The theory of Externalities tells us that the Market either produces too much or too little of something which gives rise to a benefit or a cost received outside the market- i.e. the Market isn't using some relevant information and thus is making the wrong decision.
However, if a competitor takes away your business, though you incur a loss, there is no Externality because it is part of your business, since you are in that market, to have taken account of that possibility.
Let's say I'm running in the park holding a ball and you come and tackle me and throw me down on the ground and run away with the ball. Has a crime occurred? Not if we're playing rugby because the whole point about being a rugby player is that you are meant to be taking evasive action so as not to get tackled. If you go crying to Mommy saying 'that rude girl tackled me and took away my nice ball', Mom will smack you and send you to bed without your crack whore.
Similarly, a businessman who loses out because his competitor is better than him is not subject to any 'External cost' because the whole point about being a businessman is that you need to be constantly thinking about how to be competitive.
Sure, things like 'Asymmetry of information' can give rise to market failure but that's a different kettle of fish and has nothing to do with Social Costs and Benefits and the Theory of Externality.
Steve Landsburg, surely the stupidest Econ Prof of all time, disagrees. The following is his argument, which if accepted by Policy Makers, would destroy Technological Capitalism by shifting the focus to 'sunk costs' of existing firms. By saying X loses 10,000 when what has actually happened is X failed to make a profit of 10,000- you create sympathy for X. Public policy gets distorted. Govts. feel they have to take action to defend inefficient monopolies because they are pictured as poor and vulnerable widows and orphans losing their only source of income. Thus, Govt. gets a chance to intervene- perhaps offsetting its protection of the Corporate fat-cat by feather-bedding the Trade Union Luddite.
BTW, Landsburg is not a Commie nutjob nor a Keynesian bleeding-heart but, ludicrously, advertises himself as quite the reverse.
This is his example from the IT industry, 'where it’s clear that profit-maximization can easily lead to too much innovation. I’ll do the accounting both ways to make it clear that both ways are right.First, the assumptions:
Alice has developed a word processor, which she sells online. It costs her $5000 a year to maintain a server, where you can download a copy for $1000. She sells 100 copies a year, and therefore collects $100,000 in revenue. Most of the consuemrs who buy those copies value them at more than their price. In fact, the total value of those 100 copies to the consumers is $200,000.
Bob has an idea for a word processor that’s a little better than Alice’s, so that each consumer would be willing to pay $10 more for Bob’s than for Alice’s.
If Bob develops his word processor, how much can Alice charge for hers? Because her word processor is inferior to Bob’s, she’s got to undercut his price by $10 in order to maintain any customers at all. So if Bob charges $600, Alice charges $590. But then Bob can steal all of Alice’s customers by lowering his price to $599.99, whereupon Alice must lower her price to $589.99, whereupon Bob steals all her customers by lowering his price another penny….and the race to the bottom is on. But Alice’s price cannot fall below $50, because then she wouldn’t earn enough to cover her server costs. So Alice, who is smart enough to foresee all this, gives up and cedes the market to Bob.
Once Bob has the market to himself, he doesn’t have to worry about re-entry by Alice, because they both know perfectly well that the instant she renews her server contract, the race to the bottom will be back on and she’ll have spent $5000 for nothing.
Now if Bob sells his word processor for $1000, it’s he instead of Alice who earns $100,000 a year in revenue and therefore (after subtracting the server cost) $95,000 in profit. He weighs this against the $80,000 cost of developing his word processor and takes the plunge.
I claim that Bob’s decision is privately wise (i.e. wise from Bob’s point of view) and socially foolish (i.e. it reduces social welfare, defined as the total dollar value of all the gains to consumers and producers). We can calculate the costs and benefits of Bob’s decision in either of two equally legitimate ways. Because they are equally legitimate, they lead to the same bottom line: Bob’s private benefit exceeds his private cost by $15,000 (which is why he plunges ahead), while the social cost exceeds the social benefit by $79,000 (which is why we wish he wouldn’t).
Method I:
Private Cost: $80,000 (Bob’s cost of developing the software)
Social Cost: The same $80,000.
Private Benefit: $95,000 (Bob’s profit from developing the software)
Social Benefit: $1000 [The gain to 100 consumers, each of whom now has a word processor worth $10 more]
Method II:
Private Cost: $80,000 (Bob’s cost of developing the software)
Social Cost: $175,000 (Bob’s development cost plus Alice’s loss of $95,000 in profit)
Private Benefit: $95,000 (Bob’s profit)
Social Benefit: $96,000 (Bob’s profit plus the $1000 gain to consumers)
Bottom Line:
By either accounting method, the external cost (i.e. social cost minus private cost) exceeds the external benefit (i.e. the social benefit minus the private benefit) by $94,000. Therefore Bob makes the socially wasteful decision to develop his software.
Either way, Alice’s loss of $95,000 in profit is offset by Bob’s gain of $95,000 in profit. In Method I, we ignore this transfer since it washes out anyway. In Method II, we count it in the social caclulations, both as a loss to Alice and a gain to Bob. Again, both ways are correct.
Important Addition:
In this example, Bob faces a yes/no choice about whether to develop his software. In many examples, Bob makes a continuous choice about how much of an activity to engage in. In those cases, we expect that Bob engages in the activity until at the margin his private benefit is equal to his private cost. That considerably simplifies the calculation, by allowing us to ignore the private costs and benefits completely and focus entirely on the external costs and benefits (where “external” means “social minus private”).
One More Thing:
Bob’s innovation might well have social benefits we haven’t accounted for, primarily the inspiration it gives to other innovators who might face different numbers and whose innovations might be socially valuable. Those benefits aren’t accounted for here. Therefore, in IT, there might either be too much innovation or too little — but it would require an extraordinary coincidence for there to be just the right amount.'
Why is this fucked?
Well, Landsburg tells us that consumers currently receive 20000 dollars of benefit for Alice's product. 100,ooo of that is 'consumer surplus', 95,000 is Alice's producer surplus (profit) and 5000 is factor income for the guys running the Server.
Bob's idea for a program is better. If he develops it and everyone switches to Bob's product, then the new Total Social Benefit is 201,ooo. But, it will cost Bob 80,000 to develop his system. Landsburg thinks he shouldn't- it would be a waste of resources from the Social point of view because the rate of return is too low. That's an empirical matter.
Suppose Bob is a good businessman. As such, he will know that Alice can reduce her price to 50 dollars without incurring a loss. So the maximum he can charge is 60. There are only 100 customers. He gets 6000 revenue. If he too has to hire a server at the same price as Alice, then his profit is 10oo per year. It will take him 80 years to recover his investment. So he doesn't invest. The Market guided him correctly. No extraordinary coincidence was required for investment in innovation to be 'just the right amount'. On the contrary, it is absolutely routine and of the essence of a non-failing Market to ensure that this is what happens at the aggregate level.
Suppose Bob is a megalomaniac, not a businessman. Then he just goes ahead regardless. Social Benefit is still has a lower bound of 201,ooo. However, 'consumer surplus' has increased by 195,000 while 'profits'- i.e. producer surplus- has decreased by the same amount. That may be a good thing allocatively or it may be a bad thing dynamically. However, what it isn't is a case of market failure by reason of Externality. It's just a story about a guy who chose to spend 80,000 to gratify his ego. He could just as easily have bought a sports car or paid for a penis enlargement. Positive Economics has nothing to say about this. We don't know in advance if it is a good or bad thing that Alice's erstwhile profits have now turned into Consumer Surplus. Maybe Alice was a poor widow and the purchasers of her product were Evil Corporations. Maybe the reverse is true. Still, all the relevant information was available to the Market and so no Externality arose. Okay, there was Market failure because Bob acted irrationally and also you had a Monopoly, but those are separate kettles of fish.
There is one instance where Bob makes a sound decision by investing his 80,ooo. Suppose our economic future is bleak. A hundred years from now the only product that still commands a market is Bob's product. In that case, what we have here is 'rent contestation'. But, once again, that's a different kettle of fish for Econ theory- it has nothing to do with with the Theory of Externalities, under which rubric Social Costs and Benefits are subsumed.
Landsburg has previously made utterly fallacious arguments which have the effect of destroying the Economic argument for freedom to consume and invest. Now he disables Capitalism's engine for what Schumpeter called 'Creative Destruction'- i.e. Technological progress.
Why is this man teaching Economics?
