Last Updated 18 Jun 2020

Externalities in Business

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Definition of externalities: Externalities recently became an important and a popular term in the business world, especially with the risen of debates and arguments about the externalities’ costs and benefits, and the ethical issues related to it. Almost everybody deals with an externality everyday but without being aware of it (kaydee, 2008). The simple definition of says that Externality is the effect of an economic transaction which impacts somebody who was not involved in that transaction.

The more complicated definition sates that Externalities can be defined as the different types of effects which impact some parties (individual or entities) as a consequence of other parties’ activities. These effects occur without any choice of the affected party and without taking their interest into account by the affecting party (kaydee, 2008). When any economic trade occurs between two parties, they both benefit from the trade. Sometimes, a third party is being affected as well by this trade, the effect can be a negative effect or a positive one; and these effects are what we call externalities (Anon. nd). For example, if we take any business organization as one party and the customer is the other party, they both have the trade of the organization sells or provide goods or services, and the customer pays to obtain this good or service. However, the society as a whole could be considered as a third party, any external costs the society pays or any external benefits it gains from this trade (costs and benefits not included in the market price of the goods or services) are then considered to be an externality.

By breaking down this example, the business organization or the customer can be considered to be the affecting party, the society, the third party, is thus will be the affected party, the external costs and benefits are the externalities (Anon. , nd). Types of externalities: There are two types of externalities, the positive type and negative type. The external benefits are always considered to be positive externalities, these benefits affect the outsiders in a positive way, give some advantages and without any payment required.

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The external costs are considered as negative externalities, these costs affect the outsider negatively, impact them in disadvantageous way, and the outsiders are forced pay these costs without any choice (Jonson, n. d. ). There are lots of examples to clarify each of the two types. The negative externality which is some analysts call it as external costs and some other call it as external diseconomies can be seen in the global warming which is considered to be number one negative externality; the change in the climate came as a result from the emissions of burning the oil, coal and gas.

The water pollution as a result of adding poisons to the water or the several contaminated chemicals which are dumped by industrial plants in lands or lakes participates in harming the people, plants and animals. The over fishing which comes as a consequence from the over harvesting of a fishing company harms other fishing companies harvesting in the same ocean. The company trucks using a road may create congestion or traffic jam which impacts negatively other road users.

In the animal production, the industrial farms which generate huge outputs of animal products generates a negative externalities in the form of increasing the antibiotic resistant bacteria, contamination of rivers and waters by the disposal of the animal waste. These farms as well result in another externality of the animal welfare reduction due to the close quarters where the animals are kept.

The problems which may be caused by the nuclear plants when storing the nuclear waste in impropriate way, and the radioactive waste which is generated thorough the energy production of the nuclear power plants may affect the current and new generations. The external cost of health decline which is a consequence of smoking, the external cost in the form of car accidents due the consumption of alcohol by drinkers which may lead to pedestrians killing or injure, are all considered as negative externality. All the previous negative externalities examples harm the environment and the inhabitants.

The environment, the people, plants and animals are the parties which are affected negatively without any choice from their side and without taking their interests into consideration by the externality generator (Shaprio, Khemani, 2003; Anon. , nd). There are many examples also to be mentioned to describe the positive externality. When someone buys a certain product, it would increase the product value to other people who already have this product, the increase of the value is considered to be an external benefit for these people, this type of positive externality sometimes called the network externality or the network effect.

When an invention is discovered or information is made more accessible, then other people will externally benefit from using this invention or the information. The education also gives a positive externality to the whole society, the more are the educated people in the society the more the whole society better off even people who are not educated as the rate of crime will decline which means more safety.

Another example of positive externalities is when a foreign company opens a new branch in another country, although the deal is between the foreign organization and the country, and although they both benefit financially from this deal, but as well people will benefit by having opportunities for jobs, salaries and kind of secure life, this extra benefit for the people is considered to be positive externality.

Also, when people buy a specific type of a commodity, the demand on these commodity increases, which as well increase the work chances for distributors, or when people buy a car model, then the demand for mechanics of this certain car model increases. Construction as well may give positive externality, when roads and bridges are built and opened; it may give a chance of opening new areas for housing and establishing business entities (Shaprio, Khemani, 2003; Anon. , nd; Anon. , 2007). Externalities and the ethical theories:

Generally, externalities are always a term which creates a situation of social injustice, its existence generates socially unbalanced outcomes, regarding the fact that a party may gain external benefits without paying any type of costs, or a party who may suffer from and forced to pay external costs without any choice (Anon. , nd). The question about ethics in all cases of the externalities moves around the universal ethics. The universal ethics are defined as a system of ethics that can apply to every human being. The externality then, with its both types, the positive one and the negative, may lead to a violation of the ethics.

If we analyze the negative externality example we mentioned of the radioactive pollution, as such an externality will contain external costs, people who will be affected by the negative outcomes, will consider the harm they will be exposed to as explicit costs which they did not put into account before. The harm could be in the shape of lung and body diseases, and the extra payment for medical checks and medicines. As the radioactive company serves the people by providing utilities, people will see the harm generated by the same company – the negative externality- as a reduction of the utility.

The negative externality here then raises an ethical problem as it is simply considered as a violation of ethics as harming others (Anon. , nd). Regarding the positive externalities, it again raises an ethical issue by violating the universal ethics as the positive externalities type is always connected to the term which is called “free riding”. To explain how positive externality violates the ethics, let us refer to our example of education, when the society as a whole and as a third party, benefits from the education process in the form of being an educated, productive and well being society.

Everyone then in the society will benefit, even people who were not educated will benefit without paying any cost. For such people, who will benefit from the educated, productive and well being society they are living in, it is considered external benefits as they did not pay for education, but on the contrary, they are free riding on the cost of others who had to go through and pay for the education process.

Another example is the society health care, when people go and obtain the vaccination, the society will be protected from the transmitted diseases by its vaccinated members, but the people who did not receive the vaccination will still be protected from the diseases and will benefit from the healthy and protected society, actually they are free riding on the costs of the other members of the society. The free riding problem- the positive externality- is considered to be against the ethics and raise an ethical issue of benefiting from the borne of others (Anon. , nd).

Also externalities raise an ethical issue due to the problem that the value or equivalent of any externality is difficult to be determined, most of the externalities are hidden, negative externalities are hidden by the traders, and positive externalities are hidden by the third parties benefit from it, which considered cheating, and breach the simple ethical rule “do not cheat” (kaydee, 2008). With the nowadays absence of ethics, the behavior changed negatively in a dramatic way, People do not think anymore about the externality which they going to create once any product they buy reach the expiry date.

Companies do not think about the consequences of their waste disposal of the manufacturing operations. Injustice is considered to be a violation of ethics, when a third party is negatively affected by a transaction which is out of his or her control, there is then a case of injustice. Similar, when someone is affected positively by a transaction which is out of his or her control and he or she does not pay for this benefit, again the injustice takes place (kaydee, 2008). Some analysts have different opinion; some will argue that there is no ethical issue about externalities, meaning that there is nothing to do with wrongdoing.

The supporters of this opinion say that most of the businesses are trying to achieve the purpose of their existence; they try to achieve their target whatever it is, making profit, providing goods and services, and keeping the employees employed. The conflict of interests between the businesses’ activities and the different parties around does not mean that businesses are doing anything wrong (MacDonald, 2007). Corporations actually should work under some certain core concepts which most of the time create kind of ethical dilemmas, these concepts are the business ethics rules which each business should respect and follow.

But it is clear that these concepts are not strictly followed by business leaders, most of corporations do not pay much attention to business ethics and lots of businesses do not pay attention to the ethical implications of the externalities and its damage of the environment. As it is said: In business, it’s easy to talk about ethics, but it’s damn hard to be ethical. If we look back in time, historically two important ethical philosophies were created, the Western Ethical Philosophy and the Eastern Ethical Philosophy.

Generally, philosophers came up with a number of ethical principles that control and guide business activities, these principles can be considered as ethical standards which always get codified into laws. One of the most important and well known ethical systems in the western ethical philosophies was the Hippocratic Oath, these principles was created by the Greek physician Hippocrates, and they are still used today, these principles in total generally direct people to the concept of "Do no harm. " The eastern example is the karma which adopts the concept of cause and effect, what are the negative and positive results of any conduct.

This ethical system simply says that if you harm others, then the harm will eventually return to you; according to that, if the business creates good consequences then this good will return back to the business, and if the business does harm others, then the harm will also return and harm the business (Johannsen, n. d. ). So, both philosophies and some other philosophies not mentioned in this paper, raise the ethical issue of harming others, which is related to the externalities consequences, as one of the five core business concepts from the perspective of the harm and the negative effects that businesses generate.

Worth to mention that the five core business concepts from the view of causing harm are: Shareholder Wealth, Profit Maximization, Fiduciary Responsibility, Return on Investment (ROI), and Externalities (Johannsen, n. d. ). In any business, all the accounting figures including profits and costs are always shown on the financial statements, but in the case of the externalities (which some financial analysts call it financial liabilities) the financial statements do not show the external cost or the external benefits of the corporation.

Some will argue that this is considered to be a manipulation and a breach of ethics, and that the businesses should, clarify, confess, be responsible and pay for the externalities they cause. But some others will argue that the externalities are so hard to be described as a number or figure, and thus cannot be shown in the financial statement as liabilities, and so it can not be described as a manipulation or a breach of ethics. One of the important and well known ethical theories that may describe the externalities in a better way could be the utilitarian ethical theory.

The utilitarianism refers to the idea that the moral worth of any action, whatever this action is done by an individual or by an entity, the moral worth will be determined only by how the action’s consequences participates to the overall utility. Thus, the utilitarianism indicates a type of consequentialism, as the moral worth of the action then will be judged according to its results and its effects on people. The utility here is considered to be the overall pleasure and the absence of pain.

The utilitarian ethical theory describes the different types of actions, any action is considered to be an ethical action- in other words to be morally right - if its moral worth is positive, meaning, the action’s outcomes contribute in developing the overall utility or the overall happiness or pleasure among people. However the action will be considered as an unethical action- or morally wrong- if its moral worth is negative and its consequences are decreasing the overall utility of people and cause them suffering or pain (Anon. , nd).

If we put externalities in practice according to the utilitarian ethical theory, then both types of externalities, the positive and the negative, are to be considered as unethical actions. The negative externality affects the third parties by reducing their utility, in all our previous examples of negative externalities, environment and people end in suffering and pain. Talking about the positive externalities, they are as well considered unethical as the third parties are affected positively but without paying any cost for these benefits which in a way increase their utilities but on the account of others.

Although this ethical theory was successful for a period of time, it was faced with lots of criticism which came up later. One of the important criticisms was that the utilitarian ethical theory described the positive and negative externalities as symmetric in nature, and those externalities will lead to non optimal outcomes which call for the necessity of government intervention. Mr. Murray Rothbard wrote in his book, Man, Economy, and State, a good criticism of the utilitarianism approach of externalities. He stated that the positive and the negative externalities are not symmetric from the ethical perspective of property rights.

He says that the two externalities types are completely different in nature; he argued that the injustice in the case of the negative externalities is due to the failure of the authorities in protecting the property rights of every party involved. Opposite, in the case of the positive externalities, there is no violation of the property rights of the party who gives the external benefits but only when the authority tries to extend this benefits (Cleveland, 2002). Another ethical theory which can explain the externalities is the social responsibility theory.

The corporate social responsibility term- which is divided into four parts, the legal, the discretionary, the economic responsibility, and finally what we are interested in, the ethical responsibility- refers to the obligations of the business to work and conduct the operations in ways which achieve its own interests and the interests of all its stakeholders. Thus, the business is to be considered as a socially responsible if it pays attention and make sure that its activities do not harm or affect negatively its stakeholders (Sandy Millar, Christopher Theunissen, 2008, P69) (Anon. 2008). When we look at externalities from this theory’s point of view, especially the negative type of externalities, any business which causes harm to the environment, people and society in total, should not be then considered as socially responsible business. This business often works on achieving its own interests and purpose of existence (making profit and satisfying the shareholders), but it fails in keeping its social responsibilities and obligations towards the rest of the stakeholders and thus lead to externalities.

As mentioned, the most important interest and the main target for most corporations are to satisfy their shareholders needs, and that comes by making profit. This aim is the most argued that it is the reason for corporation to act unethically and not paying attention to the social responsibility and lead to unethical practices which cause the externalities. At the end the corporation is just a legal structure and its moral responsibilities comes from the moral responsibilities of the corporation’s shareholders, employees, and managers.

If the managers are being unethical conducting unethical activities, and if the shareholders are being unethical by approving and giving the green light to the managers to go ahead in such unethical practices, then it at the end reflects on the overall corporation of being ethical or unethical, of being socially responsible or not (Anon. , 2008). This leads to another approach, which is the general ethics theory. Ethics is what examines and judge the human behavior; regarding what is right and what is wrong, regarding what is just and what is unjust, and regarding what is fair and what is unfair.

To behave ethically is to behave in a manner which is right or moral. The behavior then is considered to be ethical if it is right and the vise versa. But what does determine if the behavior is right or wrong? What does determine if the behavior ethical or unethical? Generally, the society comes on the top of the list of what determines what is right or wrong, even if societies are sometimes different from one another in some of specific rules and determinations of the morally correct behavior, but at the end they all agree some general standards and principles which should be followed.

When combining the two theories together, the social responsibility and the general ethics, we find that externalities happen due to many reasons. There is no one agreed moral code, and people, including top executives, have weak sense of good moral especially that nowadays people are mostly far from religion and their morals come often from their experience.

This conflict of good behavior and gaining high profit is a good example, when choosing between being socially responsible or profit in the existence of weak sense of morals, the business represented in its official will chooses the profit. In multinational companies, externalities are more likely to happen as these companies operate in different countries; each has its own people and its own culture and moral codes which may conflict with each other.

Individuals in such companies, when working with different groups with different values and moral codes, tend easily to break their own values, ethics, and behavior which they believe to be the right way, in order to fit, adapt to and be accepted by their group instead of standing up against the wrong behavior, their own interest to be recognized do beat their social responsibility which they are obliged towards the society. Suggested solutions for externalities: There are some solutions which came up to deal with the issue of externalities.

Most of these solutions are faced by criticism due to various reasons. Social Conventions, Regulatory Limits, Mergers, and corrective taxes are considered to be the most important answers to deal with the externalities. The social conventions approach aims to deal with externalities through the social conventions and traditions. But it faced with a criticism that it forces people to take into account the externalities they cause, and that it may work with individuals but its effectiveness will not be useful with high cost externalities generated by multinational companies as instance.

Merger, another solution for externalities, gathers all the parties involved in the externality to merge, but again it failed to solve all situations, it could solve the negative externalities between some firms by merging them together, but in a situation like a polluter company and the people around this company who are affected negatively by the pollution, how can the company and the people merge together? (Gibson, 1996).

The regulatory limits approach is supposed to be the most common approach for dealing with externalities, simply it does not only suggest to impose regulatory limits for the externality amount generated by any party, but as well imposes a fine for any party generates externality which exceeds the regulatory limits. The corrective taxes approach aims to impose corrective taxes in order to push all parties to be socially responsible and limit the amount of externalities produced.

If we take pollution as an example, then corrective taxes will be imposed on each unit of pollution equal to the same amount of damage affected the society. The two approaches, which in a way close in concept to each other, aim to force the externalities generators- including businesses- to absorb the cost incurred by them. Still, both approaches are faced with problems which weaken them.

The regulatory limits approach has some difficulties especially when it comes to the determination and detection of the firms breaching the limits and by how much is the violation of the limits (Gibson, 1996). The corrective tax approach has lots of supporters who completely agree that externalities generators should pay the full cost for their faults, and by punishing some business, this will work as a red alert to the rest to pay more attention to business ethics and to behave in a better ethical and moral way.

But still the ideas is facing lots of criticism, the opponents claim that when implementing such a tax system, the first result will be the price increase as the businesses will try to keep their profit margin stable, especially after the increase of their costs due to paying the corrective tax, this will eventually lead to a decrease in demand and thus economical problems. Also, the opponents argue that in some externality cases, such as pollution, it is difficult to determine the polluter and the amount of harm was caused (same like the regulatory limits).

And even if the damage amount can be determined, it appears the biggest problem of externality which is the estimation of the externality effects. Positive or negative externality should be measured and translated into a value which will determine the corrective tax amount (Gibson, 1996). Some businesses, when faced with the problem of externality, and when they are accused by affecting negatively third parties, whatever it was environment, people or other businesses, they sometimes follow what is called the obstructive response, which indicates the lowest degree of social responsibility.

According to this type of response, accused businesses tend to deny all the responsibility, and argue that any evidence that they generated an externality is misleading; they also do their best to delay investigations and the conformation of externality evidences, they did not only breach the ethical rule of “do not harm” by they as well breach the rule of “do not cheat”. Conclusion and recommendations: Externality with its two types, the positive and the negative, happens all the time in our normal daily life; it has several effects on all parties involved.

Environmental harm is the most important and recognized consequence of the negative externality. Several ethical theories can be used to explain the ethical nature of externalities, the utilitarianism, the social responsibility, and the general ethics theories. Generally, externalities are considered to be a violation of ethics. Many reasons cause the externalities, but most importantly is the absence of ethics, and the good moral of people, which lead to absence of business ethics and morals as business at the end consists of groups of people.

There are businesses which pay attention to the social responsibility and the good moral, these businesses try to meet their obligations towards their business environment, sometimes through setting up special committees or professional experts in order to discuss and solve their ethical problems. But most businesses are clearly tend to ignore their social responsibility and act mostly in the way which serves their own interests and deny any claim or evidences about the externalities and harm they may cause to their business environment.

There are several possible approaches to deal with the problem of externalities, but each approach has its weaknesses. There is a strong support for persuading businesses to fully take the responsibility and pay for the externality’s cost incurred by them. The opponents of this opinion argue that this cannot be done as it is difficult to determine the amount of harm produced and as well difficult to translate it into a value. Some other opponents claim that businesses do offer to the society and the business environment more benefits than harm in the shape of better economy, employment, utilities and welfare.

Top executives and managers and generally business officials should work and ethically apply the core concepts in ways which prevent the externalities and the harm which could be generated by their decisions. They also have to solve the problem of interests’ conflict and act in a way that balance and achieve both interest as much as possible. Business officials have to establish moral principles to determine an organizational core value to control and guide the organization’s practices and to set a moral climate within the organization.

Any business that violates the ethics should then be suspended from continuing its operation for a period of time; at least till correction step is taken. People should return and relive the ethics and values, and they have to act and behave rationally. Governments must play stronger role to deal with the externality problem. Many approaches can be followed like a well define for property rights, Criminalization, Civil Tort law, and Government provision. References: Anonymous. , nd. Definition of Externality. (Online). Available at: About. om: Economics. http://economics. about. com/cs/economicsglossary/g/externality. htm. (Accessed 20 July 2009) Anonymous. , nd. Externality. (Online). Available at: Wikipedia, Answer. com. http://www. answers. com/topic/externality-1. (Accessed 22 July 2009) Anonymous. , 2007. Externality. (Online). Available at: Guardian. co. uk. http://www. guardian. co. uk/business/2007/apr/11/businessglossary9. (Accessed 25 July 2009) Anonymous. , nd. Utilitarianism. (Online). Available at: Wikipedia, the free encyclopedia. http://en. wikipedia. rg/wiki/Utilitarianism. (Accessed 28 July 2009) Anonymous. , 2008. Social Responsibility. (Online). Available at: OPPapers. http://www. oppapers. com/essays/Social-Responsibility/159386. (Accessed 1 august 2009) Cleveland. , A. , 2002. The Failure of Utilitarian Ethics in Political Economy. (Online). Available at: The Independent Institute. http://www. independent. org/publications/article. asp? id=1602. (Accessed 28 July 2009) Gibson. , H. , 1996. Externalities: Implications for allocative efficiency and suggested solutions. (Online).

Available at: Hunterlink. http://www2. hunterlink. net. au/~ddhrg/econ/ext1. html. (Accessed 28 July 2009) Johannsen. , M. , nd. Five Core Business Concepts Causing Ethical Problems for Organizations. (Online). Available at: A Glossary of Political Economy. http://www. legacee. com/Info/Mindset/BusinessEthics. html. (Accessed 27 July 2009) Jonson. , P. , nd. Externality. (Online). Available at: A Glossary of Political Economy. http://www. auburn. edu/~johnspm/gloss/externality. (Accessed 20 July 2009) Kay Dee. , 2008. The Ethics of Externalities. Online). Available at: Engineering Ethics Blog. http://engineeringethicsblog. blogspot. com/2008/11/ethics-of-externalities. html. (Accessed 20 July 2009) MacDonald. , C. , 2007. Externalities and the Ethics of Small Matters. (Online). Available at: The Business Ethics Blog. http://www. businessethics. ca/blog/2007/03/samosa-ethics-externalities-and-ethics. html. (Accessed 20 July 2009) Shapiro. , D & Khemani. , R. , 2003. Externality. (Online). Available at: Glossary of Statistical Term. http://stats. oecd. org/glossary/detail. asp? ID=3215.

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