Gautama Buddha was staying in a village for a short duration of time. People from far-flung areas came to acquire wisdom from him. A rich businessman was a devotee of the Buddha who lived in the same village where Buddha was staying. He was grappling with a problem and hadn't met him for a very long time. He was reluctant to tell his problem to the Buddha. The cause of the reluctance was to admit his mistake in front of him. He tried everything and was unable to find the solution to the problem. Finally, one day he asked Buddha, "Oh! wise one please help me. I am in a terrible dilemma." Buddha replied softly, "My dear, What happen? Why are you looking so worried?" "I am a businessman. I am losing money while trading. My trade partners are using and taking advantage of me. They are winning at my expense.", answered the businessman. Buddha understood the problem and smiled at him. He told him to wait for at least three days before taking any big financial decision. Be patient and don't let your emotions overpower you. When you give a piece of bread to a dog, he won't eat it immediately. Dog smell it to make sure that it was safe and then eat it. The dog used the power of smell before making the decision. Similarly, use your wisdom before making any big decision in life. Never be in a hurry and don't act impulsively. Finally, Buddha looked into the eyes of the businessman and understood that the lesson becomes imprinted on his consciousness.
The story is full of wisdom and contains many insights. Patience is a virtue. The best way to inculcate patience is through fasting. Fasting kills cancerous cells and has many other health benefits. Another insight is not to react impulsively in any situation. There exists a gap between a thought and a response. In between that space, one can either make or break his life. A span of three days will help the businessman to look at the problem objectively and from various angles. A high Intelligent Quotient(IQ) will help a person to crack difficult exams and to solve the complex problems of life. A high emotional quotient(EQ) will make a person mature and helps him to forge healthy relations with others.
Gautama Buddha was a king who renounced his kingdom to understand the mystery of life. He wandered from place to place and enriched himself with many experiences. Finally, he became enlightened. Another insight from the above story is that the teachings of Buddha are helping contemporary men to live a peaceful, silent, and blissful life. His actions are acting as a positive externality to people who wants to become spiritual in their life.
Success is an outcome of the right actions at the right time. Humans are bound by their actions. They can't achieve anything without actions. According to the first law of ecology, "Everything is connected to everything else." Actions follow the law of cause and effect. They have intended or untended consequences. Everybody wants to do actions whose consequences won't come back to bite them. At the surface level, it seems impossible to predict the unintended consequences. As one digs deeper, he can observe that all unintended consequences follow a similar pattern. The awareness of those patterns will help us to avoid them.
When we try to pick out anything by itself, we find it hitched to everything else in the Universe. John Muir
An externality is a commonly used term in economics. This model will serve you to make optimal decisions in life. An externality is a cost incurred or benefit received by a third party who doesn't have direct control over the factors that cause it. People like Elon Musk, Steve Jobs, Gautama Buddha, etc. pursued their dreams(life's calling) to live a happy and contended life. Their actions act as a positive externality to the people like us. Their audacious steps encourage others to endure harsh conditions and not to give up under any circumstance. They taught us to keep hammering the stone(complex life problems) with an axe(wisdom) until it breaks(solved).
Externalities are of three types:
Positive Externality
Negative Externality
Positional Externality
Positive Externality: The idea of the positive externality is the benefits received by the people who haven't participated in the transaction. The aesthetic exterior and alluring garden of a house create a sense of joy in the hearts of neighbors and passers-by is an example of a positive externality. Externality produces spillover effects. It occurs when the effects of an event spill over the core interaction of an activity. The employee of the industry gets medical training to help others during an accident. The employee can utilize those skills to help others when an accident occurs outside the industry. The sharing of information and skills acquired at the training with the members of other teams helps them to achieve their goals like a promotion at a faster pace.
The government holds vaccination programs to prevent the outbreak of deadly diseases like polio, measles, smallpox, etc. Vaccination generates antibodies within people to fight against fatal viruses. The government wants to achieve herd immunity among its population. Herd immunity is a term used in the medical domain which describes that the majority of the population has developed immunity against a particular disease.
Diseases can spread if they have an eligible host to infect. Vaccination increases the antibodies in the environment. Some people can't be vaccinated due to their suppressed immune systems. If you have taken the vaccination then you are not only protecting yourself but your action acts as a positive externality to those who can't be vaccinated.
The publication of research papers exhibits positive externalities to those who use their applications well beyond their initial scope. Their time is not wasted on reinventing the wheel. In fact, they are standing on their shoulders to see the wider horizon. The discovery of probability is an example of a positive externality. It was initially used to solve gambling disputes. Later on, it is used in other disciplines like calculus, finance, Artificial Intelligence, etc. Now it becomes an intrinsic part of us to make optimal decisions. Patents and Copyrights are issued by the government to protect the intellectual property of researchers. It helps them to earn money before their ideas become streamlined. We all benefit and researchers have the incentive to continue their work.
The positive externality comes at a cost. It poses the free-riding problem. A person who enjoys the benefit without paying the cost tends not to value it. The common resource being exploited causes the tragedy of the common problem. A citizen who cheats while paying taxes is free-riding on the services provided by the government. An employee who is not doing any substantiative work is free-riding on the rest of the project.
Negative Externality: People who bear the cost of a transaction without their participation in it. Suppose a person came home at the night from the office on Friday. He was feeling exhausted and crashed into bed after eating dinner. People living nearby were in a party mood. The loud music was disturbing his sleep. He was bearing the cost without his consent. Another example of a negative externality is of a person who smokes a cigarette affects the health of the people standing nearby him. A person reclines his seat on an airplane. He enjoys more space at the expense of a person who is sitting behind him.
Some people chose not to get vaccinated due to the fear of the harmful effects of vaccination. Their actions are preventing them to achieve herd immunity. Along with that, they are acting as a negative externality to those who can't be vaccinated due to their suppressed immune system. People living near the airport and industries suffer from nose and air pollution bearing the cost without getting any compensation for it.
Positional Externality: It occurs when the decisions change the perception of future value. It takes into account the second-order effects. Suppose a person stays late and leaves the office around 7 pm. His colleagues left the office at 5:30 pm. He wants to remain in the good books of his boss. He thought that it might help him to climb the ladder of ranks. Parkinson's law states that the work expands to fill the time allocated to it. He is not adding extra value to the organization. Those who leave early will be presumed lazy. They will also start staying late in the office. Now staying late in the office becomes a new norm creating a lose-lose situation for everybody.
Veblen goods are also an example of a positional externality. The items like diamonds, Lamborghinis, tailor-made suits, etc are considered Veblen goods. They have very high value due to scarcity. People signal high status by owning them. The ubiquitousness of such items will remove them from the category of Veblen goods. The purchase of Veblen goods causes the positional externality on those who already own them. The utility derived from consuming any good is relative to its average value in society. The value of a new shiny car increases exponentially if people living nearby are driving old wrecked cars.
The cost of an externality can't be measured directly. They can be addressed by using internalization. It is an act of imposing a massive cost on an entity that causes a negative externality. The price imposed tries to maximally cover the cost of dealing with the consequences of the activity. Internalization also tries to create incentives that prevent the happening of a negative externality. The government imposes high taxes on cigarettes. The high insurance premium is offered to smokers as compared to non-smokers.
The construction of tolls to reduce traffic congestion on highways. The high tolls forced the citizens to use public vehicles. It also helps in reducing pollution. The government sets the limit for industries for the emission of air pollutants by issuing carbon quotas to them. The tax credit will be given to industries that use green technology. When unethical behavior is left unchecked and upon crossing a certain threshold becomes the new norm. Therefore, professional codes will be implemented by the government to prohibit immoral conduct.
The Coase theorem is also very helpful in dealing with a negative externality. It was given by Ronald Coase who won the Nobel prize for it in the year 1991. It states that an externality can be internalized efficiently without further need for intervention(either by the government or by an entity regulating the externality) if the following conditions are met:
Well-defined property rights.
Rational actors.
Low transaction cost.
Suppose an industry is releasing waste material in the nearby river. The residents of the area where the industry is established visit the river in the evening to see a beautiful sunset. The release of waste products by the industry makes their experience very unpleasant. The industry acts as a negative externality for the visitors. The river is a public good that is neither owned by the resident nor by the industry. The residents have two options.
File a legal case against an industry.
By using the Coase theorem.
Filing a case costs millions of dollars and takes a lot of time and effort. The Coase theorem will be of immense help in such situations. The government will issue a permit for the industry to release the pollutants into the river. It poses a limit on the industry to release waste products into the river. Along with that people have to pay a minimal cost to see the dazzling beauty of the river. The profit will go to the industry. It meets the criteria of well-defined property rights. The industry as well as residents are rational actors. The industry will try to maximize profit by using green technology. It will also take care of the river to make it a beautiful tourist spot. The more people visit the river, the more profit for the industry. Coase's theorem has created a win-win situation for both parties for a low transaction cost.
Conclusion: Our actions have the potential to change the trajectory of our lives. They generate positive, negative, and positional externalities. Try your best to generate the maximum number of positive externalities. Counter the effect of the negative externality of others with your positive externality. It creates more positive light in the universe. Align your actions that will bring a smile to the face of your loved ones.
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Photo by Helena Lopes on Unsplash
Good examples