Author:  Lori Alden

        Sheila is standing in the ticket line at a movie theater when four friends walk up and ask if they can cut in line in front of her.  Sheila quickly determines that the opportunity cost to her of letting them do so is one minute -- that's the time she would gain if she didn't let them cut in line.

          But what about the other people in line?  If Sheila lets her friends get in line ahead of her, then not only Sheila but everyone in line behind her will have to wait an extra minute to get an admission ticket.  If there are ten people in line behind Sheila, then the cost to them of letting the friends cut in line is ten times one minute or ten minutes.

          When something you do harms another -- and that person isn't compensated for that harm -- then you are creating an external cost.  If you talk loudly in the library, or play your stereo at midnight , or smoke cigarettes, or neglect to bathe, or drive while drinking, or practice your violin, you are probably imposing external costs on others.

         The social cost of a good or activity includes both the opportunity cost to you plus any external costs imposed upon others.  For example, the social cost of Sheila letting her friends cut in line is:  

                            Social Cost of Letting Four Friends Cut in Line  

Opportunity cost to Sheila of being delayed:        1 minute
External cost to people behind Sheila:   
             10 minutes

Social cost:                                                             11 minutes  

            Should you take external costs into consideration when deciding whether to do something?  Most people do.  If they didn't, ours would be a very unpleasant society to live in.  We call people who fail to consider the external costs of their actions rude.  

            We create external benefits when others benefit from something we do but don't compensate us for their gain.  Mrs. Nappi, for example, keeps her front lawn manicured and plants hundreds of flowers in her planting beds.  People who pass by get benefits from her landscaping, but don't compensate her in any way.  This means that her beautiful front yard produces external benefits.

             Almost everything we do causes some sort of external benefits or costs, collectively called externalities.  When we plant flowers, pick up litter, or comb our hair, we create external benefits for others.  When we smoke, drive, or sneeze, we often impose external costs.  Some activities, like wearing perfume, may cause external benefits for some and external costs for others.  

A rule for making decisions  

        Here's a decision-making rule that incorporates externalities:  

            Do something if its social benefit outweighs its social opportunity cost.  

             The social opportunity cost of doing something includes both the private opportunity cost to the decision-maker plus any external costs.  The social benefit is equal to the private benefit to the decision-maker, plus any external benefits.     

         People who take external costs and benefits into consideration when making decisions are said to internalize externalities People who internalize externalities weigh external costs and benefits just the same as their own private costs and benefits.  When making decisions, they try to make society better off, not just themselves.

             But some people aren't very considerate.  The failure of some individuals -- and firms -- to consider the effects of their actions on others is the root of countless social problems like rudeness, crime, and excessive pollution.  One of the most challenging problems in our society is to find ways to get more people and firms to internalize their externalities.   

How can we get people to internalize externalities?

     Suppose that Alicia is chewing gum loudly while taking a state board exam.  This annoys Jim, who can't concentrate.  How can we get Alicia to internalize the external costs of chewing gum?


1.   Etiquette  

             Here's what The New Emily Post's Etiquette by Elizabeth Post has to say about chewing gum:   

            ... Chewing gum, in itself, if it is done quietly and unobtrusively, is not unattractive.  But when one does it with grimaces, open mouth, smacks, crackles, and pops, and worst of all with bubbles, it is in the worst of taste.  

            The book also urges us not to stare, belch, or talk with our mouths full.  On the other hand, we should hold doors open for others, write thank-you notes, and give our bus seats to pregnant women.  Why?  To reduce the external costs we impose upon others, and to increase the external benefits.  

            Ms. Post summarizes good etiquette this way:  "The cardinal principle of etiquette is thoughtfulness.  This implies concern for the effect of your actions on those around you."   People with good manners balance the rights of others against their own.  In other words, they internalize externalities.  

            It's not clear what motivates people to obey rules of etiquette.   There's no Etiquette Police to enforce the rules, and no Court of Etiquette to sentence offenders.  Yet many people choose to be guided by the rules of etiquette anyway.  They know that without it, our society would be a very uncivilized place to live.    


2.  Negotiation.  

            Alicia violated a rule of etiquette when she chewed gum loudly.  But maybe it was because she didn't know she was annoying anyone.  It's hard to internalize externalities if you don't know they exist.  It might be helpful, then, for Jim to talk to Alicia.  He could take her aside and ask her to please stop, or perhaps to chew more quietly.

               People often remind others about external costs with signs, like "Please don't smoke," "Hang up and drive!", and "If you can read this, you're too close."

3.  Move away from the externality.    

            Another solution might be for Jim to change seats and move away from Alicia.  Perhaps he could sit in an empty seat on the other side of the classroom when he returns from lunch.  Then Alicia could chew gum while Jim took his test in peace.   

            Some people, though, would object to this solution out of principle.  They would argue that Alicia doesn't have the right to impose external costs on Jim.  Since it's her fault, she should be the one to move, not Jim.  

            But what if it wasn't Alicia's gum chewing that annoyed Jim, but rather the noise she makes when she erases her answers?  Or what if Alicia went to a remote bench to chew gum during lunch and Jim walked over and sat down next to her.  Do you still think that Alicia should be the one to move?  

            It takes at least two people to create an external cost -- the person causing the annoyance and the person being annoyed.  And it's not always clear who's to blame.  Many people would blame Jim if he were annoyed by the sound of Alicia's erasures.  

            Regardless of who's to blame, sometimes the "victim" is in the best position to prevent the external cost from occurring.  Suppose your sister annoys you when she practices her clarinet.  One solution would be for her to soundproof her room at a cost of $850, but a cheaper one would be for you to buy a pair of $2 ear plugs.  


4.  Regulation  

            Suppose that Alicia refuses to stop chewing gum, and that Jim is not allowed to move from his assigned seat.  Jim might then ask the proctor to ban gum chewing during the exam.  Doing this would completely eliminate the external costs from gum chewing in the classroom.  

            A problem, though, with inflexible rules like "No gum chewing" is that they don't allow for better solutions to be worked out, like having Alicia chew quietly or having Jim change seats.  

            Unfortunately, regulations sometimes become necessary when etiquette and negotiations break down.   For example, many communities and organizations now have rules which ban smoking.  This prevents smokers from annoying nonsmokers, but it also prevents people from working out better solutions among themselves.  

            Even if regulations did work well, we couldn't rely upon them to deal with all external costs.  To see why, try this experiment when you wake up tomorrow morning:  See how long you can go without imposing external costs on someone.  You probably won't get very far.  Some people wouldn't make it past the first buzz of the alarm clock.    

            Now consider what it would be like if we tried to control all external costs with regulations.  Here's what some of the regulations might look like:


Rule 13,327.  Alarm clocks.  The clock's sound-generating mechanism must be set to 60 decibels or less if others are sleeping within a 25 foot radius of the clock and choose not to be awakened by it.   

Rule 5,219.  Birthday candles.  The person celebrating his or her birthday (hereinafter known as the Birthday Person) shall spray as little moisture on the cake as possible when blowing out the candles.  The Birthday Person shall refrain from blowing out the candles if he or she has a cold, flu, or other contagious disease.  

             Can you imagine memorizing volumes full of rules like these?  And no matter how well the rules were designed, there would still be countless pleas for special exceptions. For example, the required 60 decibel alarm clock isn't loud enough to wake Mr. Jackson, who's hard of hearing.   And Sally has a contagious disease -- athlete's foot.  Does that means she can't blow out her birthday candles?  

            But all of these rules are quite unnecessary.  There's a single rule that can cover everything from alarm clocks to zoo trams, yet bend easily to meet the special needs of the people involved.  And it's small enough to fit into a fortune cookie.  The rule is this:  Internalize externalities. 







Lori Alden, 2005-7.  All rights reserved.  You may download the content, provided you only use the content for your own personal, non-commercial use.  Lori Alden reserves complete title and full intellectual property rights in any content you download from this web site. Except as noted above, any other use, including the reproduction, modification, distribution, transmission, republication, display, or performance, of the content on this site is strictly prohibited.