According to Davide Colander, government acts like a “referee” in that government can act to “set rules” in the course of commerce. The major way is through federal and state legislation through the mechanisms of “taxes, subsidies, or regulations” (Colander, 2013). This works principally in business when two parties act together in a private contract to benefit each other financially. A problem arises when they are likely to “not take into account any effect that an action may have on a third party” (Colander, 2013). This is defined as an externality – company A and company B enter into a contract to produce a product, but neither take into account that there may be pollution. In this event, it is a negative externality, as the aggrieved third party is society members (Bay, 2010). A positive externality would be education, as society benefits generally when, say, a citizen enters into a contract with a university, and the citizen then acts as a more responsible member of society (Colander, 2013).
Externalities also take the form of what are known as “spillovers” This is another way to explain how “costs or benefits of a good” affect others. That is, when a contract to produce a product is felt by others than the immediate parties to the contract, then that which is felt by another party is known as being “external” to the contract at hand. Another example of a negative externality is when two parties enter into a contract but end up producing incorrect amounts of a good or service (McConnell, Brue, Flynn, 2009). An example of this would be the production of corn. Too much or too little production can cause imbalances for society’s needs.
In purely economic terms, if a company produces a product that then dumps waste products into waterways that then affect wildlife and human use of the waterways, they have created a negative externality, a negative cost, without bearing responsibility. So, the company may benefit from lower production costs, but wildlife and society bear these costs. The lower costs of production shift the supply curve to the right for the company, and they also then tend to overproduce. If the company were regulated legislatively such that they would be economically responsible for clean-up – much less, prevention – of the pollution, then that would be accounted for in the cost to produce (McConnell, Brue, Flynn, 2009). To correct for negative externalities of air pollution, the federal government enacted the Clean Air Act in 1970, and for water the Water Pollution Act of 1972. Both of these acts enact a fee for pollutants, and an additional fee for cleanup. These affect the costs of the production, and therefore raising the marginal costs and “therefore induces them to produce less output” (Baye, 2010). Ultimately, though, it is government acting as the referee between producers and society, and using legislation and tax to correct for the negative externality of production.
Government also plays a referee role in positive externalities. Using education as the example, in order to have society benefit more from education, both the federal and state government either subsidizes students through low-cost student loans or through grants to educative facilities. The student benefits from both by being able to afford higher education and also by benefitting from well-equipped schools. Added to this individual or “private marginal benefit” is also the “social marginal benefit” since society benefits by dispersion of knowledge through, for instance, the student sharing information with co-workers (Colander, 2013). In the case of higher education, government creates demand from low-cost loans and increases supply by subsidizing colleges and universities as they might not have enough resources through tuition, alone, and thereby have an underallocation of educative services (McConnell, Brue, Flynn, 2009).
The role of government, therefore, can either discourage overproduction or encourage underproduction through evaluating negative and positive externalities, respectively. In either case, government seeks to balance the needs of contracts with the needs of societal good.
Bay, Michael R. (2010). Managerial Economics and Business Strategy, 7th Ed. New York, NY: McGraw-Hill/Irwin.
Colander, David C. (2013). Microeconomics, 9th Ed. New York, NY: McGraw-Hill/Irwin.
McConnell, Campbell R., Stanley L. Brue, and Sean M. Flynn. (2009). Microeconomics: Principles, Problems, and Policies. New York, NY: McGraw-Hill/Irwin.