Infernal Ramblings
A Malaysian Perspective on Politics, Society and Economics

Externalities and Poverty

Written by johnleemk on 12:44:22 am Jan 4, 2007.
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Orthodox economics generally applies the concept of externalities to issues such as pollution or traffic congestion. (An externality is basically when a decision made by a producer or consumer affects someone else not involved in the transaction. As mentioned, an example is pollution - a polluting firm is affecting people not involved in its business transactions when it pollutes.) However, after doing a bit of pondering, I have reasoned that it might not be all too illogical to apply economic theory concerning externalities to poverty.

Poverty has always been a major flaw of the free market - it has been the largest impetus for the development of competing economic systems to capitalism, such as communism and socialism. Although many criticisms of capitalism can be addressed by orthodox economic theory (which, contrary to popular belief, advocates regulation of markets in certain situations) it is more difficult to answer the question of why poverty exists in a capitalist system.

Social Darwinists would argue that the poor deserve to be poor because they do not contribute to society as much as the rich. This is not necessarily an accurate statement, however. Economist Paul Krugman developed a metaphor for this idealised Darwinism by suggesting that according to social Darwinists, we live in a society where everyone is a fisherman, and the sole determination of how many fish we catch is our own skill. However, he argues, in reality we live in a society comparable to that of a gold mining camp. Skill is one determinant of success, but luck plays a major role in determining whether you strike gold or live out your days in poverty. As one joke has it, to be as rich as Bill Gates, one must "Choose Your Grandparents Carefully" and "Choose Your Parents Carefully".

In my view, this is where the concept of externalities come in. Those born into poverty and thus trapped in the poverty cycle (although some might argue the poverty cycle is non-existent) are experiencing a negative externality because they are unable to realise their full economic potential. If my parents could not afford to feed me, clothe me and educate me, I could not be attending college (or any institution of education for that matter) right now. I could probably never attain a substantial degree of economic success, without being extraordinarily lucky. All this is through no fault of my own - I played no role in the transactions that led to my parents' poverty, and I played no role in the decisions they or others made that led to their poverty.

As you might know, the orthodox way of addressing the problem of externalities is to "internalise" them by either taxing those responsible (and thus internalising the costs to society created by the irresponsible actions that led to the externalities) and/or by creating "property rights" and compensating those who have suffered from the externalities. Normally, we use the first approach because it is extremely tricky to properly address the issue of rights. If my dog spews carbon monoxide and makes your dog die of lung cancer, how can you prove for certain that your dog wouldn't have died if there was no pollution? And what if you stay in Johor Bahru and I stay in Singapore? Would you have to file suit in a Singaporean court to claim the costs of treating your dog's cancer from me?

A similar problem arises in poverty - identifying those who have created the externalities is extremely difficult. Furthermore, to continue our earlier example, each individual who has contributed to my parents' poverty would likely have contributed only a few cents' worth. Collecting these small sums would not be a very cost-effective proposition. The solution, then, is (as is done with pollution) to tax society as a whole, and pay me to right the wrongs done to me. (This payment need not be made in cash - it could be made through free healthcare and education.)

This is a very neat and tidy way of positively (that is, proving through a series of factual instead of opinionated statements) proving that the normative (opinion-based) belief in welfare as a means to right society's wrongs is a justified belief. However, a corollary question can be asked: if we can do this to address the negative externalities of poverty, what about the positive externalities of those born into wealth?

After all, Bill Gates received a tonne of opportunities simply by being born into the right well-connected family. These opportunities were his simply by right of who his parents were - they had nothing to do with any decisions made by him. This is a classic case of a positive externality - or is it?

I would argue that this cannot possibly be a positive externality because there is choice involved. In a classic externality, at least one of the parties has no choice about their circumstances - either the source of the externality cannot control it (in the case of a positive externality, where those who are not party to the transaction derive benefits from it) or the person experiencing the externality (in the case of negative externalities) cannot choose to avoid it.

In the case of inheritances, choice is exercised by the parents to pass on their wealth to their offspring - and the offspring exercise their choice to reject or accept their inheritance. As a result, I do not believe there is much of a case for viewing the inheritance of an estate as a positive externality.

Conventionally, economics has dealt with the problem of income inequality in an indirect manner. Commonly, for instance, economists condemn great inequality of income because it has a negative impact on the economy. (The rich have a greater propensity to save instead of consume, and as a result there is not enough aggregate demand for goods and services.) As a result, this has led many economists - including the famous pro-free marketeer Milton Friedman - to advocate poverty-fighting measures such as the negative income tax.

Nevertheless, I feel that if you need another economic reason to consider income inequality an undesirable thing, treating poverty as an externality is a good thing to do. If we view poverty as a negative externality, we not only see poverty as undesirable, but also see that the solution is not necessarily equality of results but equality of opportunities. Those born into poverty are unable to avail themselves of opportunities available to the rest of society through no fault of their own - and thus it is incumbent upon society to address this externality by making opportunities for education and self-advancement available to all.


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Infernal Ramblings is a Malaysian website focusing on current events and sociopolitical issues. Its articles run the gamut from economics to society to education.

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