Latticework of Mental Models: Externalities

About five years back when I moved into my current apartment community, the area around was pretty much empty. The open land and the surrounding greenery attracted so much that making the decision was a no-brainer.

Or so I thought because I forgot one thing. I should have asked for a guarantee that the greenery will stay that way.

It didn’t take much time for small houses to start mushrooming around the campus. Honestly, I shouldn’t be complaining. It’s a free country and people are allowed to construct houses. But it’s always the second order effects which create unexpected problems.

With inadequate supply of water from the government, came the need for bore wells for every house. I guess you can imagine where this story is going.

With bore wells getting installed in some or the other house every few weeks, started the unwanted and unbearably irritating noise emanating from heavy mechanical devices, drilling holes in mother nature’s heart.

I felt I was living in the middle of a factory. I had never signed up for this.

In today’s capitalist society, when I want to listen to a song on iTunes, I have to shell out money for it. But if I am forcefully exposed to a deafening, non-musical, and unhealthy sound, why am I not being compensated for it? Who should pay for my misery? The driller, the landowner, the government? I demand that all of them should but nobody seems to be interested.

Once someone has bought a piece of land and paid the required taxes and duties, he or she is legally allowed to drill a hole in their land, because they have paid the price. But have they really paid the full price? Does the tax include the ‘cost of inconvenience’ caused by such activities to others?

For many years I have been at the receiving end of quite a few unpleasant noise polluting activities and sadly I don’t remember getting a tax rebate for the same. I am sure I am not alone. It’s a social problem affecting almost everybody in some way or other.

Now before I give a picture of myself as an innocent and helpless victim of such atrocious and violent acts of noise pollution, let me admit that I have been an offender myself. There is at least one instance that my selective memory allows me to divulge.

While getting a pigeon net installed in my balcony, which required drilling at least 40-50 holes on the shared concrete wall, I ended up creating severe nuisance for my neighbours for couple of hours. And all I had to do was fetch a permission letter from the apartment owner’s association without paying a dime for it.

There’s nothing that my neighbours could do except to wait for their opportunity to put holes in their walls and feel avenged.

So how do we explain this socio-economic aberration?

Sometimes our actions do not have direct costs. These actions can affect others and yet we do not suffer any consequences. The instance of drilling that I just quoted above is a great example of something called negative externality.

Imagine the plight of those living close to airports. They neither get a sound sleep nor a discount coupon from airlines. Or for that matter those living close and downwind to industrial areas emitting toxic gases and air pollutants.

So that’s our mental model for today – Externalities. An externality is cost incurred or benefit received by a third party who has no control over the factors that created the cost or benefit.

In other words, externalities are the spillover effects we experience from an economic decision made by someone else. We experience the externalities without paying a price for the benefit or receiving compensation for the cost. Which means externality can be both negative and positive.

Negative Externality

Imagine yourself reaching home on a Friday after a very tiring and hectic work week and all you want to do is crash on your bed and sleep. But your neighbours are in the party mood. I smell a perfect setup for negative externality. I am sure you can relate to Jerry in this short cartoon video.

Let’s go back to the example of the factory that emits too much smoke. Its owners do not suffer the costs experienced by those downwind, so there is a mismatch between private and public costs.

It is not that it’s an unsolvable problem. Policies – like imposing taxes on emissions – can correct the mismatch. Still there is no channel for the emission taxes to directly flow to the victims.

An attempt to solve this problem has given rise to a whole new industry called carbon emission trading. Every pollution causing industry is assigned its quota of carbon credits that it’s allowed to do. If it emits more carbon dioxide (a proxy for pollution) than it’s allowed, it can buy carbon credits from another company which hasn’t used its quota of carbon credits.

Passive smoking is another hazard in form of negative externality.

Positive Externality

If the exterior of a house is particularly beautiful, both passersby and neighbours alike will receive a benefit from its appearance.  When a private gardener plants an assortment of beautiful plants in her front garden and enhances the environment for her neighbours and passers-by.

Public goods like parks, national security, and public education are costly to provide. Economic theory tells us people will try to free ride i.e., to let others do the work and pay the costs. But, of course, many public goods are provided voluntarily. People vote to pay taxes to educate other people’s children and to maintain parks they will never visit.

Another interesting example that I came across is about the polio vaccination program that government of India has been doing for years. It requires vaccination of every child upto the age of 5 years irrespective of the fact that it has already been vaccinated before. When a child is vaccinated, the concentration of polio antibodies increases in the environment and the threat to unprotected children gets diluted. That’s a positive externality created by a protected child for the unprotected ones.

When someone is courageous enough to pursue their life’s calling, they not only end up creating a meaningful life for themselves but create a positive externality for others who get inspired.

If you think about it, people like Warren Buffett and Charlie Munger generate tremendous amount of positive externalities by continuing to do their own work.

Measuring Externalities

Without a price tag on externalities, it is difficult to consider their value and, therefore, their effect on society’s total welfare. Indeed, this is how they are defined.

The inability to charge for externalities may be a problem and is therefore an opportunity for better resource allocation.

Markets have trouble measuring externalities. Ensuring maximum social welfare may require specialized institutions to monitor the positive and negative spillovers created in private markets.

We already have some institutions that do this: government agencies that limit air and water pollution, tax credits that reward energy conservation, a legal system that imposes liability on firms that supply unsafe products, and professional codes that proscribe unethical conduct.

In Business

Value creation is an important goal for all companies, but value creation for a company’s shareholders isn’t always necessarily aligned with value creation for society as a whole.

A company involved in manufacturing tobacco products or alcohol (even sugared beverages) may be operating very ethically in all money matters. But when it comes to adding value to the society by such businesses, it becomes a highly debatable topic.  If one used the mental model of externalities, it may help think through this problem.

In Investing

Investing in a well-run business where the management changes subsequently and mis-allocates capital, creates negative externalities for its investors.

Another example of negative externalities in the stock market is when a leading company from an industry lists on the exchanges, which reduces the valuation premium that other listed companies from that industry enjoyed in the past. This is what happened, for example, when TCS listed on the exchanges in 2004, which reduced the valuation premium that investors in Infosys and Wipro had enjoyed in the past.

Speculators selling good quality stocks in a market crash is a positive externality for a sensible, long term investor. Of course you have to be prepared to take the full advantage of these opportunities. Bargains in market aren’t as easy to find as a neighbour with a beautiful garden.

Conclusion

Here is an excerpt from the book Poor Charlie’s Almanack –

It is clear throughout these talks [Charlie’s] and speeches that Charlie places a premium on life decision over investment decision. His mental models, drawn from every discipline imaginable, recur repeatedly and, in no way, focus on ‘business portfolio strategy’ or ‘beta’ or ‘Cap M’. Rather, they center on fundamental truth, human accomplishment, human foibles, and the arduous path to wisdom. Charlie once said, “I wanted to get rich so I could be independent, like Lord John Maynard Keynes.” Independence is the end that wealth serves for Charlie, not the other way around.

I hope you understand that learning mental models from various disciplines will not just help you improve the quality of your decisions in investing but as a side effect of this learning process, you will become a better thinker in general.

Do let me know if you have any additional insights about externalities and how it applies to life and business of investing.

Take care and keep learning.