Externalities

Definition:

An externality is a benefit or cost which “spills over” to a third party.

Externalities can be positive or negative.

Example: 

Positive Externality — taking care of my front lawn.

This is a positive externality because the benefits of a tidy front lawn accrue to my entire neighbourhood by making it more attractive and pleasant to my neighbours. That is, my neighbours don’t have to incur the cost of taking care of my lawn, but the incur spillover benefits from my activity.

Negative Externality — pollution.

Pollution is the most common example of a negative externality. If I throw my trash in the streets around my neighbourhood the negative consequences affect my neighbours as much as they do me.

Why is it important? 

Externalities take place any time the market fails to fully price the full effects of an activity.

In such a case where externalities are not fully priced in, too much of a good will be produced because someone else will pay for these costs. If there is a positive externality, too little of the good is produced because the producer doesn’t receive all of the benefits associated with the action.

In a more general sense, externalities distort incentives causing us to engage in too much or too little of an activity.

Thinking about externalities resulting from certain actions will help us to consider alternative actions that otherwise we might not if taking into account only the direct costs and benefits.

Marginality (Marginal Benefit, Marginal Cost, Diminishing Marginal Utility )

Definition:

Marginal concepts in economics look at changes in output which result from a specified change in the input.

Marginal Benefit — the additional utility (satisfaction) deriving from consuming one additional unit of a particular good or service

Marginal Cost — the additional cost incurred by production of one additional unit

Diminishing Marginal Utility — every additional unit of consumption will provide less utility than the previous

Examples:

Marginal benefit — My total enjoyment increases when I get one additional scoop of ice cream

Marginal cost — Every additional scoop of ice cream increases the total cost of my ice cream cone

Diminishing Marginal Utility —  I derive more enjoyment from the first scoop of ice cream than I do from the 100th.

Why is it important:

The importance of marginal thinking cannot be overstated. It’s a fantastic mental model / lens through which to look at problems and situations.

Marginal thinking is already interesting taken in the economic sense. For most processes in life it is worth thinking about  what a small change in input would do to the output. That is, will that extra effort really produce enough effect to justify it?

Thinking at the margin involves thinking about changes and what small variations could do to the overall result. Thinking at the margin is not something that comes natural to most people as we tend to focus on the overall picture rather than thinking about changes and their effects.

On a metaphorical level, thinking at the margin means thinking near the boundary of a problem.  In that sense, thinking at the margin requires us to think about what that boundary is, which is useful in itself. Then, it requires that we think about changes.

The concept of diminishing marginal utility is also interesting to analyze in a bit more depth. There are many things in life and in different domains that ascribe to this ‘law’ of economics. For example, the enjoyment of most activities only add additional enjoyment up to a point. Beyond a certain threshold, more and more gains will actually lead to less enjoyment and could even lead to overall negative enjoyment.

Application:

It is possible to apply marginal thinking to any problem involving an input and an output. While it’s most obvious applications are to decision making in the economic or utilitarian sense, it’s also interesting to reflect on marginal thinking as a lens to aid in general decision making.

An insightful use of marginal thinking is asking yourself these two questions:

  1. If you found yourself with an extra hour of free time, what would you do more of?
  2. If you found yourself with an hour less of free time, what would you cut back?

This is thinking marginally at its prime. If you think about this long and hard it turns out that if your answers to both these questions differ at all, you are not doing the best you could be doing in managing your life prioritizing lower value activities over higher value ones. That is, you should simply replace things from your second answer with things from the first answer. This same logic applies to money, energy, and most of your resources in life.

Comparing marginal benefit with marginal cost is an interesting decision-making tool. For example, I’m not going to spend 10 more minutes working on this text as I don’t think the extra time spent on it will add much value, but 10 minutes of sleep will do me wonders tomorrow. 😉