Health economist Jason with the second in our series of articles about economic concepts crucial to global health… This article looks at the concept of externalities.
Let’s focus on an example, if I pay 64 cents for a cigarette, and believe the pleasure I get from smoking it outweighs the price, then I might choose to smoke it, ignoring other factors such as advertising or addiction. But there are more than non-financial costs at play here such as the health costs that may occur as a result of smoking. However, cigarette manufacturers don’t pay for any of the non-financial costs, so there is no need for them to raise prices to cover a financial (a.k.a. health) burden. The smoker, or the health system, will pick up these health and other non-financial costs.
These costs that aren’t passed on to the consumer through the price of the product are known as “spillover” costs or negative externalities.
If the manufacturer is only paying their own, private costs such as materials/ingredients, equipment, labour and potentially some taxes, then the consumers will only pay these costs, with a profit margin added on top. On the other hand, the full social costs would be the private costs as well as things like health impacts, environmental impacts and productivity impacts.
Social costs therefore include all relevant externalities.
From an economic viewpoint, this means the market price of cigarettes is below the socially-optimal level, leading to an outcome where the market quantity consumed is above the socially-optimal level (people smoke more, because the cost is artificially low and doesn’t reflect the total social ‘price’ incurred).
Externalities and the Health System
In countries where the government does not provide free healthcare – which is most of the developing world – this situation can lead to financial ruin for smokers and their families who were only made to pay private and not social costs at the time of consumption. Similarly, in countries that have access to free or subsidised healthcare, this burden is shifted from the individual to the government.
Given governments’ constant battle to reduce costs, the presence of externalities is strong reason for governments to explore the need for intervention, such as regulation to limit consumption or taxation to try and align private costs with social costs.
Externalities and Development
The externalities framework is an extremely useful lens to examine actions: micro and macro. Let’s, for example, use that lens to look at an international development project.
Consider a well-intentioned organisation set up to deliver free, treated bed-nets to a region with a high prevalence of malaria. The private costs for this action are around the production of the bed-nets and their delivery to the selected region.
The social costs are a little trickier to identify and require a bit of research into the relevant region. For example you may need to consider that there is already a local industry that produces bed-nets. What would happen to that industry if suddenly they were made available for free? The destruction of the industry would be a social cost because it involves loss of employment, productivity, revenues and output.
Thinking even more broadly, presume that the new well-intentioned organisation only plans to distribute bed-nets for a limited/set period. What happens when they stop? If the local industry was no longer operating, the product will likely have to be imported unless local industry can develop again quickly, leading to higher prices than beforehand.
People’s expectations also change. If they have been receiving the bed-nets free for a period of time, why should they be expected to pay for them all of a sudden, especially if the prices are much higher than before? This could result in a dramatic drop in their usage, leading to a potentially higher prevalence of malaria than before the organisation ran the project.
All of these are substantial social costs and negative externalities. If these aren’t considered, then the organisation will do their figures and falsely believe that their project looks efficient. If the organisation is willing to compensate everyone for the issues they create, then economic theory says we should allow it. But of course, what well-intentioned organisation would go down this path if they were actually aware of the impact they were going to have on the region? Their money and resources could be better spent elsewhere, and other potentially more sensible programs could become more attractive options.
The externality lens can be applied to the countless examples of failed development programs. In many cases their failure is due to the organisation not considering all of the negative externalities of their actions. In addition, environment and climate change issues are rife with externalities, where polluters are generally not made to pay anywhere near the true cost of their actions on the environment.
Externalities are not inherently evil. We’ve been talking about negative externalities.
Positive externalities also exist.
Consider the production of clean drinking water. The private costs can differ depending on the context and the chosen solution, but could range from the construction of a basic hand pump to the implementation of a comprehensive, centralised treatment and distribution system. In a context where clean drinking water was not previously available, the health improvements for the area can be extremely high, with the private costs vastly outweighing the social costs or benefits of building a pump. This is further exacerbated when you consider that the construction of a water pump isn’t associated with a profit margin taken on the amount of water pumped.
In the presence of positive externalities, government subsidisation can assist in facilitating a good return on social investments. But whilst this could be feasible in high-income nations it is not feasible in low-income nations particularly during periods of financial turmoil when the government may not have the capacity to fund subsidies – despite the potentially enormous positive externalities. This is where non-government organisations, including the private and not-for-profit sectors, can play an important development role and cover the private production costs.
Non-government action would allow the social benefits to be reaped without a large profit, if any, to be made. In short, they’re cashing in on the positive externalities and delivering/reaping benefits beyond their investment.
The term ‘externality’ is commonly thrown around, so hopefully you now have a high-level understanding of this economic concept; how it can be a useful lens to catalyse and analyse actions in global health; and the importance of contextualising the narrow use of this term within the broader social, cultural, political and economic landscape.
Until next time.
Jason is a health economist from Melbourne, Australia and works for PricewaterhouseCoopers (PwC). Since joining PwC he has undertaken consulting work across a wide spectrum of social policy areas, and this fostered a strong interest in public health. Keen to combine his skills, Jason enrolled in a Master of Public Health and focussed on health economics, economic evaluation and global health. He recently worked with WHO (Euro) to improve their understanding and usage of health economics concepts in the area of health promotion.