Externalities and minding other people's business

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Have you ever been kept awake at night by a neighbor’s loud party? If so, you have experienced what economists call an externality. Your neighbor enjoys loud partying but does not consider that you suffer by being kept awake. This is called an externality because there is an effect outside of the decision-maker that he does not consider in making his decision. When externalities are present, decisions that are optimal for the person making them are not necessarily optimal for society. Your neighbor enjoys the party more than it costs him—otherwise he wouldn’t hold it—but if the harm to you is greater than your neighbor’s benefit, then it would be better for society if the party didn’t happen.

Excessive noise is annoying but externalities can create more serious problems. A recent report by the Guangzhou Institute of Geochemistry warns of high levels of antibiotics found in China’s river basins due to hospitals and farms improperly controlling sewage. These antibiotics get deposited in the nearby rivers which can become breeding grounds for antibiotic-resistant bacteria or be ingested as the river water enters the drinking supply or food chain. This is dangerous because whenever antibiotics are present, there is the risk that some resistant bacteria remain after the non-resistant ones are killed. Once bacteria become immune to a particular antibiotic, it is less effective and preventing infections may require higher doses or alternative medications that have worse side effects.

Why then are those who run hospitals and farms not more careful? For the same reason that your neighbor’s party keeps you awake at night. It costs money to remove antibiotics from water emissions. Hospitals and farms don’t want to bear this cost because they receive only a tiny benefit in return. The probability that the owners or employees of these institutions will suffer from a resistant bacteria specifically caused by them is very small even though the probability that someone will suffer is quite high. Their decision is particularly understandable if they face strong competition. A farm that cleans its emissions will operate at a higher cost than its rivals that do not. As a result, just as the noise wafts out of your neighbor’s apartment the contaminated sewage flows out of hospitals and farms.

What should be done? Markets are usually a good way to run an economy. However, externalities are an exception. The problem is that the market doesn’t price the externality. If your neighbor had to pay you for the damage the noise caused you, then he would always make the decision in society’s best interests. If he was willing to pay you an amount you were willing to accept, then the party would go forward. If not, then it would be cancelled. Similarly, if farms and hospitals had to pay for damages that they caused others due to creating antibiotic-resistant bacteria, then they would treat their emissions if the cost of doing so was less than these damages and otherwise not. Because the market doesn’t price these collateral effects we get too much noise and too many antibiotics in river basins.

The government can improve the market by pricing the externality via regulation. The government can set a maximum allowed antibiotic concentration in emissions and impose a fine for non-compliance. If the penalty is close to the potential damage that untreated emissions cause, then the hospitals and farms will make the right decisions for society. If the emissions treatment cost is below the penalty then the antibiotics will be removed and otherwise not. If untreated emissions are very dangerous, then the government should set a draconian punishment which would be equivalent to outlawing all untreated emissions. Implementing this is not easy as monitoring emissions sources is required but monitoring at least large farms and hospitals, which are the biggest antibiotic users, should be feasible and the payoff could be huge. One study estimates that antibiotic-resistant infections could cost China a million lives per year and a cumulative cost in the trillions of dollars by 2050.

Prof Brian Viard is Associate Professor of Strategy and Economics at Cheung Kong Graduate School of Business. He explores the workings of economics in everyday life and business in China through this column.

[This article has been reproduced with permission from CKGSB Knowledge, the online research journal of the Cheung Kong Graduate School of Business (CKGSB), China's leading independent business school. For more articles on China business strategy, please visit CKGSB Knowledge.]