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Wednesday, 8 February 2012

Externalities

An externality is a transaction that has an effect, not valued in money, on a third party, who has not agreed to the transaction. Externalities can be positive, negative, or positional. A negative externality is one that causes a cost to a third party. If your neighbour has a party but is not kind enough to invite you, it may cost you some sleep but it will not cost you money. A positive externality creates a benefit for a third party. Educated people are less likely to commit violent crimes. A program that keeps more children in school* until they are eighteen helps to create a safer society. A positional externality, also called keeping up with the Joneses, is the cost of maintaining your status. Externalities are important for forecasting in business because companies need to be aware of changes in their environment that could affect them.

In the 2009 book SuperFreakEnomics the authors discussed an invention that would help reduce hurricanes. Hurricanes are caused by overheated surface water. In the book they discuss the waters off the SE coast of America that cause hurricanes resulting in an average of $10bn worth of damage annually. The machine would get cold water from over a 100ft down and bring it to the surface to cool the water there – a reverse convection pattern. The items would cost $1bn to deploy. $1bn to $10bn seems like a bargain –and this is before human costs are taken into account - but are there any third parties who should be concerned.

Ireland has a 25th-75th percentile December temperature of 6°C - 11°C. The Kamchatka Peninsula* in Russia is on the same latitude and also on a coast. It has a 25th-75th percentile December temperature of -4°C - -9°C. This is because the Gulf Stream, originating in the warm waters off of the SE coast of America. Climate scientists fear a drop of at least 10°C for Ireland if the Gulf Stream were to somehow be (or should that read 'were sowehow to be'?) switched off by global warming. It would be tough to disinsentivise Mother Nature but could you disinsentivise another country?

* Important things to control for here are latitude and distance from the ocean. The latter because bodies of water heat up and cool down more quickly than the land surrounding it causing more median temperatures. I was delighted when I looked at the map to find such an excellent control.

If this was another person – think Mr. Burns blocking out the sun in the Simpsons – the act could be criminalized, or people could bring civil law suits, there might even be a way to tax it. These are the most common ways to prevent a negative externality. Here the situation is more like missiles have been placed on a country’s border: one country claims the right to defend itself; one claims the right to peace of mind.
Externalities are important for business because they represent hidden opportunities and threats in their operating environment. Every government budget brings with it new rules that can have profound effects on businesses that need to be thought of beforehand. Speaking of budgets, perhaps an agreed drop of several degrees in temperature might be used to leverage several billion dollars from American pockets – No Taxation Without Frozen Precipitation!

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