Over the past few decades, a revolution in thinking about the economy has taken shape. This new way of thinking was spurred on by the work of Milton Friedman and his The Transformation of Capital into Income and Techniques for Using It, and more recent works that stress spillover effects, game theory, and other non-monetary factors as important to an understanding of the economy.
These newer thoughts stress that without market-based incentives, people will not produce value for money. In fact, many believe that we are in the early stages of a second revolution in thinking about the economy: one that stresses value in terms of human happiness rather than money.
This new way of thinking has had a massive impact on our understanding of how markets work, how they maximize relative returns, and what factors should be considered when making decisions.
The absence of externalities
As discussed above, externalities refer to things that are not subsidized or cost-shared by consumers or taxpayers.
For example, people who pay a fee to use a public swimming pool receive no benefit from it unless they use it. People who pay rent money to live in a building receive no benefit from it unless they use the common areas.
In these cases, there is an outside party that dictates what people see and don’t see. An internal hard drive doesn’t have an inside hand, so there is no way for it to guide the computer to maximize storage space.
There are externalities that exist in markets, however. For example, political lobbying costs money, and therefore affects the elected officials. Or how voting rights affect who runs for office in your community and how responsive they are to public pressure.
As we discussed in earlier articles, the visible hand of markets is limited due to the presence of externalities. When this hidden hand of the market is removed, it leads to maximum profit maximization and minimum loss insurance.
This will be important for future articles as we discuss how to implement this in our businesses.
For now, think of an invisible hand that leads a business to maximize profits by producing the highest quality product or service possible at the lowest cost. This can be compared to an electrician who charges a flat rate for every electrical appliance he installs.
The illusion that market forces create products and services is very strong. People are reluctant to make choices based on price, quality, and customer service instead of technical expertise and cost-cutting measures. This can be expensive because people rely on these perceptions when making purchases.
As we saw in the first article, the idea that humanity needs a government to protect and guide it is a 19th-century concept that hasn’t stood the test of time.
In fact, despite what you may have heard before, there is no evidence that a government is called upon to help guide or maximize human happiness or utility. In fact, as we’ll discuss later on in this article, there are many instances where an entirely different type of authority — the market — does just that.
If humanity were truly looking for answers outside of themselves, then it would most definitely be turning to the government for help. After all, who better than someone sworn to uphold the law to determine if someone has violated law?
The truth is that humans are incredibly smart and independent enough to choose their own paths in life. For instance, people who take advantage of government assistance programs are usually looking for benefits but aren’t necessarily following the law when they do things.
Examples of markets with and without externalities
In a market with externalities, the market leads to an increase in total value because of the actions of companies and individuals.
In a market without externalities, such as our global economy, there is more focus on just one entity or individual. This can be good or bad!
As an example of an economy with externalities, the military-industrial complex is a prevalent force in our society. As another example, the petroleum industry controls most government agencies and institutions in our country. Both are examples of markets with externalities.
Without externalities, each person and each organization within an economy has more freedom to pursue their own agenda. This can be good or bad!
It is important for people to consider what they want from life and whether it has an impact on others. In order to make these decisions effectively, you need data.
Externalities can have many different effects on a market
When there are externalities in a market, they can have very different effects on it. Some of these externalities can be positive, while others can be very negative.
For instance, when there is pollution in the environment, it can lead to positive outcomes for humanity such as health problems for humans and animals. However, when those same conditions exist in markets, there is a chance that someone will profit from them.
Another external effect that has a big impact on markets is social ones. When people feel like they are not being heard or are being taken advantage of, they may decide not to participate in a market. This can cause lots of negative feedback in markets, which reduces the impact of one variable on an entity.
These kinds of effects may seem small, but they can have huge impacts on economies.
How are penalties for negative externalities determined?
While there are some external costs that do not affect market prices, there are also costs associated with failed markets. For example, a society that fails to adequately punish those who violate social norms will have a hard time determining when and if people comply with these norms.
As a result, violators of social norms may choose not to enter the market as they know they will be punished. This can lead to wasted money and out-of- pocket expenses for individuals who want to purchase what they need, but cannot because of the cost.
Why is this important? Because when individuals cannot be sure they will be able to comply with market rules, they may refrain from entering the market in order to minimize the risk of punishment. This can lead to lower demand and increased supply which results in higher prices for what you want than if there were rules that were followed.
How are rewards for positive externalities determined?
In order for a market to maximize its returns, there must be an external benefit to someone else. This benefit can come in the form of a payment, service, or product that benefits another person or business.
In order for a market to respond optimally to externalities, it must be determined whether the external benefit is small or large, positive or negative.
If it is small and positive, then the market will respond by maximizing its own reward – i.e., people will buy what you advertise because they like what you sell. If it is large and negative, then the market will not respond appropriately due to adverse feedback.
If there were no externalities in a market where everyone was trying to maximize their rewards, then there would be an arms-length race for individuals and businesses to produce the most favorable conditions for maximum returns.
What happens if there is a lack of competition?
If there are no competitors in the market, then the “invisible hand” of the marketplace leads goods and services to maximize their total cost of supply. This is called free market economics and capitalism.
As an example, let’s say you go to the supermarket and you want a box of cereal. The supermarket sells many different brands, so it must decide which brand of cereal it wants to offer customers. It likely decides this because some brands do not make their products fresh enough or taste good enough, nor do they match up with what other brands are offering.
Your smart phone can not tell whether a brand of cereal is good or not because it must be fresh and taste good! A “box of cereals” does not meet both requirements. This is why some supermarkets do not offer them – they do not meet both requirements.
This lack of competition can lead to prices that are too high or companies that do not make sure their products are fresh enough or taste good enough. It can also cause people to buy less or odd brands due to this lack of competition.