Externalities are consequences of transactions that are not captured by the markets nor incorporated into pricing. Externalities can be both positive and negative, and generally describe benefits and costs at the societal level.
Q. A viewer wrote in asking for “externality”, so here we go. You’ve mentioned that there’s a proper use and a slang use, but we’re very proper at Money Moves, so let’s go with that one first. What is it?
A. It’s an idea from economics that transactions can give rise to positive and negative consequences that are not captured in the pricing of that specific transaction: they are “external” to it. And there are two kinds: positive externalities, and negative externailities.
Q. OK, so please give us an example of a positive externality.
A. Definitely my favorite is the network effect, a crucial idea in startup-land. And the classic example is a fax machine. If I buy a fax machine from you at a given price, the fact that I now have one—that there are more nodes on the fax network—creates more value in all the other fax machines out there. But that benefit is not captured in the price, so it’s a “positive externality”.
Q. Got it. And so… a negative externality?
A. Here, the classic one is pollution. Corporations that heavily pollute the environment to produce goods they sell for X are generally are creating negative externalities. The negative consequences aren’t reflected in the price, or recaptured by society in any other way. Policy wonks will say the role of government is to force internalization of externalities like this.
Q. And now, time to move on to the slang…
A. Right, so lots of traders and investors use the term to mean, essentially, something that occurs “outside the trade”… something that affects the price of a security in an unforeseen way. As we discussed yesterday, the way the Spanish bailout is going, there’s a chance that Spanish bank bondholders will be forced into a more junior position by an act of the government, something that’s “external” to the normal operations of the market.
Q. So they use it to describe unforeseen risks that suddenly appear.
A. Yes. What that boils down to is this: when you hear traders use “externality,” what they’re often really saying is: “hey, not my fault”.