Minute Economics: Government and Externalities

Fareed Zakaria once stated that “things happening around the world are affecting you and me.” To us those things would be called externalities. An externality is properly defined as “a consequence of an economic activity that is experienced by unrelated third parties.” For example, if I am in my room quietly studying, but the dorm room next to me is having a wild party, my studying time is severely hampered by all the noise caused by the room next to me. I am not a part of that party, I have nothing to do with that party, but I am still being affected by the externalities of the party. Externalities are not always bad. For example, I had nothing to do with the Interstate Highway System. I was not one of the original designers, but I can enjoy the benefits of shorter travel times that the Interstate System provides.

However, with a project as big as the Interstate, who is going to fund it? No private individual would pay over 100 billion dollars for something that everyone else would freeload from. The solution comes from public goods funded by the government. Economist Charles Wheelan notes two important things about public goods. He states that they make “the cost of offering the good to additional users—even thousands or millions of people—very low” and that “it is hard, if not impossible, to exclude persons who have not paid for the good from using it.” Therefore, it is good for the government to fund these public goods, for no private individual will.

Consequently, with government backing public goods like these, it has a major role in encouraging or limiting externalities. For example, you get the great externality of having travel time cut with the interstate. However, the Federal Government has instituted speed limits on the Interstate which limits you experiencing the externality of a rogue driver traveling at 120 mph. Another department of government called the Environmental Protection Agency also helps determine what externalities a person experiences. The EPA helps mandate regulations concerning the health of the environment. Therefore one gets the positive externality of breathing in fresh air. However, an example of a negative externality caused by the government would be the large soda ban that New York City put in place this year. New York residents had nothing to do with the ban, most did not want the ban, but the Mayor of New York passed it, and its residents were affected with the externality of not being allowed to buy any large drinks. These are prime examples of how government can boost or hinder the externalities you experience.

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Follow Caleb Casto on Twitter @Caleb_Casto. 

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