Externalities: What are and how we can get affected by them (A bit of theory!)

When we talk about a company that is throwing their wastes into the river - polluting the area - because it is cheaper for them and as a consequence their total costs can be reduced, we are dealing with an example of an externality.

When we see a person that smokes inside a closed room, we are dealing with an externality too.

When someone decides to get a vaccine, yes, again an externality appears.

So, what are externalities then?

A definition can say that are decisions that would be affecting a third party that was not involved in the decision making. They can produce a positive or a negative effect over that party.

In the first case we have that the action taken by the company will be related with a negative externality of production. The solution to that problem will be that the firm will have to take care of the damage they are producing.

As a consequence their total costs (Marginal Private Cost) will probably be increased, followed by an inward shift of the supply curve (reaching now the Marginal Social Cost).

In the second example, the smoker affects other people inside the room (passive smokers) in a bad way. So The Marginal Private Benefit (directly related with the smoker) will be higher than the Marginal Social Benefit (the effect over the other persons).

By the way, the market will be in equilibrium when the Marginal Social Benefit is equal to the Marginal Social Cost.

M.S.B. = M.S.C.

Till my next post!

Prof. Fernando Julio Silva, MSc.
APRIL 2009

A higher income means a greater consumption?

WRONG! Even though if we just analyze this point from a pure microeconomic theory we can expect that an increase on income, if you are dealing with normal or luxury products, could be followed by an increase on demand. When we focus on real live we’ll see that this is not always true, due to the fact that decision making on humans is “almost unpredictable”.

When we decide to buy - or not - something a big number of factors get into the scenery, and those factors usually don’t follow economic theories!

What makes a person to buy a product “A” instead of “B”? What helps on the decision of buying now or wait a bit? How tell us the amount of units really needed? What makes us spend more money on a product that the one that we really were planning to use?

Rationality? I might say that usually the “lack of it” is our counselor.

We can use our credit cards feeling that “someone else” will be paying for that debt; but when the bill appears we crash against reality.

How many times we went to a supermarket just to buy a couple of things and we end up buying a lot of unneeded products?

On the other hand, how many times we were waiting to have some extra money to buy something that we liked a lot and when that time appears we just decide not to do so?

Or maybe we prefer to save - just in case - instead, so our level of consumption decreases.

Reasons? A big number of them. Why? Who really knows!

Till my next post!

Prof. Lic. Fernando Julio Silva, MSc.
APRIL 2009

Inflation: "with a little help from consumers".

Even though it sounds strange is true! Under an inflationary period consumers can help to increase the level of inflation, this is due to uncertainty.

People being afraid of a bigger increase on prices will start consuming more - stocking products - than what they regularly do, thus increasing prices even more.

Are consumers aware about this effect? Probably not but no one will like to be the one that will have to pay a higher price on the future or suffering cause of a lack of products in the market.

Now, try to imagine this situation under hyperinflation, prices will run out of control very fast and stock will disappear from the market.

Another reading can show us that speculation can appear from two different points of view:

a) Producers increasing their prices cause of knowing an excess of demand will be present.

b) Pure speculators that will buy now to sell when scarcity gets into the economy.

So, next time an interesting level of inflation gets into a country things could be think twice before the demand is increased and may be some type of government intervention would be welcomed!

Till my next post!

Prof. Lic. Fernando Julio Silva, MSc.
APRIL 2009