Economic Update: Externalities and Capitalism's Inefficiencies

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This program introduces the economic concept of "externalities." Those are the real costs of employers' business decisions that employers do not pay for or take into account: costs "external" to businesses' profit/loss calculations. Examples include costly damage to the environment, to employees' private lives, etc. Those real social costs are external and additional to capitalists' private costs. Therefore, capitalists' investment decisions based on comparing costs and revenues do NOT take into account the real, external costs. Thus their decisions are not "efficient." Capitalism never was the efficient system its apologists claim.


Transcript has been edited for clarity.

Welcome friends, to another edition of Economic Update, a weekly program devoted to the economic dimensions of our lives, jobs, debts, incomes- our own and our children’s. I’m your host, Richard Wolff. As we jump into this new year, today’s episode was recorded near the beginning of the Covid pandemic, and it is airing today because our team took time off for the holiday season. This episode is about capitalism and externalities- those real costs that capitalism incurs, but that capitalists don’t have to pay for. It really does say something about the system’s inefficiency. We’ll be back next week with our regularly scheduled program.

I want to devote today’s program to a concept in economics that might sound distant when I first mentioned it- it’s called externalities- but it is in fact a very easy idea to understand, and an enormously powerful tool to understand our economic system these days. So what is externality, and what does it mean in economics? Here’s the basic idea: when a capitalist, the kind of key decision maker in a capitalist system, makes a decision- to hire and fire someone, to expand or contract the business, to move production here or there, to adopt a technology- all the basic decisions that capitalists make, they make based on an assessment of the costs of making that decision, and the benefits. So for example, if they’re going to expand the business, that’s going to cost money- build another wing on the factory, buy some more trucks, hire some more workers- those are the costs. But then there are the benefits- the output, and the price you can get by selling that output in the market. And what we tell ourselves and what is taught to our children is that capitalists weigh the costs and the benefits, and they only go ahead and do something- like fire a worker, or hire a worker, or expand, or contract, or choose a technology based on the following, simple idea. The benefits have to be larger than the costs because the difference between them is more or less the profit that the capitalist can get. And, being driven by profit, he’s not going to do something- he or she- that has a cost greater than the benefit because then they’re losing money. They’re going to choose to do only those things where the benefits are greater than the cost in dollar terms because that yields a profit; and they’ll choose among their options and opportunities those which have the biggest difference between the excess of benefit over cost when you compare one to the other. And here comes the big point: it is said that capitalism is efficient because “it works this way- it only does what gives you more benefits than costs- isn’t that wonderful?” So here comes the answer: no, it isn’t wonderful- it is actually nonsense, and let me explain.

Capitalists don’t count the costs and benefits- they only count the costs to them and the benefits to them when they make a decision, and those are not the same as the costs to everybody. Let me give you the simplest examples. Suppose a capitalist decides to build a high-rise apartment building on your block, wherever you live, and to locate on the ground floor a big, expensive restaurant: what does the capitalist count? The capitalist counts the costs to him or her as a capitalist- they have to hire workers to build the building, they have to hire people to maintain the building, they have to buy furniture to put in the building, they have- you get the picture. And what are the costs? Well, I just went through them. What are the benefits? Well, it’s the people who will come to the restaurant and buy a meal, allowing whoever operates the restaurant to pay rent to whoever built the building, and to get to collect the rents if you like from all the tenants of all the apartments or offices in the building- you get the picture. But now let me point out to you that these costs, which the capitalists count, are not the only costs.

There are other costs that the capitalist does not count, and again, I’ll give you the same example. With lots of people coming to the restaurant which wasn’t there before, there’s going to be a need for parking; and there isn’t enough parking as it is on the street, so people coming to the restaurant will have to use a parking lot; and the sudden increase in demand for the parking lot will allow the owner of the parking lot to jack up the prices to park your car so that all of the rest of us who live on that block- who had nothing to do with the decision to build a high-rise with a restaurant- we will all suffer a cost of that project, namely, the higher amount of money we have to spend for parking our car, but that’s just the beginning. There’s going to be a lot more traffic on the street when you build a high-rise and a fancy restaurant on the ground floor. And you know what that means? Not to be cruel but to be honest, cats and dogs are going to get run over in that street in a way they didn’t before, meaning an enormous cost- not just financial, but emotional for whoever those pets live with, or I should say lived with. I won’t go near the question of accidents more likely to happen to pedestrians like me in that block because of a decision I had no control over and could not participate in. Oh, I hope it’s beginning to sink in. There are loads of costs. With a new high-rise and a restaurant, the traffic in this street is going to go up. That means the amount of exhaust coming out of the cabs, cars, delivery trucks in our neighborhood is going to go up, and the impact of greater pollution from those vehicles we well know is impacting our health, our lungs, our respiratory systems. How many more visits to the doctor will it cost me? How much more medicine will it cost me? Oh my goodness, these are enormous costs- and again, not just in money, but in really valuable things like health and life. The capitalist isn’t responsible for any of them, so the capitalist doesn’t count them when weighing the benefits.

Let’s pick a number: a million bucks against the costs. All the capitalist cares about are the costs he has to cover, and let’s suppose they’re eight hundred thousand. He says to himself: “great, here’s a project that’ll bring me a million, cost me eight hundred thousand... I’ll walk away with two hundred thousand in profit.” And the school teacher and the economist who should know better tell you: “see, capitalism is efficient- this project got done because profit led a capitalist to do it.” Yeah, but I got news for you: when you count the costs to the world the capitalist works in, to the community in which he functions- it turns out that the extra parking spaces for everybody, the cost of them, the lost pets, the illness, and I could go on- they’re worth much more than two hundred thousand dollars. If you had counted all the costs of the project, they would have exceeded the money, the revenue that that project brought in; and therefore, the conclusion would have been don’t do it. The benefits to the people in those apartments and to the people who went to the restaurant- worth a million dollars, no argument, those are the benefits- a million dollars for the project. But the costs, if you add them all up, are greater. The project shouldn’t be done. It’s not efficient to use resources in a way where the real costs of doing so exceed the benefits- that’s the opposite of efficiency when you do that. Capitalism does it all the time because we don’t charge capitalists for all the costs of what they do and they, by the way, half know it because they go out of their way not to pay them.

Let me give you an example. We know that for a capitalist, when looking at hiring a person to work in the capitalist enterprise, makes a decision: how much extra will I be able to sell in the way of producing goods and services and marketing them if I hire John or Mary compared to what I have to pay John or Mary? If I have to pay John or Mary thirty thousand dollars a year, but they add to the business of what I have to sell fifty thousand dollars a year, by what they add in the way of their brains and their muscles- well then, I’ll hire them. I’ll hire them because I get more in revenue (fifty thousand) than I pay them (thirty thousand). And by the same token, suppose the opposite. Suppose it costs fifty thousand dollars to pay for John or Mary who’ve been working in your company for five years, but when you look at what they add to your business, what you would lose if you fire them is only thirty thousand. Wow, then it’d be smart to fire them because you saved the fifty thousand you would have paid them, and you only lose thirty thousand because that’s all they added; so you fire them because for you, the only cost of firing them is the thirty thousand of output you don’t get anymore because they’re not there. But here again, let’s look at the costs our capitalist doesn’t count- costs that are external to his counting system, external to what a capitalist has to see. Well if you get fired, here’s some costs: you’re going to feel terrible; you may need psychotherapy; it’s very expensive; you’re going to disrupt your family; the impact on your wife, her health, your husband, his health, your children, their schooling.

Begin to think of what it means when you fire a human being: the cost isn’t just what you the capitalist lose when he or she is not working for you anymore; the costs are much larger than that; they’re all the costs of unemployment to a person. We know that alcoholism goes up when unemployment goes up, that divorces go up when unemployment goes up, that abuse between parents and children, and between spouses- all of those things- those are social costs. They require medical care, psychological attention, police activity- you name it. The social cost of unemployment is way larger than the private cost to the employer but we allow the private employer, based on what private costs he counts, to make the decision whether or not to fire. That’s not efficient; that is inefficient. The externalities are all of the real costs that capitalists don’t have to count, and that’s why their decisions are fundamentally inefficient.

We’ve come to the end of the first part of today’s show. Before we get to the second half, I want to remind you about our new book, The Sickness is the System: When Capitalism Fails to Save Us from Pandemics or Itself. Go to DEMOCRACYATWORK.INFO/BOOKS to learn more or to get your copy. I also want to thank our Patreon community for their invaluable support, and if you haven’t already done so, go to PATREON.COM/ECONOMICUPDATE to learn more about how you can get involved. And now, please stay with us. We will be right back with the second half of this program, and we’ll be back next week with our regularly scheduled program, and I thank you for watching.

Welcome back to the second half of today’s economic update, devoted to this concept of externalities. And let me remind you again: all that externalities refers to are the costs of capitalist activities that capitalists don’t have to count. The way it’s handled in economics is there’s a distinction between private costs and social costs, and that it’s important to understand that the costs that capitalists care about are the costs they have to pay, the costs they have to cover. They don’t care about the other costs because there’s no outlay of cash by them. So when they look at the cost of anything, they’re only looking at the costs they have to cover; and if (by doing something) they can make money, more than the cost they have to cover, they do it. But the point of the distinction is to understand that that’s not efficient. Now there is a way that most people kind of get that these days, even if they’re not familiar with the concept; it has to do with environmentalism.

You know we’re all aware that for decades, all kinds of capitalists, manufacturers, service providers have been choosing to do things that they claim were profitable and that they claim were efficient, as have the economists who defend this, but they’re wrong. We now know that, for example, the trucking firm that took care of waste products that were polluted in all different ways- that trucking firm only took into account the private costs it faced. It had to buy the trucks, it had to hire the truck drivers, it had to pay for the gas that works the truck, and so on. But what that truck spewed into the air, and the damage done by the exhaust from that truck to the health of people, to the number of doctor visits they had to undergo, to the speed with which gardens had to be replanted because the polluted air particles fell on the plants, or corroded the rubber in their tires, or diminished the number of years that the paint would last on their homes- the stories are infinite. None of those costs are borne by the capitalist. We the people pick up the costs: we have to clean our houses more often, we have to buy vacuum cleaners more often, to clean the results of that pollution, we pay for the vacuum cleaners, we pay- you get the picture. The costs are real, but they’re not paid for by the capitalists. So when the capitalist counts- Is this project worth doing? Are the benefits greater than the costs?- because the capitalist only counts the private costs he or she has to cover, the calculations made by capitalists are not the right ones. They don’t get you the efficient outcome. Capitalism isn’t efficient and it never was because it fails to count the social costs. It only counts the private costs, and those are never all of the costs.

Indeed, I want to give you two or three more examples to drive the point home. Okay, here’s one: When you hire a worker, you often make that worker not only come to work 9-5, five days a week, but you do something else. You make that worker a productive member of society, or at least you help him or her to be that. Well, keep that in mind when I ask you what happens when you fire a worker. Capitalists fire workers when it isn’t profitable to keep them. Every honest capitalist will tell you that. “I’m not here to do favors for my employees. It’s a deal- I pay you x and you come to work and I keep what you help produce in my factory, in my office, in my store- whatever.” The capitalists are clear, so let’s be clear with them. When you fire a worker, what is the cost to the capitalist? The answer is you don’t have the output that the worker’s effort helped you to get to sell. If you fire a worker, that’s one less widget that that worker helped to make, or it’s less of a quality or quantity of a service that worker helped you to sell. That’s your cost, and that’s what you look at. You compare what you get from that worker, that worker’s productivity we call it, against that worker’s cost- because that’s your only cost, paying the wage. Okay, now you fire the worker because what you got from him or her is less than what you were paying him or her in the way of a wager salary.

But now let’s look at the social costs. That worker is now going to suffer a certain amount of psychological loss of self-esteem, psychological stress, psychological bad mood- you get the picture. And because that worker is a married man or woman, for example, his or her spouse is going to be affected by the unemployment. They’re going to smoke more cigarettes than before, drink more alcohol than before, see a therapist in the way they didn’t before, have marital troubles that will require a counselor in a way they did not before- and I’m not done their children will face a disturbed and troubled household, their performance in school will deteriorate, necessitating a tutor if they can even afford one. I could go on, but you’re beginning to see the social cost of firing somebody is much greater than the private cost to the capitalist, who simply loses whatever that worker helped to produce. Okay? Therefore, rationally, in a society that was governed by using your head, you wouldn’t fire John or Mary if I could show you that the social cost of doing so is greater than the benefit. The capitalist saves on the wages, doesn’t have to pay the wages- that’s a benefit to the capitalist. But to the society as a whole, from the destruction and damage done by laying that worker off, the costs- medicine, alcohol, tobacco, therapy, you name it- much larger. It would be less costly for the society to keep those people working because when you look at all the costs of firing them, they exceed the benefit to the capitalists. Yes, the capitalist doesn’t have to pay wages- saves let’s say fifty thousand dollars that you don’t pay that worker. But, if I showed you (which is easy to do) that the cost of laying that worker off is a hundred thousand, anyone who isn’t disturbed would understand that the efficient thing to do was to keep that worker working, even if they only produce forty thousand dollars worth of output because saving that forty and incurring the social cost of a hundred when you look at them all is an irrational, inefficient use of resources- both human and non-human. That is, both human persons and the machines and factories and infrastructure that go with them.

There’s a general conclusion that flows from all of this, and it has to do with the coronavirus that we are all in the midst of coping with. It wasn’t profitable for companies to store ventilators, test kits, hospital facilities, doctors, nurses, orderlies, beds- all the things you need for a dangerous virus. We knew as a society that viruses come- they come all the time- and that they can occasionally be very dangerous. We’ve known that for at least a century and a half. The devastating Spanish flu- occurred in 1916, a little over a hundred years ago- killed 700,000 people. Okay, we know. But it isn’t profitable for capitalists to produce a lot of kits and store them until they’re needed. Society needs it. We are going to be losing way more money by not having prepared than it would have cost us to prepare. The number of people who will get this virus, coronavirus, because we didn't have test kits in the numbers we needed early on- just that will be devastating. The loss of life, the loss of value, of product, of wealth is staggeringly larger than what it would have cost to produce and stockpile what was necessary. It wasn’t efficient- it was profitable, but it wasn’t efficient. Let me say that again: what is profitable is not what’s efficient. What’s efficient is a social calculus. That’s why society needs a socialized economic system if it’s going to get anywhere near efficiency. It makes no sense to take a minority of the population, capitalists, and organize the decision about how we use our resources to produce profit for them. We’re here; we are not machines; we’re human beings. The vast majority of us are not capitalists and yet we’re required to live with the inefficient decisions we allow to be made by a small minority of capitalists, who only count the costs they have to pay for; and they don’t have to pay for our psychological problems, for our environmental damages, for all the social costs that they are not privately required to cover, and that they therefore don’t count. That’s a crazy system; that’s a system that doesn’t work.

We shouldn’t be surprised that capitalism didn’t do a good job with the coronavirus. It was again, the problem- the deeper problem- that we need to learn or else we’ll do this all again two, three, five years down the road, when the next virus threatens us. There’s got to be a systemic response. We have to make decisions that are based on a social counting. We know we need to be ready for the next virus. We have a private profit system that doesn’t do it, and that has captured the government so that the government doesn’t make them do it either because they elect people that let this system go on, and that support it. To watch Mr. Trump worry about the airline industry, the travel industry- when what he’s got is an emergency of dealing with the health problems of a population- is just another symptom of a system that’s all messed up.

Capitalism’s time has come, but it has now gone. We can do better. We know what we need. We understand the limits of capitalism, including its incapacity faced with the costs it calls externalities. They’re not really external because we have to live them- they’re internal. They’re only external for the capitalists to whom we have given a pass that they don’t have to count and take account of them- just we do. That’s unjust, and it’s also inefficient- and those are the adjectives that apply to a system that works this way. Thank you for your attention, and I look forward to speaking with you all again next week.

Transcript by Elain Rabady
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Showing 1 comment

  • Sonny Wiehe
    commented 2021-01-16 20:45:31 -0500
    Prof. Wolf ignores ALL the potential benefits of his examples that are not counted in the $1Mk cost of the building and restaurants while factoring in (meaning quantifying) ALL the potential costs (real and imaginable) $1M+. The potential benefits of his example may mean bringing more residents to that district which means increased tax revenue, which means potentially better government services, better public schools….you get the picture.

    If you’re going to give examples to prove a point, please don’t use logical fallacies to prove your point. BTW, I will point out that residents DO have a say in what gets built. They are called zoning laws and there are public hearing for implementation and changes to these. Granted, most residents don’t get involved in making of proper zoning laws; they leave that up to corrupt government officials who will get bought by the building and restaurant owner because their is no opposite and equal reaction by residents to their influence. Their is a government component to capitalism. Its called regulation.You reap what you sow.

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