smoking, as a negative externality warrants so much debate and discussion. Cigarettes cause more illness and death in the United States than anything else*.The adverse health effects from cigarette smoking account for an estimated 443,000 deaths, or nearly 1 of every 5 deaths, each year in the United States. More deaths are caused each year by tobacco use than by all deaths from human immunodeficiency virus (HIV), illegal drug use, alcohol use, motor vehicle injuries, suicides, and murders combined. Though it may be argued that these figures, although do suggest smoking as a problem, but they nowhere show smoking as an externality. Nevertheless, the argument fails to consider that when people start smoking they are very young and thus are not in position to consider the demerits of smoking. The reasons for not considering the costs attached to smoking are their lack of knowledge and their tendency to, heavily discount future costs. The net social cost of smoking, as estimated by a World Bank economist Howard Bernaum in 1990s is $200 billion a year for the whole world, Bernaum (1990). Estimation of degree of negative externality of smoking Although there are various arguments which aim at suggesting that smoking is not a negative externality and in fact is a positive externality. However such arguments fail to consider the externality attached with smoking in its entirety. Peck et al (2001) estimated the net private benefit of tobacco consumption to be $162 billion per year in the world. Nevertheless, even their analysis proposed that the optimum level of smoking is zero. The negative externality caused by smoking can be put under two categories. 1) Physical (causing health problems to non smokers ) 2) Financial (costs on account of health care of both smokers and non smokers, lower productivity etc) The physical externality can be caused in two ways, the adverse health effects on non smokers and the nuisance non-smokers bear, by inhaling second hand smoke. The net financial externality is argued to be close to zero. The rational behind such an argument is although smokers cause so many social costs such as medicare and medicaid; however the smokers also pass on some benefits to the society by dying early. The smokers like any other person do contribute towards social security funds like pension funds etc. However by dying early unlike others, they do not consume the fund that they had contributed and thus cause social benefit. However logically consistent this argument may sound, it fails to convince many. They argue that it’s absurd to think of dying early as a benefit to the society. If it were to be beneficial why would so many dollars be spent every year, on saving lives during crisis, epidemics etc. With regards to the physical externality caused by smoking, David Kamin (2002) argued the degree of physical externality is very ambiguous. The ambiguity arises due to the inherent difficulty in understanding external and internalized costs. He was of view that health costs are borne by only those who are chronically exposed to smoking and in most circumstances; they are the family members of the smoker. Thus he considered that a smoker will weigh the cost, of health problems to his family members and this cost will be internalized. With regards to the health cost caused to a baby due to smoking by a pregnant lady, Chaloupka, Hu, et al. (2000) argued that the mother considers the health care cost of the baby. Thus this cost is also fully internalized. However, Evans et al (1999) calculated the health costs to a baby from smoking of pregnant lady may amount to 42 to 72 cents per pack. Nevertheless it’s difficult to build a consensus on the above argument that all the smoking costs are fully internalized. Chaloupka and Warner (2000) propose that second hand health costs may amount to as much as 70 cents per pack. Gruber (2001) argues that there is another potentially sizable externality due to smoking i.e. workplace productivity loss. He stated that earlier studies had included number of sick days in their analysis; however they failed to consider the lowered productivity while on the job. Gruber (2001) suggested another type of externality which may be modest in comparison to others, however carries much significance i.e. annoyance. The annoyance like odor, breathing problems etc can be caused to non smokers through their exposure to smoke. Gruber (2001) hypothesized that if every non smoker is ready to pay $10 per year to avoid this annoyance, the externality may be 10 cents per packet. Moreover most of the people take up smoking when they are young and not in a position to consider the merits and demerits. Thus they can be considered as sufferers. Surveys show that 70% of smokers wish they could quit (Hymowitz 1997). Gruber and Koszegi (2002) argue that the decision to smoke is better modeled in a framework which allows smokers to be time-inconsistent. Thus smoking is a negative externality caused to society and needs to be dealt with. The solutions to the problem There are various measures that can be employed to deal with the problem of negative externality of smoking. But all these solutions come through government interventions only. The government may intervene in many ways: 1) Taxing cigarettes This is one of the most often used ways to deal with the menace. Warner et al (1995) said that to analyze the optimal level of taxation, form an economic perspective two concerns are important i.e. Efficiency and Equity. Efficiency – A major concern in efficiency consideration is the amount of revenue that can be generated by the tax. According to Ramsey rule tax rates should be negatively correlated with the elasticity of the product. Since charging higher on products with low elasticity does not decrease the consumption by a great amount, and thus does not reduce the tax amount. Cigarette as a product does not command very high elasticity (around -.4), since smoking, predominantly is an addictive behaviour. Thus charging higher tax allows the government to collect higher revenue without much loss in efficiency (loss of consumer surplus). However since, elasticity is a function of duration also, in longer run elasticity tends to be two times higher than in short run. Another important issue in efficiency consideration is “bearing the cost of consumption decision” (Warner et al 1995). Tax on cigarettes does try to lower the gap between private and social cost of smoking. Equity – Equity is the other important consideration in economic analysis and policy making. It deals with the fairness in the Taxes. There are two guiding principles for it, the benefit principle and the ability to pay principle. The benefit principle supports tax quite well, in the sense that tax does make people pay for what they enjoy. It argues that since smokers enjoy health care at the cost of society, they must pay for the benefit that they receive. Taxes on cigarette can be the way they pay the society back. The ability to pay principle holds that people should be made to pay according to their ability to pay. There are two types of equity here; horizontal equity and the vertical equity. The vertical equity holds that those who are more able to pay must be made to pay more than those who are less able to pay. Cigarette taxes violate vertical equity consideration of economic analysis. These taxes tend to be regressive. Since smoking expenditure is a higher proportion of overall expenditure in case of poor than affluent people. Thus the same rate of taxes paid by the poor and the affluent affects poor more severely than it affects the affluent. However, considering how price elasticity relates with income suggests that elasticity is negative related with income. Thus the price elasticity of poor people will be higher than that of affluent. Thus the regressive impact of taxes on cigarettes tends to get balanced as poor buy less cigarettes at higher prices thus they end up paying less amount tax in comparison to affluent. Another alternative available to government is to divert the revenue collected from cigarette taxes towards the welfare of poor people only and thus the regressive nature of taxation will be taken care of. Another argument in favour of Tax on smoking is, since youngsters have higher elasticity than older people, the impact of taxes is more on young people in comparison to their older counterparts. Since the rational decision making of young people is questioned and not of the older people, the problem of irrational consumption can be taken care of by discouraging youngsters from smoking, through taxes. Banning Cigarettes There can be two types of ban on cigarettes. One is banning smoking entirely, which is an extreme case and does not increase any welfare in the society. While banning smoking in certain parts does seem to help. Boyes and Marlow (1996) discussed that banning smoking in restaurants and bars does two things. First, bans take away the allocation rights from the owner and thus users can no longer bid for it. This is clearly a market failure, as prior to bans the smokers and non smokers were bidding for the zone and market was assuring them utmost satisfaction. Second, they argue that bans transfer the income from smokers to non smokers as non smokers no longer have to demand non smoking zone, which might have come at a cost. Thus bans do follow the benefit principle of equity. However, the exact merit of bans has to be calculated by estimating the negative externality caused by smoking and the income transferred from smokers to non smokers through bans. The bans however, are ineffective in dealing with the problem of smoking by kids, as the kids normally avoid smoking at places which are the usual targets for such bans. Advertising and educating people against smoking Advertising has shown the least effectiveness in terms of dealing with problem of smoking externality. The estimation of its impact can be calculated as negative advertising elasticity of smoking. The impact of cigarette advertising on consumption has been quite substantial, thus banning cigarette ads is an important step towards dealing with smoking problem. Nevertheless, the impact of education programme or negative advertising has not been proven very effective. The cost of advertising by the governments is also a cost to the taxpayers. Conclusion Although government has, for long tried to deal with the problem of smoking, however the results have been mixed in almost all the parts of the world. The reason for this lack of consensus over various aspects related to smoking. Policy makers, economists etc do not concur on major issues like: degree of internalization of the cost, the economic value of human life in monetary terms. Other important issues to consider are the substitutes of smoking and how they affect the different parts of the society. Research is also needed in the behaviour of youth and how smoking today affects their future. Economics has to compare present and future costs present and future benefits of any policy. Howsoever sophisticated analysis, economics may be able to perform however, it cannot give normative answers to questions like should cigarette be banned or not? These are better determined by our personal values and political orientation. Although economics can help us equipping decisions makers with required data and insight, however the decision has to come from human judgement and not from numerical figures. 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