External influence on a third party not directly related to the transaction or financial activity. That effect can be negative or positive. The classic negative example of this is when a factory is polluted and the smoke settles on the people living in its area. Their laundry cost will increase. Worse, they suffer from lung and lung diseases. These negative costs did not contribute to the factory’s production costs. When the bee keeper contributes to the pollination of the surrounding crops, thereby increasing their yield. The profits she made through the land business of raising these bees would not benefit the surrounding farmers. Both of these are called market failures and we have government intervention to address them. Either the factory is asked to install a scrubber to reduce its emissions to zero so that the cost is fully internalized or taxed for redistribution to the local community. Similarly, a beekeeping space business can be subsidized to promote it by taxing the surrounding crop growers. Externality is an example of market failure. But not all market failures need to be addressed through regulation, taxes or concessions. Defining property rights clearly creates the conditions for parties to negotiate prices to internalize these costs or benefits. This market-based solution is the essence of the famous theory of Nobel laureate Ronald Kos.
There are plenty of examples of externals. For example, road congestion is caused by the external cost imposed by individual drivers on everyone else. Companies invest less in training if they fear that trained workers will be hunted down and its benefits will go to rivals. It should be noted that there is a difference between cases of pure market failures and anti-competitive behavior, asymmetric information initiated by the use of monopoly and exploitative prices or incomplete competition.
However, there is another type of externalization in which the influence on a third party is acted upon by market policy. Therefore, it is not a market failure, the market works well. This is called pecuniary externality. An example of this is urbanites rushing to rural areas to buy a second home or farmhouse, skyrocketing local prices and making housing unaffordable for locals. Negative externalization on local folklore worked through pricing policy, i.e. increasing demand. There is no market solution for such externalization. Many economists may even hesitate to call such a phenomenon extraterrestrial. After all, in a market-oriented economy, although not everyone is a party to every transaction, almost all interactions between supply and demand affect all consumers and producers through pricing policy.
In February, the US state of Texas experienced an unprecedented sub-zero cold weather, which caused a huge imbalance in electricity demand and supply. In general, the electricity market in Texas runs smoothly, and it is one of the most sophisticated markets, balancing with real-time price innovation and friction-free adjustments of supply and demand. However, due to the inadequacy of winter, half the supply gas froze in the pipelines, which did not come online. Second, the sudden freeze will increase the demand for home heating, which in Texas is largely dependent on cheap electricity and is not used. In previous weather episodes, like the hurricane of 2017, the utility regulator was able to balance demand and supply without any interruptions. Even in extreme cases, the situation is resolved with controlled and well-rotated failures (i.e. ration). But this February storm caused more than 20% of controlled failures of demand, and everything became heavier. Most homes are without water and electricity for days. At least 100 people have died from the cold, and gas prices have risen more than 4,000% — the market policy is working. It is an extreme form of black swan incident and monetary extroversion.
This is similar to what we see in India’s second wave Kovid. Sudden and steep spikes of infections have created a huge demand for antiviral drugs, hospital beds and oxygen. All three are in short supply. As a result, prices have risen, especially on the black market. Hospital beds are made available for a few lakhs of rupees, or there is a bottle of remindivir that sells for tens of thousands of rupees. To make matters worse, there are stories of police finding stockpiles of life-saving drugs, patients not finding beds or dying from lack of oxygen. Whose fault is it? Should hospital administrators not store adequate amounts of medication? Shouldn’t they plan the oxygen supply and the high efficiency of the beds? It is not as loud as the face and it works at normal times. In fact, a long time ago, there was an additional supply of remindesivir. But we are now in the background of the black swan. Markets do not work. The government must address this shortage on a war footing. Centralized allocation of oxygen cylinders is underway. Industrial oxygen was diverted to hospital use. Licenses have been issued to more companies to produce Remindesivir. Vaccine production is accelerating, so are imports.
When it comes to an extreme situation like the Kovid crisis, or when it’s like a shortage of affordable housing, wealthy externality can only be resolved through an intrusive and redistributed public-policy response. Exacerbation of inequality in areas such as health care, housing or education is a market failure that has no easy ‘market solution’.
Ajit Ranade is the Chief Economist at the Aditya Birla Group.