Placeholder Image

Subtitles section Play video

  • When is a potato chip not a potato chip? When it’s an externality.

  • An externality is when a transaction between two peoplecall them Art and Bettyhas

  • an effect on a third person, Carl, without Carl’s permission.

  • Suppose Art sells Betty some potato chips. Now Betty really likes potato chips. She opens

  • the bag; she’s looking forward to eating the chips. As she eats them, she makesyum,

  • yum, yumsounds. Just look at her. She loves it.

  • But no matter how loud she is, there is no externality unless someone, like Carl, is

  • there to hear it. Obviously Art benefits from selling the product, and Betty benefits from

  • buying the product since this exchange was voluntary.

  • But Carl’s affected by a negative externality. He’s harmed. He didn’t get anything, but

  • he has to listen to all that crunching and yum-yumming. It really annoys him. So it takes

  • three to have an externality: a seller, a buyer, and at least one additional person

  • who is not voluntarily a participant in the transaction.

  • In a previous video, I claimed that prices can tell people the right thing to do. But

  • if there are externalities, do prices tell us everything we need to know? The answer

  • must be no, because with externalities, the price of something and its actual cost are

  • different. The price is the amount Betty paid to Art, but the cost is the amount Betty paid

  • to Art plus the cost to Carl of having Betty munch potato chips in his ear during class.

  • The problem with externalities is that prices do not capture all of the costs of the transaction.

  • Instead, some of the costs are borne by people who never gave their permission. It seems

  • like the solution would be to try to adjust price so that it coincides with the total

  • cost. For many people that meansfix it with

  • taxes.” In other words, impose a tax equal to the difference between the market price

  • and the true cost to force the buyer and the seller to bear the full cost of their transaction.

  • This is what economists call internalizing the cost.

  • We may not need to resort to government action, of course. One way we solve externality problems

  • is called manners. If Carl tells Betty her crunching is bothering him, shell probably

  • apologize and stop. Then there’s bargaining, a solution proposed

  • by R. H. Coase. If Carl complains, Betty might make a side payment sharing her chips with

  • Carl. Once Carl’s crunching too, there are no externalities, only chips.

  • Even if these solutions don’t work, it may not be easy to fix it with taxes through state

  • action. Remember, the problem is information. Prices don’t contain the full information

  • about cost. But where can accurate information be attained? How can the state be expected

  • to acquire more accurate information and then act on it effectively?

  • The most interesting answer to these questions came from the original scholar who proposed

  • fixing it with taxes, A. C. Pigou. Pigou was a really smart guy and understood that guessing

  • at the correct tax would be very difficult. Back in 1920, Pigou said, “It is not sufficient

  • to contrast the imperfect adjustments of unfettered enterprise with the best adjustment that economists

  • in their studies can imagine, for we cannot expect that any state authority will attain

  • or even wholeheartedly seek that ideal. Such authorities are liable alike to ignorance,

  • to sectional pressure, and to personal corruption by private interests. A loud-voiced part of

  • their constituents, if organized for votes, may easily outweigh the whole.”

  • Thefix it with taxessolution often has unintended, bad consequences. The government

  • has a knowledge problem just like everybody else. Every economics student learns about

  • externalities and Pigouvian taxes, but professors rarely mention how hard Pigou himself thought

  • it would be to get those taxes exactly right.

When is a potato chip not a potato chip? When it’s an externality.

Subtitles and vocabulary

Click the word to look it up Click the word to find further inforamtion about it