ParisTech Review

Externalities have nothing to do with witchcraft except on the important point that like the fairies or sorcerers of lore they tend to rear their head looking for revenge when they don’t receive an invitation to the party. The last two centuries of industrial development have largely occurred with scant regard for the consequences of our actions. The bill has come due in the form of dwindling supplies of non-renewable resources and the fact that our demand far outstrips the ability of the biosphere to reproduce itself. The ecological footprint has emerged as a quantifiable measure of the extent of human demands. Whether we asked for it or not, the effects of our actions, both positive and negative, have largely surpassed the processing limits of our current models of public or private accounting.

Since well over 20 years ago, when environmental issues erupted onto the global policy agenda, we have struggled to implement an effective system of accounting standards for pricing the costs of the unwanted side-effects of progress. It has been simpler to view isolated crises as one-off market failures and leave governments to clean up the mess. In reality, it is at the level of enterprise, regions, and indeed at the wider macroeconomic level that it has become indispensable to begin integrating theories on externality in order to fully understand the massive transformations taking place as globalization gathers pace in the domains of productivity, innovation, and policy efficiency. More specifically, we can use these theories to evaluate specific cases such as the levels of financial goodwill on offer during a takeover bid. Using externalities we can evaluate why an organization’s actual financial health might bear little correspondence to the figures being presented in financial reports. What is often not included amid the graphs and tables is a reliable appraisal of the human factor or other less tangible assets. Some of the more common examples might be the extent and stability of relationships with various suppliers in a given territory; the strength of the bonds felt by clients through the excellence of the services they are receiving; or perhaps, the level of investment made in market research.

The need to include what may appear immaterial to an explicit system of codification becomes clear when attempting to render a truly comprehensive economic portrait of a given situation. Externalities have emerged as the key to unlocking our understanding of actions that are too often oversimplified by a tendency to attribute their existence to invisible forces. Financial analysis can take on a new dimension when it is able to move beyond mere numbers and operate on the borders of the future possibilities of a given enterprise thereby permitting day to day decision making based on values that can never be truly understood if we limit ourselves to the certainties of the balance sheet.

Conditions for the appearance of externalities
Externalities appear at the frontier that exists between the commercial and non-commercial spheres when no automatic financial compensation accompanies an instance of movement between the twin domains. One example is provided by the interaction between vendors and clients of the local butcher who integrate into their price calculations all direct or indirect costs associated with bringing the product to market. Nevertheless, merchants operating in the Chicago stockyards at the turn of the previous century took little notice of the externalities associated with the transportation of livestock over the long distances that separated the city from the wide open prairies. There was no reliable economic indicator to account for the sparks that escaped regularly from locomotives and the fact that they regularly provoked fires devastating the acreage of farms unfortunate enough be located near the tracks. Whenever there is a financial transaction between two parties that produces effects on a third party that remains outside of economic considerations we are in the realm of externalities or spillovers. In cases where the effects are positive (increased benefits to consumers, gains in productivity for producers, or more efficient provision of public services) we are dealing with positive externalities. When the effects are negative (such as mercury poisoning in the inhabitants of Minamata Bay in Japan or levels of water pollution so elevated that even industrial use is jeopardized) we are speaking of negative externalities.

Externalities can also be organized according to their nature such as those associated with urban areas or where there is a cluster of industrial activity surrounding a defined river, rail, or road network that allows each of the parties involved to reap benefits that none would be capable of financing individually. As they pool resources each enterprise benefits. In the domain of production, an externality is defined as any unseen element that contributes to the quality or quantity of overall economic activity. A classic example is provided by the mutually beneficial relationship between developers of orchards and producers of honey. Honey producers need flowers and farmers need bees to pollinate their fruit trees and the quality of each commodity is improved through the existence of the other. We are dealing with pecuniary externalities when a third party modifies the price of goods upstream in the production process to encourage sales. An example can be readily drawn from the subsidies provided to the steel or dairy industries that allow producers downstream to retain and grow market share.

A similar process is underway in the sociological domain although the language employed differs as in discussions over the disappearance of social links or the disaffiliation of the unemployed. The closure of local coffee shops will most certainly shrink GDP as sales for food and beverages decline, and salaries stop being paid. The loss of each post office means the loss of a public sector job and requires local residents to sacrifice essential services or travel ever longer distances to receive them. In both cases the final result in terms of GDP is hard to establish and could be negligible. If the local lunch counter closes there will simply be a rise in the consumption of home delivered pizza and the like. As for our post office scenario, the sending and receiving of certain types of mail will surely decline but if there is a real demand for other services then another business will rise to fill the void. What cannot be measured in economic terms however is the threat these types of closures represent to the social fabric of the local communities affected. The degradation and eventual disappearance of local commerce has the potential to upset the social ties that bind communities together as can be observed by the rise of delinquency and serious crime in affected areas, serving to heighten feelings of insecurity and exclusion among local residents.

The negative externalities produced by the commercial sector have become more visible as our awareness has increased. Typical examples would be the soil pollution produced by industrial farming techniques or motorists who pose a threat not only to the lungs of their fellow residents but to the entire planet through the contribution of exhaust fumes to global warming. What receives less attention are the more numerous but less visible positive externalities that are produced through non-commercial interactions and have considerable influence on the health of the commercial sectors of the economy. An event as innocuous as a simple conversation between two IT professionals over coffee to debate the finer points of a particular technological challenge can create ripple effects that reverberate outward and are of huge benefit to third parties. The engineer at a neighboring table receives the flash of inspiration he so desperately needs and weeks are trimmed off the development timeline of the next big idea. This is particularly true when such an event takes place in an urban agglomeration or one of the many clusters (geographic concentrations of interconnected companies) that exist across the globe.

Asymmetry between externalities
A given environment that suffers degradation through failures in bookkeeping or conscious pillage can endure until it becomes a hindrance to the market or life itself. We are always quicker to perceive the cost of a given course of action than the benefits and it is no different when we are dealing with externalities. The effects of negative externalities are more readily perceived than positive ones as when contemplating the notion that our actual living space is constituted of what we define as being located within ‘natural’ borders. There is nothing natural about them and it is only after we lose territory that we become conscious, often too late to do anything about it, of any positive externalities associated with a given geographical area. Another example is provided by the caring professions—such as the individuals charged with caring for young children—and the power this sector has over the long term employment outlook of the wider population. In the late 1970s experts were able to determine that if the unpaid labor of women in the home (childrearing and domestic responsibilities, with the latter being the most easily calculable) were compensated fairly it would have to be at roughly double the minimum wage in the country concerned.

Positive externalities provide a compelling explanation for what economists have identified as a global productivity surplus. Encompassed in this term are the positive outcomes that have been difficult to attribute to the mere contributions of labor, investment, or technical progress. What emerges are synergies based on a multiplicity of unseen interactions that congeal to produce economic growth. The process can be observed to govern across a wide range of activities including those of enterprise, industry, and national or locally based initiatives to the same degree as can be observed at a macro-level. If the whole appears larger than the sum of its parts it is because both production and consumption have incorporated a much larger range of positive externalities than they have generated corresponding negative ones.

If real life could be reduced to the same degree of certainty outlined above there would be little need to acknowledge the fact that in transactions between two actors there arise a wide and unpredictable range of external effects and contradictory signals. The sheer volume of human interactions means it is close to impossible to forecast or explain their effects using the language of the markets. To use the metaphor provided by the iceberg, commercial transactions represent no more than the exposed tip of much larger mountain and conceal more than three quarters of what is actually taking place. The interactions taking place below sea level have a considerable impact on what happens above meaning much of what can be observed on the tip, if we understand it to represent what is measured through economics, is being profoundly influenced by the unmeasured activity below.

Understanding the importance of negative externalities is a way of promoting a degree of what could be defined as ecological rationality. Giving positive externalities their due is how we validate the transformation, already well under way, toward a future where work and other forms or productive activity exploit the potentials of cross-pollination and exchange in much the same way as our beekeeper and orchardist in the previous example. Indicated in both cases is a model that represents the transformation of society from one that is concerned only with the production of basic commodities such as honey or wax to one that has moved to exploit new potentials and is based on the notion that the act of pollination in itself creates value. For further illustration of this point I refer readers to my two recently published works Cognitive Capitalism (Le capitalisme cognitif, Editions Amsterdam, 2007, Paris, forthcoming in 2011 at Polity Press London ) and The Bee and the Economist (L’abeille et l’économiste, Carnets Nord, Paris, avril 2010). To evaluate the magnitude of the transformation we need only remind ourselves of the enormous gulf that exists when a comparison is made between the massive financial benefits gained through the economic activity enhanced through the pollination process and the actual output of the bees. If the latter represents annual production equal to roughly $1 billion dollars we can safely predict that the value of the other activities influenced by the positive externalities created through the interactions to be of a magnitude 790 times higher. This figure represents about 33% of the $4.2 trillion value of global agricultural production and is a figure that would rise even higher if we factored in the income generated from the sale of honey or the economic benefit of spillovers on environmental health.

Thus in an economy based on the notions of pollination—or conversely, the pollution and over-exploitation of our non-renewable natural resources (such as fossil fuels)—all of our assumptions on the macroeconomic fundamentals that form the basis of much of modern society must be called into question. This includes, but is by no means limited to, a reevaluation of our notions of general equilibrium, growth, debt, and liquidity. As we demonstrated in The Bee and the Economist the vast array of financial instruments that have been put into the service of boosting market liquidity are by no means based solely on speculation. Instead, we aimed to illuminate the shift toward an economy of pollination/predation characterized by a level of intensity in the nature of flux and movement that has largely surpassed the limitations of the input/output models of neo-classical economics.

It would be useful now to turn our discussion to a thorough explanation of why defining the importance of externalities will allow us to better appreciate the profound transformations taking place daily at the heart of enterprise and other productive activity, and their implications for the future of all areas of microeconomics such as in theories of motivation or cooperation between agents.

Business, entrepreneurs, and revisiting the production landscape
Externalities provide a satisfying explanation of why certain innovations are swiftly adopted by the entrepreneurial class. They also serve to illuminate the dynamics of companies at the heart of the most productive sectors of the economy. Human interaction is complex and the commercial sphere represents only a small share of overall human endeavor. When a commercial activity is able to mobilize latent and undervalued, or completely overlooked, inputs it will always hold an advantage over its competitors who lack the resources to exploit these partially, or indeed free, externalities. When two businesses are locked in competition the costs associated with production have a tendency to become fairly equal which is why the ability to identify a margin for maneuver through harnessing the power non-price competition is so critical to success.

One obvious example would be the unfair advantage enjoyed by heavy polluting industries in regions where they are not weighed down by the burden of environmental legislation or the need to comply with certain standards of excellence. A more subtle logic applies in the case of more virtuous activities but exists nevertheless. As more positive externalities work their way into activities at various levels from small business up to the level of national economies the more efficient they will become in the organization of labor and in harnessing the power of the market. In the short-term, the success of an enterprise rests on its capacity to identify and capture (or pillage) more positive externalities than its competitors and/or to discharge the maximum amount of negative externalities onto the environment.

The success or failure of a given enterprise has come to depend on non-commercial spillovers and the most innovative products are those that have evolved to exploit the efficiencies of radical new forms of organization. They are the creators of the platforms that will act as a foundation for future development or the integrators of human activity, promoting spontaneous cooperation, exchange, and confidence in the interested parties. One model could be the symbiotic relationship that develops when one combines an iPod, iTunes, and the iPad to provide consumers with the magical ability to compose their own sonic library which is then integrated into every aspect of their lives and becomes part of their personal identity. But the dream is never quite achieved and the quest for the missing link to complete the experience and make it perfect allows the company to interact with what we have called a prosumer in new and unexpected ways. I owe this example to Antoine Rebiscoul, so recently lost to us this last September, who opened my eyes to the possibilities of this new form of interactive marketing where the consumer actually becomes an integral part of the development process as we’ve seen with the emergence of early adopters and the digital prosumer.

What the leaders of a given enterprise may present in their final transaction costs as belonging to the logic of the markets, and a representation of their own internal cost, could in fact be at least partly explained by the successful capture of hidden externalities. In a similar fashion, when a business loses the capacity innovate and reinvent itself the resulting decline could be attributed to a failure to harness the full power of these very same unseen forces. Indeed, if we look at Schumpeter’s explanation of the gulf that separates mere managers from entrepreneurs the primary characteristic separating the two is the ability of the latter to harness the potential of positive externality. Whether through an innate power to tap into the deepest desires of the market or an uncanny ability to comprehend a range of technical advances and apply them to problems in ways that were never imagined, or even intended, the successful entrepreneur is always on hand to exploit the birth of new ideas and materials. The logic can be extrapolated outward to the level of any cluster of excellence or other local production network where cooperation between a number of small to medium sized businesses creates competitive advantages that surpass the technical and organizational capacities of individual firms in matters relating to variables such as market size, product range, or prices.

A final illustration of the dynamic can be drawn from the human factor that beats at the heart of any successful undertaking. The importance of social connectivity, as defined through the work of Luc Boltanski and Eve Chiapello in The New Spirit of Capitalism (Le nouvel esprit du capitalisme, Gallimard, Paris 1999), can never be underestimated in the knowledge economy where decisions on employability and competence rest largely on our ability to constantly adapt to conditions that are as yet unknown. When social links are weak or disconnected then we are no longer in the realm of positive externalities. When we are exiled to the outskirts of the metropolis, figuratively or literally, we become stigmatized and lose a significant proportion of our employability.

Calculating Externalities
One of the overriding questions of our times is how to pilot those sectors of the economy where externality plays a fundamental role. In other words, how do we articulate boundaries between market and non-market elements without creating fertile ground for market manipulation? As our world increases in complexity we can no longer afford to reduce our understanding of advanced industrialized economies to the axioms that served in simpler times without creating a threat to future development. Economies must urgently resolve some notable tensions if they are to continue to thrive. First, our economic models need to be adjusted to better accommodate global environmental imperatives and start internalizing the numerous negative externalities produced through human activity. Second, incentives need to be created to encourage economic development that generates more positive externalities than it consumes. Satisfying these ambitions will require a global approach that accounts as much for issues related to consumption, transportation, and recycling as more bread and better issues related to innovation and production.

The traditional route taken by enterprise where individual well being creates the optimal conditions for the realization of shareholder value is no longer bearable as model for sound corporate governance. Prosperity hinges on fulfilling, tempering, or limiting targets according to the following principles:
1) Offset negative externality through the creation of positive countermeasures to reduce its impact;
2) Create the conditions necessary to produce more positive externalities than we consume;
3) never proceed to a final evaluation of whether the balance of conditions has been a success unless the two previous stages have been completed. In other words, it would be folly to limit ourselves to the notion that we can make direct compensation for the effect of environmental degradation (a negative externality) by simply supplying more positive externalities. This delusion has plagued the decisions of industrial planners who had convinced themselves that we could simply innovate our way out of the environmental crisis through scientific progress. A reciprocal program of taxation on carbon emissions, while indispensable, will not ipso facto lead us the knowledge economy envisioned at the Lisbon summit of 2000, whose aspirations have been left largely unfulfilled.

Given the nature of the principles we have posed how do we then integrate them with our understanding of externalities? The usual methods consist of focusing on externalities through the lens of the market, such as in the creation of carbon trading regimes or “pay to pollute” legislation. This logic conveniently neglects the vast differences that exist in deployment of these tools or that they are at times in violent opposition with each other. The permission to emit pollutants locally (the juxtaposition of terms is shocking) up to a certain ceiling, as fixed annually by administrative organs, and transferable to different locations, has raised objections in countries traditionally opposed to a carbon tax.

For some clarity we should remind ourselves of two simple ideas:
a) When an externality is integrated completely into the costs associated with a given commercial transaction (through price mechanisms or fiscal tools) it ceases to be an externality. What is gained in transparency is lost in flexibility.
b) The frontier between commercial and non-commercial activity constantly shifts with the passage of time as was demonstrated so clearly by Gøsta Esping-Andersen in the opening chapter of The Three Worlds of Welfare Capitalism. Whereas some activities have been fully or partially integrated with the market others have been withdrawn fully or partially from any commoditization. Even the most open economies make use of non-competitive price setting mechanisms such as subsidies or protectionist legislation.

If we are willing to understand the world’s resources in their larger sense it becomes quickly apparent that significant portions escape explanation through market forces. Society is unwilling to place a price on human life for instance. In some other instances however we simply lack the technical capacities necessary for integration. Finally, some activities are by definition non-commercial.

Thus, we can distinguish a group of Type 1 externalities that are encountered daily, in both positive and negative forms, and have been completely integrated into the calculations of even the most traditional economic thinkers. Public services provide a textbook definition of a resource we are unable to reduce to a point where it conforms to such basic market principles as optimization of return on investment. Examples are everywhere and include defense, health, and transportation, as well as a significant proportion of education spending. These essential services provide significant spillovers that reverberate out into the wider society and have been completely integrated into economic theory as is clear through the importance placed on taxes and other social contributions. In such cases, the externalities are financed explicitly and are expected to continue in this fashion.

Another group of Type 2 externalities can also be discerned where cost is impossible to calculate because the activity is by definition “priceless” in both senses of the word. In one sense, attributing cost exceeds our technical capacities or we would have already done so. In the others, we are trying to place a cost on something for which price could conceivably border on infinity. A breathable biosphere is clearly priceless. Whatever spending is required to allow the continued human habitation of earth is impossible to reduce to the certainty of cost benefit analysis. It is equally preposterous to imagine a world where our use of natural resource is metered or charged by the hour. On the contrary, certain resources must be removed completely from the economic equation. In the case of enterprise, this logic applies when placing knowledge and technical expertise, innovation, and autonomy within the context of the fuzzy halo which surrounds Type 2 externalities.

In the history of human endeavor great strides have always been made when certain domains have been protected and sealed off from the demands of the market. An obvious example is our autonomy over our physical selves when engaged in labor, a necessary precondition for a world without slavery or indentured servitude. To go one better, in the knowledge economy of today it would be unthinkable to look at the brain as a sort of primary resource that we can continue to draw from without having to face the fact that it’s connected to an actual person who’s basic needs must be met in order to continue living. Why should a separate logic apply to other priceless resources?

The answer is that we cannot afford to treat Type 2 externalities as if they belong to Type 1 where it is possible for the externality to be completely integrated into the market. To achieve success, a thorough housecleaning is in order at the heart of enterprise and other sectors of market activity. During this process an inventory needs to be taken of the externalities that exist and a classification imposed according to our two types. Such a process would represent a strategic move to reconstitute the playing field going forward in order to create increased space for maneuver over the long term. Additional advances could be made in policies that promote innovation as well as anticipation allowing organizations to make difficult adjustments to whatever unexpected changes occur in the future. A determination of what should be reintegrated into the direct orbit of a given enterprise as well as what will allow the generation of positive externalities, as relates to commercial transactions, has become indispensable to the already arduous task of management. Finding what allows the capture of the positive externalities specific to the conditions under which a concern operates and will operate under in the future, this is the road that lies ahead and will ensure renewed legitimacy for entrepreneurs as they struggle to achieve their aims in an environment in which nothing can be taken for granted.

To conclude, an attempt must be made to reconcile a certain model of growth with the exigencies of every other aspect of human activity by placing a premium on productivity and intelligence as well as a healthy respect for the ecology of the planet we all must share. We must create an ecolonomy in which the demands of the economy are finally reconciled with our ecological destiny.

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