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External Economies And Diseconomies

External Economies And Diseconomies

External diseconomies

External economies


The concepts of external economies and diseconomies (“externalities”) treat the subject of how the costs and benefits that constrain and motivate a decision maker in a particular activity may deviate from the costs or benefits that activity creates for a larger organization. Most of the economic literature on externalities has focused on the operation of an entire economic system, with particular reference to the effectiveness of prices, markets, competition, and profit motivation as regulators of production and consumption.

Economic theory suggests that a system characterized by private ownership of resources and sufficient competition will maximize total income and economic welfare. The system will establish an equilibrium in which product prices equal their costs on their respective margins of production. Costs include an opportunity rate of return on invested capital, which is an element of business accounting profit, and the rewards, or “rent,” that especially endowed resources may command. Production costs also reflect technological constraints, and producers employ the least costly method of producing any given output. A further characteristic of the equilibrium is that similar resources, including capital, obtain equal earnings or returns in all activities. If earnings were unequal, resources would enter more profitable activities and leave less lucrative ones until earnings equality comes about. The resulting allocation of resources is also consistent with consumers’ preferences. Finally, consumers’ demands, through their influence on market prices and hence profits, determine the allocation of resources.

The system works in such a way that the wide diffusion of decision making which is necessary if complex systems are to operate at all is permitted. Each decision maker only needs to have knowledge about the things he consumes, or produces, or his occupation. That individuals can so narrow their focus permits a division of labor and, in turn, the resulting gains of specialization. The vital mechanism (and social institution) that facilitates such specialization is the price system, or market organization. The price system is an “information system” that provides producers and consumers with the signals that guide their behavior. Hence, the economic system is highly interdependent: the combined behavior of individual decision makers spontaneously determines relative prices and quantities of items produced and consumed, while relative prices are the signals, constraints, and opportunities to which individual decision makers respond and adapt.

Such a general equilibrium system has two specific qualities: (1) Production costs of each item, on its respective margin of production, when viewed in a social cost sense, equal the price of each item. (2) The price of each end product accurately reflects the incremental satisfaction that consumers attach to it. These two qualities constitute a “social optimum” in that national income and economic welfare are maximized [see, however, WELFARE ECONOMICS]. Note that it is only optimal if the marginal social costs of each activity equal the social benefits they create. If the social cost of an activity exceeds the costs relevant to the decision makers in the activity, there is an external diseconomy. If the benefits of an activity exceed its marginal cost, there is an external economy.

Due to the extreme interdependence within an economy, the behavior of a given industry can increase the cost of other industries in ways which need not be socially undesirable. Some of these phenomena, too, have been associated with the subject of external economies and diseconomies. One of the difficulties in the evaluation of externalities is the problem of determining which are socially desirable or undesirable and should be promoted or counteracted by public policy measures and which do not warrant government interference with the private sector.

The subject of external economies and diseconomies thus treats possible mechanical shortcomings of an economy that cause individual decision makers to operate in a fashion that thwarts the full attainment of broad social objectives. To some students the possible wide extent of externalities is sufficient basis to justify extensive government intervention in the private sector of the economy. To other students this point is debatable. The resolution of these differences has been, and remains, a major unsettled issue in economics.

External diseconomies

Technical external diseconomies. Technical external diseconomies, sometimes called “nuisance effects,” were extensively discussed by A. C. Pigou ([1920] 1960, part 2, chapter 9). They arise from undesirable by-products of a production process. An example used by Pigou is the case of steam locomotives emitting sparks that cause fires. A farmer’s livestock that eats his neighbor’s crops is another example. Extensive lists of unwanted byproducts may be drawn up in modern societies– from air and water pollution to traffic congestion associated with the automobile.

Such unwanted by-products are a natural consequence of many production processes. They impose a cost upon society similar to the cost of productive resources necessary to produce the desired product. They create a social problem insofar as their cost may not be properly allocated between different segments of the economy.

Let us consider further Pigou’s example of spark-emitting steam locomotives. Assume that the marginal cost of employing resources to produce a ton-mile of railroad freight service may be 3 cents. The railroad system, however, “causes” 0.5 cents worth of damage per ton-mile because of fires inflicted on farmers’ crops adjoining the right-of-way. Whether such behavior creates an unwarranted social cost, and what the appropriate social policy should be to deal with it, pose some subtle and complex issues.

The main force of Pigou’s treatment of the subject is that the “social cost” of producing a ton-mile of freight is 3.5 cents (3 cents for the railroad’s own costs, plus 0.5 cents for the destroyed crops). The policy prescription is that the railroad should be made to pay farmers for their destroyed crops or that railroads should be taxed or restrained in other ways that will prevent damage.

Coase (1960) has demonstrated, however, that this traditional approach to “nuisance effects” is wrong. The relationship is reciprocal. Crop damage is “caused” just as much by the farmer’s growing crops along the railroad’s right-of-way as by locomotives emitting sparks (indeed, the doctrine of “causation” is spurious). Moreover, to restrain railroads in arbitrary ways may impose a greater social loss (due to higher-cost railroad services) than the loss of some crops. The proper solution is to design a system that maximizes the economy’s total product.

Such a solution might be found by recognizing that in producing the crops associated with the 0.5 cents per ton-mile of damage, farmers must purchase resources worth, say, 0.4 cents. Under these conditions, the railroad could pay farmers 0.1 cent not to grow crops along its right-of-way. Farmers would be just as well off as if there were no railroad; freight costs would be 3.1 cents per ton-mile, instead of 3.5 cents if farmers were arbitrarily awarded “full” damages; and 0.4 cents worth of resources would be freed to produce other products. Indeed, this kind of solution is often worked out spontaneously by bargaining between the concerned parties or is brought about through legal adjudication.

The social problems associated with external “nuisance effects” arise when certain scarce resources are treated as if they were “free goods”- because of faulty specification of property rights, or because it is difficult to identify in some quantitative way who causes the nuisance or who suffers from it (or both), or because the administrative costs of “solving” the problem may be more costly than the nuisance itself. Many students suggest that activities imposing unregistered social costs upon society be subjected to special excise taxes; however, the precise design of excise taxes that would not themselves distort resource allocation is difficult. Other students urge extensive state regulation. However, a distressing number of nuisance effects are due to activities that are already either regulated or managed by the state, for example, highway systems and government-owned public utilities, suggesting that effective solutions may not be easily attained from that quarter.

Sweeping solutions to the nuisance effect problem do not appear readily available. Thus far in virtually all social systems they have been coped with on an ad hoc basis. Perhaps one of the best ways to achieve better social guidelines for treatment of these problems is for economists to give more attention to the precise content of property rights, in terms of their economic effects, and for lawyers to employ economic analysis to evaluate the social utility of legal principles applied to torts.

Pecuniary external diseconomies. Consider industry A (for illustrative simplicity we assume that it only requires labor as a resource) which expands its output (see Table 1).

Table I
OutputWorkersWageTotal costAverage and marginal cost per unit to firm“Marginal cost” per unit to Industry

This example illustrates an “increasing cost” industry. The wage increase is necessary to induce more workers to enter the industry. The operators responsible for hiring the additional workers, by forcing up the wage, may be said to impose an additional cost upon their colleagues. This kind of cost increase has been termed an “external diseconomy.”

It was with reference to cases like this that some students suggested (e.g., Pigou [1920] 1960, pp. 223–225) that the free operation of private business firms resulted in too much output by “increasing cost industries” and that they should be subject to taxation to restrict output. The implication, as illustrated by the arithmetical example, is that the $60.50 is the “social cost” per unit of the additional output; whereas the price that actually emerges in the market is $10.50.

The implication that the increasing cost was a social diseconomy raised some fundamental questions about the nature of costs. The clarification was achieved by D. H. Robertson ([1924] 1952, pp. 143–159) and especially F. H. Knight ([1924] 1952, pp. 160–179) and reiterated by Ellis and Fellner ([1943] 1952, pp. 242–263). The essential points are as follows:

Under competition, with many producers in an industry, each producer will view the cost (or wage) of hiring an additional worker as his marginal cost. In our example, it is $10.50. The $10.50 is also the average cost of production. In a private, competitive equilibrium, the average cost, the marginal cost to each producer, and the market price will be equal. If we take a collective view of the industry (which might be the case if it were operated by a socialist trust or a private monopoly) the “marginal cost” of $60.50 appears, which results from reckoning the possible impact of industry expansion upon the wage level. The question is: Which marginal cost concept is valid from an overall social welfare viewpoint?

The $10.50, rather than the $60.50, is the relevant measure of the marginal social cost. It represents what workers on the margin of production in the given industry could earn producing alternative products in other industries. Increasing the output of industry A requires enticing workers from industry B. If $10.50 is necessary to attract a worker into A, it is because he can earn $10.50 in B. Consumers give up $10.50 worth of B to get an increment of A. The marginal social cost of A is therefore $10.50. It is also the marginal cost upon which private decision makers focus and the signal that the price system generates.

That the shift in consumer demand and the consequential raising of the wage level in industry A operate to create an apparent marginal cost of $60.50 is simply a result of the fact that product prices and wages (and other resource earnings rates) are mutually determined by the operation of the price system. For a central authority to try to prevent the wage increase in industry A would (apart from thwarting consumer preferences) create many problems. First, other means to get additional workers into the industry would have to be found. If, even after getting additional workers into the industry, authorities sought to maintain the $10.00 wage and product price, they would create a rationing problem insofar as consumers would demand more of the commodity at $10.00 than they would at $10.50. Finally, the higher wage of $10.50 for all workers would induce the proper use of the specialized resources: at a $10.00 wage, production managers would not use the workers as efficiently as they would at a $10.50 wage. [For a further discussion of these points, see COST.]

External economies

Technical external economies. Consider the situation where a group of farmers dam a stream in order to obtain a supply of irrigation water. The resulting pond may stimulate the fish population and thus enhance fish output and the earnings of fishermen. Increased irrigated acreage devoted to apples will increase the supply of nectar, improve the productivity of bees, and increase the output of honey; conversely, a larger bee population can increase pollenization and raise apple yields.

Such external economies are creatures of multiproduct activities and are similar to the technical external diseconomies cited above. They are probably not as frequent because private producers are adroit at forming arrangements whereby they can capture their by-products and derive a profit from them. For example, in our irrigation pond–fish example, neither the value of irrigation water nor the extra fish may–separately–justify the expense of the dam that makes both possible. But a merger between a fisherman and a farmer would create the necessary arrangement by which the full gain could be captured privately and thus accrue to society.

Technical external economies may nevertheless exist in important areas–where property arrangements are inadequate to capture privately the full benefits of an activity–and are sufficient to justify state intervention. For example, public education and health are areas where, while it may be of some economic worth to an individual to educate himself (or his child) and to keep his family healthy, greater social benefits are obtained if the state pushes the activity beyond the margins that individual incentive would achieve. Multiple-purpose river development projects are further cases in point. Such projects can provide electric power, flood control, navigable waterways, irrigation, and recreational facilities. In principle, a private group with a charter granting it proprietary rights over an entire river basin could construct and operate an appropriate multipurpose river development project. But such a monopoly would have to be carefully controlled by the state to prevent the private group from exploiting such a powerful ownership right in unsocial ways. Hence, it is simpler for the state to design, create, and operate such multipurpose projects.

It should be recognized, however, that this type of argument is used to justify or rationalize many kinds of subtle and not-too-subtle forms of state intervention in support of various industries or forms of consumption. In prewar Germany agriculture enjoyed state subsidies on the ground that peasant boys made good soldiers; in the United States at present the maritime industry enjoys subsidies and the mineral industries enjoy preferential tax treatment in the cause of national defense. Whether the relationship between the costs and the benefits of each of the many government interventions warrants the government action is moot: very few such programs are actually subjected to rigorous cost-benefit analysis based upon modern quantitative and analytical techniques.

Economies of scale. When an industry expands its output, it will normally procure additional goods and services from other firms or industries. Some of the supplying industries may operate under conditions which would permit them to enjoy “economies of scale.” Such a condition means that an industry is not fully utilizing its capacity, perhaps because the market demand is not large enough to take all of the output the plant is efficiently capable of producing. Where economies of scale exist, it is possible to produce additional output at lower average unit costs. Because the industry utilizes its capacity more intensively, it spreads its overhead and fixed capital costs over a larger output and enjoys an “internal economy.” Industries that can exploit internal economies are also termed “decreasing cost industries.”

When a given industry expands its output in a way that necessitates purchases from decreasing cost industries, the industry that expanded initially may also enjoy lower costs. For example, as coal mines in a given district increase output, the railroad serving the mines may experience lower average unit costs. If the lower unit costs are passed on to the coal mine operators, the latter experience a “pecuniary external economy.”

The extent to which such pecuniary external economies occur, and the impact they have on market prices, depends on several factors that can only be determined empirically on a case-by-case basis. First, it is a question of fact as to just how important economies of scale are in the economic system and how important their variation between different industries. Although railroads and electric utilities are often cited as examples of decreasing cost industries, what if the railroad or power plant is already fully utilized? Second, when a firm enjoys economies of scale, the activity is imperfectly competitive, or even monopolistic. As illustrated by the coal mining-railroad example, the railroad enjoys a monopoly subject only to the competitive constraint imposed by, say, motor trucks. Unless there is some institutional arrangement such as a public utility commission that forces a rate reduction, the larger coal traffic and consequent lower unit costs will only increase railroad profits. The “internal economy” will not become an external economy to anyone else.

Finally, whether an external pecuniary economy actually permits lower prices for the expanding industry’s end product depends upon two opposing forces: the external pecuniary economy will lower cost; however, the industry’s expansion can bid up the prices of hired resources and other inputs. The net balance of these opposite forces can only be determined through examination of the composition of the expanding industry’s required inputs.

Division of labor and economic growth. Another set of external economies is dynamic and closely associated with economic growth and development. As an industry expands, the growth can create a number of supplying firms and activities which, through increased specialization, afford lower-cost products and labor services. There can arise specialized banking and financial facilities, firms that specialize in machinery design and repair, warehousing and transportation specialists, and numerous other activities oriented to servicing the industry. A labor force will emerge that is more sophisticated. If an industry is concentrated in a given region, knowledge gained in one segment rapidly spreads and speeds the rate at which cost reductions occur and are “competed away” through lower prices. The phenomenon was well treated by Young (1928).

Thus industry expansion stimulates the division of labor. The keener division of labor lowers costs. The lower costs and resulting lower prices increase output even more, which permits a further division of labor. Such a process helps explain the historical development of great regional industrial areas. The phenomenon, when it cuts across an entire economy, can provide a basis for a “take-off” toward the goal of a high degree of economic development.

The external economies associated with industrial development and growth (as well as those associated with economies of scale) pose special problems in the planning and public policy of undeveloped countries. These countries usually produce raw materials or semifinished goods for export and import finished products. Policy makers thus face interesting but perhaps difficult options. To exploit externalities originating in the division of labor at a minimum cost of scarce capital, the best place to start might be the industries that are already the most developed. However, these industries are likely to be the raw material or semifinished product export industries. If they are developed further, the external economies may accrue mainly to foreigners through lower-priced exports. It may thus appear more attractive to concentrate on the development of industries that will produce products which are extensively imported. The foundation for such a development strategy may be meager, however, and the cost-effectiveness per unit of investment may be low.

But it is in manufacturing industries where great gains–apparently resulting from exploiting both the dynamics of the division of labor and economies of scale–have eventually occurred. In recognition of these historical phenomena in Western developed countries, some students (e.g., Rosen-stein-Rodan 1943) have advanced the doctrine of “balanced growth.” This doctrine suggests that economic development should be promoted on a wide front so that the external economies of each industry will be mutually reinforcing, thus generating a cumulative process of over-all industrial development.

The precise investment strategy that a developing country should adopt is not evident on a purely theoretical basis. Much depends upon the price elasticities and income elasticities of its traditional export industries. Moreover, a country can design a structure of tariffs and export duties that could prevent an inordinate amount of the benefits due to external economies from accruing to foreigners. And by earning more foreign exchange through more efficient operation of its export industries, a country may more effectively gain the resources to finance its internal capital investment programs; or resources may be freed from the export industries to be available for domestically oriented endeavors. Finally, careful attention should be given to the precise qualities of the economy’s resources that may provide the basis for the proposed statesupported domestic–as contrasted with exportoriented–industries. At a minimum, it appears that a development program must be integrated with a foreign trade policy. [For further discussion of the issues in this section, see ECONOMIC GROWTH, articles on THEORY and MATHEMATICAL THEORY.]

Growth repercussions. Another variety of external economies may be designated as growth or investment repercussions. They were labeled “pecuniary external economies,” however, by Scitovsky (1954). Consider the example where the steel industry enjoys high profits. It expands its capacity and consequently increases its output. The larger output reduces steel prices. The cost to steel-using industries thus falls, and they enjoy higher profits. Their enhanced profits, although external to the steel industry, may be attributed to additional investment in the steel industry.

From this sort of sequence, Scitovsky developed the following line of argument: The profit signal revealed to the steel industry alone is an inadequate measure of the profit that should guide investment in the steel industry. If the steel-using industries were integrated with the steel-producing industry, managers of the integrated industries would have a better guide for their decisions. However, the repercussions and interactions of investment in a major industry can extend throughout the entire economy, which would suggest that the entire economy be “integrated.”

Thus it is asserted that the price system provides a poor guide for investment decisions. The policy implication is that central planning and decision making is a better way to allocate investment than is decentralized decision making, since the central authority can explicitly take into account such external economies. A milder policy prescription is that private investors be provided with better information about one another’s intentions, which may be done through the French variant of economic planning [see PLANNING, ECONOMIC, article on WESTERN EUROPE].

The contention that private investors may be unable to exploit this class of pecuniary “external economies” recognizes that, in fact, a market mechanism and its system of price indicators do not provide “perfect” intelligence of what the future holds. But the price system is not the sole source of information in an economic system: businessmen communicate with one another in other ways; they communicate with engineers and scientists on technological possibilities, and they conduct consumer surveys. Conversely, central planners or government officials also operate under imperfect knowledge. The critical substantive issue here is therefore: can the aggregate of private investors– each highly knowledgeable about his own business and responding to prices he confronts in the market place–more efficiently use investable resources than can a central authority, which may have less detailed knowledge about consumer preference and technology but a broader view of the economy in its entirety? Both types of decision making will be “imperfect” because all decision makers have imperfect knowledge. In part, the question will turn upon how highly developed the price system and private communication systems are in a particular society. In a developing economy the information system may be poor. Hence, a case may be made for a high degree of central planning in such a setting.

However, even if an instance can be found of the price system being an inferior information system, the case for central planning and control of investment is not established. The price system combined with private investment decision making provides widely diffused control over investable resources. Centrally controlled investment decision making is subject only to constraints that affect the entire economy. The choice is therefore one between many small decision makers making many small mistakes because of a poor information system, as opposed to the central authority possibly making fewer mistakes but perhaps making monumental ones. Which system is the most efficient is not obvious.

External economies and diseconomies are a manifestation of the fact that, in complex systems, one man’s decision or behavior can often have an undesigned impact upon others. The trick in system design is to establish arrangements by which the mutually interacting and dependent behavior of all decision makers harmonizes so that the larger system operates in an optimal or efficient way.

The kinds of problems and phenomena we have discussed are not unique to the operation of a private enterprise social economy, although they have been most extensively treated by economists in such a context. The large multiproduct corporation, the government agency, a military service, or a university–organizations that may be characterized as “closed” systems and may be “centrally managed” to a high degree–have identical problems. Decision making and authority are necessarily diffused (governments consist of departments and bureaus, armies consist of divisions and squads, etc.); the decisions of many must nevertheless result in some coordinated and mutually consistent behavior; decision makers must be constrained as well as motivated; finally, they must be able to obtain knowledge about their constraints and opportunities, which includes the impact of the behavior of others. In varying degrees, discussions of externalities focus on these fundamental aspects of system or organization design and management.

The problems are basically those of specifying over-all system objectives, measuring effectiveness criteria, identifying and measuring the relevant cost concept, determining the relative merits of alternative information systems (with particular reference to the cost and worth of obtaining and communicating information), and specifying the appropriate “decision rules” that should guide individual decision makers.

Much of the economic literature on “externalities” suggests that economists have often failed to meet these problems head-on. On the other hand, the discipline of economics and much of the literature on the general operation of the price system –the product of nearly two hundred years of effort to understand the workings of a complex social economy–provide worthwhile insights into the problems that confront all large organizations.




COASE, R. H. 1960 The Problem of Social Cost. Journal of Law and Economics 3:1–44.

ELLIS, HOWARD S.; and FELLNER, WILLIAM (1943) 1952 External Economies and Diseconomies. Pages 242–263 in American Economic Association, Readings in Price Theory. Homewood, I11.: Irwin. → First published in Volume 33 of the American Economic Review.

FLEMING, MARCUS 1955 External Economies and the Doctrine of Balanced Growth. Economic Journal 65:241–256.

KNIGHT, F. H. (1924) 1952 Some Fallacies in the Interpretation of Social Cost. Pages 160–179 in American Economic Association, Readings in Price Theory. Homewood, I11.: Irwin. → First published in Volume 38 of the Quarterly Journal of Economics.

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ROHERTSON, D. H. (1924) 1952 Those Empty Boxes. Pages 143–159 in American Economic Association, Readings in Price Theory. Homewood, I11.: Irwin. → First published in Volume 34 of the Economic Journal.

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