Social Welfare: Evaluating Change in Food Markets

Abstract

Economic principles help us explain observed outcomes as the result of each person having made consistent choices from their limited options. This approach helps us predict how people respond to new circumstances, and also provides a framework for inference about changes in the level of multidimensional wellbeing that a population can reach when their circumstances change. The first section of this chapter shows how changes in welfare can be compared in terms of economic surplus for consumers, producers and others in each community. We show how the concept of economic surplus helps explain and guide decision-making around policy choices, with strengths and limitations relative to other approaches. In the second section of the chapter, we use economic surplus to begin analysis of market failures, starting with externalities. Externalities are the unintended impacts of market activity on other people who may be harmed or benefit from nonmarket side effects of production or consumption. We discuss the many externalities that arise in agriculture, food systems and health, using economic surplus to show how decision-makers can consider the interests of both market participants and people affected by nonmarket externalities.

4.1 Economic Surplus: Who Gains from Market Transactions?

4.1.1 Motivation and Guiding Questions

So far we have focused on changes in quantities and prices, which could affect different people in society to different degrees. How much does each person gain or lose from a change? Can we add up different peoples’ gains and losses, to compute the change in total welfare for society as a whole? And how do market outcomes affect other people in society, for example the victims of climate change caused by greenhouse gas emissions?

Our economic principles explain observable quantities and prices as the result of each person having made consistent choices from their limited options. Systematic analysis of those choices allows us to draw diagrams showing how people will adjust along lines and curves towards potentially predictable points, based on attributes of each line such as its degree of curvature, slope and elasticity.

The lines used to predict outcomes in our analytical diagrams all result from people having chosen the option that was best for them. We can now use that to infer something about the population’s preferences, and what movements along each line or curve reveal about how far towards their goals they can get in each market outcome.

To quantify improvements or worsening in how far each person could get towards their goals, we will interpret the areas between curves as a measure of economic surplus, and use changes in the area of economic surplus to compare gains and losses for each person in the society of interest. The concept of economic surplus is a measure of wellbeing only for the people making transactions in a given market. Each society’s economic surplus from those transactions consists of consumer surplus from willingness to pay along the demand curve, producer surplus from marginal cost along the supply curve, and the gains or losses incurred by other actors such as government agencies or traders who hold licenses and quotas.

Having defined economic surplus for market participants, we can compare that to the unintended side effects of a change in production or consumption, which we call externalities. Among the most important negative externalities is greenhouse gas emissions, but other external harms include water pollution and antimicrobial resistance, and there are also many external benefits from expanding healthier and more sustainable activities. The term externality is used to signal that these costs and benefits are felt by other people, and therefore not already counted in economic surplus of decision-makers in production or consumption. In some cases externalities harm or help the decision-maker’s own future self, for example when consumers are unable to take account of how their current food choices affect their long-term health. Adding or subtracting externalities to the economic surplus of market participants gives us a more complete measure of societal wellbeing and is the first of several market failures to be addressed throughout this book.

By the end of this section, you will be able to:

• 1. Derive producer and consumer surplus from supply and demand curves;

• 2. Use economic surplus to identify who gains and who loses from changing opportunities to make market transactions, and the relative magnitudes of those gains and losses, in markets with and without trade;

• 3. Distinguish a population’s total gains or losses from the gains or losses per person that might be caused by a policy change, and identify how that difference influences policy choice; and

• 4. Describe how separability between production and consumption affects the impact of a policy change in markets with and without trade.

4.1.2 Analytical Tools

The analytical diagrams drawn so far in this book use only symbols such as S and D for the curves or P and Q for the axes. The elements of each diagram are a set of smooth lines and curves leading to points, providing qualitative insights about these elements relative to each other. Drawing each diagram without numbers is confusing at first but very helpful later, because the same diagrams can be reused for a wide range of examples.

The definition of each element on each diagram leads to a distinctive shape, such as PPFs being bowed out and S being upward sloped. Contextual knowledge allows us to draw each element on diagrams tailored to particular situations. Individual diagrams in Chapter 2 refer to a person, and the market diagrams derived from that in Chapter 3 refer to a type of product in a population, such as apples in Massachusetts. The distinctive shape of each element follows from people having chosen what they do, from a limited set of options. Those choices involve production and consumption of each product, and also exchange of that product between people.

Economics consists of using contextual knowledge to construct an appropriate model for each situation, selecting from the modeling toolkit described in this book. The book provides a large number of examples, but every student can and should redraw the diagrams around their own examples to see how the same logic of economics plays out similarly or differently in each situation.

The new element introduced in this section is economic surplus, defined in terms of areas between lines and curves in each market. Economic surplus is remarkably useful as a measure of social welfare derived from economic models of any market, yielding deep insights into questions such as why governments adopt the policies we observe, and how those observed policies might be improved to help people get farther towards their goals. Later we will use economic surplus in its general form, labeling areas on each diagram with letters and shading. Drawing each element without numbers reveals the qualitative principles of economics that would hold for any example.

In this chapter we introduce a new way of explaining individual choices and market outcomes, switching from abstract diagrams to a specific case study with actual numbers and the names of people. This concrete example allows us to derive the population’s economic surplus from each person’s choices, along supply and demand curves whose slope and position comes from their individual circumstances. Results of the model follow from each person’s choices for how much to produce and consume, exchange within the community and trade with others.

The concrete example in this section reveals how economic principles follow from a universal observation about human behavior, which is that each person has chosen from limited options. The results we obtain come from the diversity of those options. Diversity among people leads to gains from exchange within a community, and also gains from trade with others, but also inequities and market failures that could be addressed by government policies.

4.1.2.1 A Toy Model: Introducing the Alphabet Beach Fish Market

The example community we introduce in this section is Alphabet Beach, an imaginary place with specific features that are easy to explain. Playing with this toy model can be fun, and useful to see how the principles of economics unfold in each scenario.

The Alphabet Beach fish market involves eight people, each with their own circumstances. Five are potential buyers of fish, and three are potential fish sellers. Each potential seller could sell up to two fish per day, of which each potential buyer would want only one. All fish are identical and cannot be stored so the market for fish repeats anew on the beach each day.

Alphabet Beach is a useful toy because we can easily imagine breaking the rules. For example, what if people live in households? What if we add other foods, or different details? We could spend hours playing out any scenario. Later in this book we will look at real data, and return to all possible scenarios that fit those data using more abstract diagrams, but for now let’s go to the beach shown in Fig. 4.1.

Fig. 4.1

Demand and supply of fish at Alphabet Beach

Our diagrams refer to just one aspect of life, which is the market for fish. In Fig. 4.1 the vertical axis shows the price of each fish, which could be expressed in any unit of currency. For example, a more elaborate toy model would introduce another food, such as coconuts, and the price of fish could be coconuts per fish. Then we could draw indifference curves for consumption between these two foods, and production possibilities for harvesting coconuts or catching fish, all with relative prices that involve no money at all. For now we focus on just one thing so do not need to specify the units of price, but can use any familiar word such as pesos or dollars.

What matters in our toy model is the number of fish, shown along the horizontal axis for each individual and for the village as a whole. Market demand and supply comes from adding up quantities bought or sold by each person. In this toy model, each potential consumer can buy only one fish, and each potential producer can sell up to two fish. The quantity for each buyer or seller is fixed, so the slopes of demand and supply come only from diversity among people.

In our toy model each person’s name signals their interest in fish. In the left of each panel in Fig. 4.1 we see each individual’s own demand and supply curve for one person, and then we add those up horizontally to obtain demand and supply in this whole market. If we allowed each person to buy or sell a varying number of fish, there would be some slope for their individual demand or supply curves, but in this simplest case the demand curve is sloped down only because people differ.

For demand, each buyer’s circumstances are shown by their willingness and ability to pay for one more fish. Ana would pay up to 9 pesos or dollars per fish, Bob up to 7, Cat up to 5, Deb up to 3 and Ed up to 1. Each person could have a different fish demand for many reasons, such as differences in their wealth and income, cooking skills or food preferences. If we wanted to change demand, we would need a lot of other data about each person to see what lies behind their willingness to pay, but to predict market outcomes and evaluate economic surplus it is sufficient to observe their revealed preferences and effective demand.

For supply, each seller’s circumstances are shown by their marginal cost of bringing one more fish to the market. For Fio, fishing comes easily and he can catch his couple of fish at a cost of just one peso or dollar per fish. For Gio and especially Hijo, production is more costly. Each potential supplier could have a different cost of production for many possible reasons, such as differences in travel time, the other opportunities they have and their fishing skills or preferences for other kinds of work. If we wanted to change supply, we would need a lot of other data about each person to see what lies behind their cost of production, but to predict market outcomes and evaluate economic surplus it is sufficient to observe the quantity they are willing and able to sell at each price.

The staircase shape of supply and demand in Fig. 4.1 could lead to some ambiguity about the exact price or quantity of things. Smooth curves in our general models lead to a specific point that we can label as the predicted quantity or price. When things are lumpy and indivisible, like a whole fish, we leave room for negotiation about that last incremental unit. That aspect of this toy model is more realistic than the point predictions derived from smooth curves, but takes some explaining. As shown below, the outcome of our toy market comes down to negotiations between one seller and one buyer, and the result is a range of possible prices.

4.1.2.2 Market Equilibrium Between Buyers and Sellers

In previous chapters we derived supply and demand from individual decisions, based on all potential choices we might observe from all possible options people might have. Now we have a concrete example of eight individuals, each with only one choice to make. The five potential buyers decide whether or not to buy at the offered price, and the three potential sellers decide whether or not to go fishing based on the price they would receive. Ana, Bob, Cat, Deb and Ed would all like to buy a fish each day at any price up to their willingness to pay, while Gio, Fio and Hijo would like to go fishing if they receive a price of at least their marginal cost.

There are many possible ways that the people of Alphabet Beach could interact, each of which is a specific market structure. Market structures come from the technologies and institutions through which people buy and sell. For example, Gio might introduce an app through which buyers bid for home delivery, Ana might build a shop with a refrigerator to sell fish later in the day or the whole group might form a government that sets policies. The institutional aspects of market structure are themselves influenced by technology, making it easier or more difficult for people to communicate and sustain each type of organization.

The market structure we introduce first is known as perfect competition. The use of ‘perfect’ in that name conveys the idea of a benchmark extreme case. Reality always falls short of perfection, and later in this book we will present models for market failures such as monopoly power (when there is only one seller or only one buyer that controls the entire quantity) or information asymmetries (when buyers or sellers cannot see product quality, so they expect low quality even if it could be high). Those are forms of imperfect competition that yield systematically different outcomes from the benchmark found here, and any type of activity could generate externalities that are yet another kind of market failure. Many different potential outcomes can be analyzed with our toy model, each based on a different scenario.

To reach a perfectly competitive outcome, a product of known quality must be exchanged among enough different sellers and buyers for none to influence total quantity. Under those conditions, interactions between people lead to a price and quantity with the distinctive feature that no other quantity could yield a greater sum of all economic surplus for the society as a whole, and is economically efficient in the sense of taking fullest possible advantage of the society’s resources to generate wellbeing for all market participants. But economic surplus is mostly useful to measure whether a change is equitable, based on the distribution of benefits and costs within society.

All principles of economics, including predictions about each market structure and changes in economic surplus, rely on the idea that observed outcomes result from each person having done the best they can. Economics is most useful for situations where people have learned from experience, perhaps through their own trial and error, and avoided repeating their mistakes. If that has happened, the choices we observe were selected from the person’s limited options, as the actions that were best for them. We all are used to thinking of our own choices that way, as the best of our options to pursue our goals, and the toy model of Alphabet Beach Village helps us imagine a group of other people each with their own objectives.

Later in this book we will return to predicted outcomes of different market structures in various circumstances, focusing on how policy and program interventions might alter the efficiency and equity of each outcome, and also the vulnerability and resilience of societal outcomes to shocks over time. For now, we can use the example of Alphabet Beach to understand what we mean by a perfectly competitive market, and the economic surplus that each person obtains from it, beginning with the decisions of each individual interacting with each other as shown in Fig. 4.2.

Fig. 4.2

The equilibrium price and quantity of fish sold at Alphabet Beach

To see how markets work, it may be tempting to look at Fig. 4.2, observe the two lines and conclude that the outcome must be where they cross. That would be a mistake. Competitive markets would move towards that outcome, but different market structures would lead to different outcomes. The model is not the market, just like a map is not the land. The purpose of imagining Alphabet Beach fish market is to remind us that economics is about people, and having a toy model of imaginary people allows us to play out the consequences of many different scenarios.

For example, we can imagine Ana, Bob and the other potential buyers walking down to the beach to see what’s offered each day, while Fio, Gio and other potential sellers show off their catch. There could be fascinating details of how transactions might work, and we can use our toy model to imagine all kinds of things that might vary from day to day and place to place. As economists, we are interested in what Alfred Marshall called ‘the ordinary business of life’, looking to predict the average outcomes we might typically observe over a wide range of circumstances. To make that prediction, we need to imagine all eight people having experienced enough different outcomes to avoid doing things that are not the best they can do.

The curves on Fig. 4.2 and the table to the right of that diagram specify what each person is willing and able to do. Ana would buy from any seller offering a price at or below 9, while Bob would buy from any seller at or below 7, and so forth down to Ed who would buy only at or below 1. The demand curve and the first two columns of table at the right show the cumulative number of fish that would be bought for each price from 9 to 1. Similarly, among sellers, Fio would sell to any buyer paying a price at or above 1, while Gio would sell to any buyer paying at or above 2, and Hijo would sell to any buyer paying at or above 4. That is the supply curve, and also the last two columns of the table at the right.

A first question about equilibrium is whether a predictable outcome even exists. Quantities and prices might be random, or predetermined by factors outside the market. And if the model does predict outcomes, the equilibrium could involve more than one price (for example, a different price for each buyer), or prices that fluctuate within a range. We can use our toy model to see how, as people learn about the market, their behavior might cause convergence towards predictable outcomes. Playing with the example of Alphabet Beach reveals economic mechanisms by allowing us to explicitly say how each person might learn from experience, and what alternative outcomes might have arisen in the past but are not repeated enough to be frequently observed.

Starting with price, all potential buyers (Ana, Bob, Cat, Deb and Ed) might sometimes discover that they paid more than another buyer for the same kind of fish. They would learn that to reach their various objectives, it would be better to make at least some effort to keep shopping and buy at the lowest prevailing price. Similarly, each potential seller (Fio, Gio and Hijo) might sometimes find that they had sold for less than another seller, and they would learn how to sell at the highest available price.

As each person learns about the market, prices will converge but the outcome depends on market structure. All buyers and all sellers see the same price only when there are many of them, seeing what each other pays for a product of uniform quality. We have already seen how taxes can create a gap between prices paid by buyers and sellers, and we will soon see what happens when there is only a single buyer or a single buyer for each type of product who sets the quantity. In that case we might see price discrimination with different prices for each unit, sometimes through product differentiation with different qualities of each unit so as to get different prices for it. Market models to explain those outcomes are based on additional constraints, such as barriers to entry or limited information, each of which creates a different market structure. With no such constraints, in the perfectly competitive benchmark model prices converge to a single value, or range of values.

Learning about market opportunities causes convergence not only in price, but also in quantity. Having a toy model allows us to tell imaginary stories about each individual person in the market. For example, one day there might be just Fio catching a single fish, which they give to Ana because she is the person who can pay the most. But Fio would soon learn that a second fish to Bob is worthwhile, even though Ana would not pay as much. Gio might then discover what Fio had learned, which is that he too could sell one fish to Cat, and that in fact it’s even better for him to sell one to Cat and one to Deb. Gio’s choice drives down the price received by Fio, so both receive the same price.

In the toy model of Alphabet Beach, our prediction is that a quantity of exactly 4 fish will be sold at an equilibrium price that could be anything between 2 and 3. Competition among sellers leads to a single equilibrium quantity, but leaves uncertainty about the equilibrium price because the marginal unit is a whole fish sold by Gio to Deb. That is a one-to-one negotiation, in which Gio will sell if the price is at or above 2, and Deb will buy if the price is at or below 3. The actual outcome will depend on a bargaining process that would depend on factors outside this simple model, from which we know only that quantity will be 4 and price will be in the range of 2 to 3.

4.1.2.3 Economic Surplus for Consumers and Producers

Our market model is useful not only to explain and predict outcomes, but also to infer from each person’s choices something about how far they got towards their goals. That inference about wellbeing is done using the concept of economic surplus.

Economic surplus is defined in terms of each market model, adding up the area between different lines and curves. We start with economic surplus of market participants, and in the next section we include external costs and benefits that are unintended side effects of production or consumption. Later chapters include change in the value of government services, and ultimately, the entire society’s changes in economic surplus are the sum of changes lost or gained by everyone in the community, including market participants plus those affected by externalities and the government. The change in overall total economic surplus available for an entire society is important, but as we will see, much of the action comes from changes in the distribution of economic surplus and equity within societies.

Economic surplus for consumers, known as consumer surplus, is defined as the area between their demand curve and the price paid. Likewise, producer surplus is defined as the area between producers’ supply curve and their price received. The definition of economic surplus is area on a diagram and is not any kind of ‘surplus’ amount of goods in the sense of excess quantity along the horizontal axis. Areas on our diagrams are measured in terms of height (price) times length (quantity), so economic surplus is a value measured in local currency terms.

Consumer surplus is related to each person’s income and expenditure, while producer surplus is related to their revenue and profit, but economic surplus is not the same thing as income or profit. Economic surplus is an inference about wellbeing that we draw from the model. It is not a variable we could potentially observe outside the context of each market diagram. To the extent that each person chose whether and how much to buy or sell, we infer that each individual making a market transaction must have gained something from it, and the total economic surplus available for the entire society is the sum of what each individual gained from transactions in the market we are analyzing.

In practice we will focus on change in economic surplus, as a way of measuring changes in wellbeing based on the difference in outcomes from each scenario. The absolute level of economic surplus for an entire society can be calculated but that is not our focus, because the shape of each line or curve is actually measurable only in the vicinity of observable points. As we have seen, the elasticity of response to change can be empirically estimated from actual data, or derived from contextual knowledge about the market of interest, but extensions of each line or curve beyond the region of potentially observed points is poorly defined and has no practical value.

Using our toy model of Alphabet Beach helps explain economic surplus, because it allows us to see very clearly how a change in policy or other factors affects each individual’s wellbeing. Producer and consumer surplus are shown on our diagrams as shaded areas that could be added up as shown in Fig. 4.3.

Fig. 4.3

Definition and calculation of economic surplus for consumers and producers

Showing economic surplus in terms of each individual on Alphabet Beach reveals how the concept works, in terms of both strengths and limitations.

For consumer surplus, in this example we know that Ana, Bob, Cat and Deb were potentially willing to pay up to 9, 7, 5 and 3 respectively, but in the end they all paid between 3 and 2, so the economic surplus they obtained is the dark-shaded area between demand and price paid. Four fish were purchased, generating a total consumer surplus of 14. We can imagine how this measure of wellbeing might be related to wellbeing, but we do not actually know why Ana was willing to spend more than Deb. Without additional data we cannot know how a change in consumer surplus actually affects each person, but we can infer that the transaction has helped them achieve whatever goals they have for how to use their income and other resources.

For producers, in this model we know that Fio and Gio could have caught and sold fish for just 1 and 2 respectively, and in the end they both received a price between 2 and 3, so the shaded economic surplus they obtained adds up to a total producer surplus of 4. Again we can imagine how this number might be related to Fio and Gio’s livelihoods, but from the potentially observable facts we can only know that being able to sell fish helped them use their limited resources to achieve their goals.

Using our toy model allows us to see how and why Ed and Hijo are excluded from the market. Ed would like to buy fish but is able and willing to pay less than it would cost to produce, while Hijo would like to sell fish but that would cost him more than buyers would be willing and able to pay. For that reason, Ed and Hijo gain none of this market’s economic surplus. In real societies, market participants often use some of what they gain from it to help others, through either charitable donations or government services, and economic surplus analysis helps us understand the role and need for those non-market activities. The diagram also reveals how different participants gain different degrees of benefit from the market. Those differences will turn out to play a decisive role in how economists explain, predict and assess the impacts of policy.

In our toy model we know exactly what each person has gained from the market, because we specified each producer’s marginal cost and each consumer’s willingness to pay. In reality those are not observable. All we have is empirical estimates or prior knowledge about prices, quantities and scenarios to be analyzed. We may have estimated elasticities from observational and experimental studies, or contextual knowledge about how people might adjust to a change. That information is enough to consider changes in economic surplus, ignoring the part of economic surplus that is difficult to measure and does not change.

Focusing on change in economic surplus due to a change in policy or other conditions reveals who gains and who loses from the change, and shows the relative magnitude of those gains or losses. To quantify the impact of change in policy on economic surplus available for an entire society, we begin with changes among consumers and producers, and then include externalities and transfers to or from government. Those changes in economic surplus give us additional insight into the mechanisms that lead to a change in equilibrium price and quantity, as shown by comparing market outcomes with and without trade.

4.1.2.4 Gains and Losses from Allowing Trade for Producer and Consumer Surplus

We have previously seen how and why individuals might gain from transactions with others, at Alphabet Beach or other settings. Our general analysis of how an individual is affected by trading with others within their own community was shown in Chapter 2, when we considered the options for a farmer who consumes all or some of their own production. We drew their PPF, budget lines and indifference curves in Fig. 2.15, revealing how a person can reach the same or higher level of indifference if they are willing to make trades with other people, instead of remaining isolated. But what happens when a whole community begins to trade with others?

Changes in economic surplus caused by opening to trade with other people provide a clear picture of who gains and who loses, in ways that help explain and predict policy responses. Later we will see changes in very general models drawn to show a wide range of circumstances, but it is useful to start with change for each person in our toy model as shown in Fig. 4.4.

Fig. 4.4

Gains and losses from trade at Alphabet Beach, with exports and imports

With our toy model we can imagine that the fish market on Alphabet Beach was isolated for decades, perhaps on the far side of a remote island, and then suddenly connected to the outside world by boat or other ways to buy or sell fish across long distances. We can then use the diagram to predict how each person in the Alphabet Beach fish market is likely to respond, and see how economic surplus helps measure the change in each person’s ability to meet their personal objectives.

The left panel of Fig. 4.4 shows the outcome when foreigners offer to buy at a price of 5. We draw this as a horizontal dashed line showing export demand for fish shipped to foreigners. The export demand line is drawn horizontal for simplicity, despite being slightly downward sloping like any demand line, to avoid the need for separate diagrams showing trade between the rest of the world and Alphabet Beach. If we drew those diagrams, we would see that the rest of the world is so much larger than Alphabet Beach that it can absorb any quantity of fish exports at an approximately constant price. The downward slope of demand for exports is imperceptible, for example when Alphabet Beach begins to export the price received might fall from 5.00 to 4.99, and we can greatly simplify our diagram by drawing a thick dashed line at 5.

When foreigners offer to buy at a price of 5, Hijo is now able to catch and sell fish, which raises total production to 6 fish each day. Fio and Gio can now also sell at that price. Producer surplus is the area between price received and the supply curve up to the quantity sold of 6, so at the new price of 5, the entire producer surplus rises to 4 for each fish sold by Fio, 3 for each fish sold by Gio, plus 1 for each fish sold by Hijo. But if we focus only on the observable facts when Alphabet Beach opens to trade, we are interested only in the change in price from between 2 and 3 up to 5. That is the area shaded with stripes, ////, sloped forward to remind us that change in producer surplus is the area between the two prices from zero out to the upward-sloping supply curve.

Because foreigners have offered 5, consumers are no longer able to buy at the lower price between 2 and 3. Deb no longer buys any fish so is excluded from the market, like Ed. Cat can still buy, but the price of 5 is all that she was willing and able to pay, so she also no longer gains any consumer surplus from market. Bob and Ana also lose from the price rise up to 5. The remaining consumer surplus is the area between price paid and the demand curve up to the quantity of 3, shown as the dark gray area between price and the demand curve, but again our focus is just the change in consumer surplus, which is the area between the two prices out to the demand curve. On this diagram that is part of the area previously shaded with forward stripes (///), but only the part of it up to the demand curve which is shown as the area that has stripes and is also shaded dark gray.

The result of our economic surplus analysis is that the three producers (Fio, Gio and Hijo) have together gained more economic surplus than the four consumers (Ana, Bob, Cat and Deb) must have lost. That difference is called the gains from trade, recognizing that there is a net increase in the whole society’s economic surplus, in the specific sense that the three sellers together have gained more from opening to trade than the four buyers lost from it. This fact may or may not be surprising, because we are often told that exports are good. What is more surprising is the symmetry with imports shown on the right side of the same diagram.

On the right panel of Fig. 4.4, foreigners offer to sell us fish at a price of 1. Again we draw this as a heavy-dashed horizontal line, for the same reason as before. In this case, the line shows the foreign market’s supply of exports to us. Their export supply curve might be slightly curved up, so for example when Alphabet Beach begins to import, the price paid might rise from 1 to 1.01, but the rest of the world is relatively large so they are willing and able to provide whatever Alphabet Beach will buy at an approximately constant price.

When foreigners now offer to sell at 1, it is possible for Ed to buy fish and all other consumers gain from the lower price. It is the producers who lose, as Gio can longer sell anything and Fio receives a lower price. The consumer surplus area gained by consumers is between the two prices up to the demand curve, shaded with backward stripes, \\\\, sloped downward way to remind us that change in consumer surplus goes out to the downward-sloping demand curve. The producer surplus loss to Gio and Fio is the lightly shaded part of that. Because demand and supply curves have some slope, the gains to the five consumers (Ana, Bob, Cat, Deb and now also Ed) must be larger than the losses for the two producers (Fio and Gio). The net gain is the striped area with no shading.

Both imports and exports offer a net gain for the community as a whole. Imports help the community by benefiting consumers more than they harm producers, while exports help producers more than they harm consumers. Those comparisons rely on equally weighting the economic surplus gains and losses to each person, reflecting the same symmetry we saw for individuals in Fig. 2.15 but now there are gains and losses for different people. In the community context, the fact that imports create some gains from result is surprising because we are often told that imports are bad. Our diagram for Alphabet Beach reveals why societies often dislike imports but appreciate exports, based on differences in who is affected, how much each person has gained or lost and the visibility of those gains or losses.

When Alphabet Beach opens to imports, the gains are divided among five consumers (Ana, Bob, Cat, Deb and Ed), each of whom gains the amount of price change for one fish each. In contrast, the losses are experienced by just two producers (Fio and Gio), each of whom has lost the price change for two fishes. There is twice as much loss per producer as there is per consumer, simply because each producer has a larger quantity at stake than each consumer. Furthermore, Gio has lost their entire fishing business, which is a highly visible and potentially devastating harm to them, their family and the community. The two producers’ losses are far more visible than the five consumers’ gains, and the producers themselves are more likely to respond with political efforts than the consumers.

In contrast when Alphabet Beach opens to exports, the losses are spread among four consumers (Ana, Bob, Cat and Deb), while gains go to three producers (Fio, Gio and Hijo). Again, each producer experiences twice as much gain as each consumer, and there is one producer whose entire livelihood has changed: exports allow Hijo to start fishing, which is a highly visible and attractive event for the whole community. The four consumers who lose from exports include Deb who can longer buy any fish, but notice that Deb’s economic surplus gain from buying a fish had been relatively small. This could be because Deb has a very low income and hence ability to pay, or because Deb does not care very much about fish. In either case the new unaffordability of fish for Deb, and the higher cost paid by Cat, Bob and Ana, is not as visible or important in politics as the new profitability of fishing for Hijo, and the higher profits earned by Gio and Fio.

The difference between opening to exports and to imports comes from the distribution of gains and losses. Each producer (Fio, Gio or Hijo) experiences a larger gain or loss than each consumer (Ana, Bob, Cat, Deb or Ed), and the marginal producer goes in or out of business (which is visible to everyone), whereas the marginal consumer just starts or stops buying (which is a private decision others might not care about). This asymmetry in distribution helps explain why societies mobilize against imports while encouraging exports, even though the whole society gains from trade in both cases.

The total gains from trade, whether exporting or importing, are real benefits. We can see that both gains from trade exist in our toy model, and in real life people have experienced and observed the gains from imports as well as exports everywhere in the world, since the dawn of humanity. Opening to imports is valuable economically, just like opening to exports, but it is much more difficult politically. In each case the winners could pool their gains to compensate the losers, and we do observe some government policies that provide safety net compensation directly tied to trade. For example, in the U.S. since 1974 the Federal government provides payments called Trade Adjustment Assistance to compensate workers who can show job loss due to imports, expanding an earlier program introduced in 1962 called Trade Adjustment Assistance for Firms that provides payments and services to company owners harmed by imports. There is no such compensation for those who lose from exports, and in both cases most governments respond to harm from trade by restricting trade itself. Those restrictions are extremely important to protect farm and food businesses affected by imports, and also a few brief export restrictions to keep prices lower for food businesses and consumers during world price spikes.

Later in this book we will see the data and examples of these policies and their effects. Knowing what to look for, and how to interpret the data and stories we see, is much easier when we have stylized models in mind about the mechanisms behind each change. Our toy model of the Alphabet Beach fish market is helpful to play out different scenarios, but real life is much more complicated. For example, each person does not have a fixed quantity they would buy or sell. In our toy model, supply and demand response came only from change in the number of people buying or selling, and the gains from trade arose only from diversity among people in their willingness to pay and cost of production for fish. Real-life markets involve both diversity among people in each community and variation in the quantity that each person is willing to buy or able to sell at each price.

In this book, all market models use linear supply and demand curves for market participants and horizontal prices for trade with the rest of the world as a simplification to show more clearly each mechanism behind the equilibrium outcomes. In any specific instance, actual supply and demand could take many different forms as long as supply never slopes down and demand almost never slopes up. Similarly, the price in trade would not actually be fixed, but the rest of the world is usually much larger than a given community and can absorb relatively small quantities traded at almost infinite elasticity shown by an almost horizontal line. We draw supply with an upward slope, demand with a downward slope and trade prices as a horizontal line because the resulting shapes are easy to draw and redraw, and lead to the same qualitative results as more complicated shapes.

Real-life applications of economic modeling rarely use linear supply and demand curves, and models that focus on international trade need not specify those prices as horizontal, because each application uses contextual knowledge and empirical data to tailor the model for that situation. Model specifications often involve smooth curves that can be estimated statistically, and may be designed for computational simulation as in more realistic versions of our toy model for Alphabet Beach. All models are ‘stylized’ to some degree, in the sense that they blur away any background variation that might be distracting, and each type of line and curve is stylized in specific ways to show how mechanisms interact to produce each outcome. The distinguishing feature of economic models is that each person in the model has chosen from limited options what is best for them. This foundation of individual optimization distinguishes economic models from other approaches to social science, and leads to equilibrium outcomes illustrated most clearly using linear supply, demand and trade lines. We will return to the toy model of Alphabet Beach, with named people and numerical values, but for most of the book we use a stylized model with linear supply and demand as in Fig. 4.5.

Fig. 4.5

Perfect competition and gains from trade with linear demand and supply

The stylized model of Fig. 4.5 shows how we may not need specific labels along the axes, and need not give names to each line and curve, because we are focused on qualitative implications of interaction between people shown by elements of the diagram that are now familiar to us. To use the diagrams accurately, we should just remember that the slopes of each supply and demand come from changes in quantity at each price for individual people, with the possibility of change in the number of people who participate in the market shown, and the area between curves and prices represents economic surplus gained or lost from transactions over a specific product among the specific group of people shown on the diagram.

When drawing a stylized model like Fig. 4.5 for any particular situation, we would want to give it a specific title such as ‘Fig. 4.1. The market for apples in Massachusetts’, and note the time period to which that model applies. For this textbook, the figure’s title instead shows the principle being illustrated. In this case, perfect competition without trade would drive price and quantity to the intersection of supply and demand, while opening to free trade would drive equilibrium price and quantity to the intersection of the price in trade with supply (for production) and demand (for consumption). The surprising outcome shown in Fig. 4.6 is that, in general for any community that opens to trade, there is symmetry between imports and exports in terms of economic surplus, with a clear asymmetry in the identity of who gains or loses.

Fig. 4.6

Adding up economic surplus and the gains from trade

The symmetry in economic surplus from exports and imports is the triangular net gains from trade, shown as the triangle between supply, demand and the price received or paid. On the left, net gains from exporting come from foreigners whose demand for our exports (their price line) is more than our own community’s cost of production (along our supply curve) and our willingness to pay (along our demand curve). On the right, triangular net gains from importing are received from foreigners who provide imports at a cost to us that is less than our cost of production and willingness to pay.

The asymmetric political response to exports and imports comes from who gains and loses within each community. Opening to exports helps producers at the expense of consumers, while opening to imports helps consumers at the expense of producers. Production is almost always more concentrated among fewer people than consumption, so each producer has much more at stake than each consumer. Producers also have assets at stake, for example the entire value of their fishing boats or apple orchards which cannot easily switch to make other things, while consumers are spending just a few dollars on fish or apples each month and can easily switch to other foods.

Asymmetry in the magnitudes of impact, where each producer cares more while consumers are more numerous, is translated into observed policies through political mobilization of each community with common interests. Producers are typically concentrated geographically, often know each other personally and may be sociologically similar, which helps them form specialized groups that have political representation. As we will see, this asymmetry provides a powerful political and social force against imports in favor of exports, thereby missing out on the gains from trade. Sustaining openness to trade allows a country’s population to gain more overall economic surplus for their society as a whole, but trade’s impact on equity and the political feasibility of remaining open to trade may depend on workers having diverse job opportunities and also a strong social safety net for those who lose from imports.

In our stylized two-dimensional models for one thing at one place and time, and especially in numerical models with many foods in many places over time, it is challenging to keep track of each change. A key feature of this textbook is use of consistent notation across all of the analytical diagrams, as illustrated in Fig. 4.6.

The qualitative results of our stylized models are easiest to discuss using letters for each potentially observed outcome, such as P_a and P_t for prices in autarky or with trade, then also Q_a for quantity in autarky and Q_p or Q_c for quantities with trade that are produced or consumed. As before we can use different shadings to denote areas of economic surplus, and it is helpful to use other letters for each area gained or lost from a change. Figure 4.6 shows the exact same scenarios as our previous Fig. 4.5, but with the diagrams made narrower to leave space for a table that adds up those letters, showing their relative magnitudes and net changes for this entire society.

The use of Fig. 4.6 reveals how focusing on changes, in this case from autarky to trade, implies a focus only on the difference between two scenarios. The areas of economic surplus denoted C and D are unaffected by trade and play no role in the analysis, which is important because we actually have no data and little confidence in our model beyond the range of observed points. The areas A and B that we infer from the model are traced out by potentially observable changes in price from P_a to Pt, and changes in quantity from P_a to Q_p and Q_c, so we can be confident that areas A and B exist. Beyond the potentially estimated elasticities of response shown by slopes between potential outcomes, the shape of each supply and demand curve beyond the observable range has no role in our results. Using straight lines with specific intercepts along the axes is done only for visual convenience.

Models of real-world markets often trace many changes at once, each of which can be quantified, providing many different numerical estimates for each value shown on the right ‘effects of trade’ column of each panel. The letters in that column correspond to areas measured in the currency units of each price change, over all the quantities along the horizontal axis. Area AB is our society’s entire benefit from trade shown as a positive (+) gain to our community, which is the difference between P_a and P_t with forward stripes (///) to show gains for our community’s producers up to their supply curve when foreigners buy our exports, and with backward stripes (\\\) to show gains for our community’s consumers up to our demand curve when foreigners sell us imports. Area A is the offsetting loss to some people within our community, which must be subtracted (−) to compute the net gain to this society as a whole which is area B.

In practical applications and analysis of current events, changes can go in either direction. Instead of gains from trade shown by area B, a society may experience a loss of trade opportunities. Opening to trade often happens gradually with innovations and investments that lower transport costs, while loss of trade opportunities often happens abruptly such as the sudden closure of a river or ocean port due to natural disaster, conflict or a policy choice. When describing each change it is important to be explicit about the direction of change, and to think about the time period of response being described, as well as the place and population of interest that would be responding to the change along their supply and demand curves. When describing policies or loss of transport that restrict trade, triangles of net loss like area B are known as deadweight losses. Throughout this book we will see many changes that create net gains to society, and many changes that create net losses, each with their distributional effects.

The net economic surplus from changes like those shown in Fig. 4.6 can seem miraculous when societies experience big net gains, and darkly mysterious when societies experience big deadweight losses. Gains from trade can be particularly important when they sustain and reward investment in innovations that allow a country to do more with less. The mechanisms behind those gains often happen slowly, and rely on the government policies and public investment as well as private investments and adoption of innovations needed for advances to occur. Meanwhile, other societies may fall behind through inaction or obstruction, especially under climate change and other environmental changes that shift production possibilities and supply inward, either slowly or abruptly. As shown in our diagrams, these outcomes rarely have one single cause. Economic models show how everything is interconnected, with each exogenous change engaging several endogenous responses.

4.1.2.5 Economic Surplus in Perfect Competition: The First Theorem of Welfare Economics

The concept of economic surplus used to measure social welfare in our analytical diagrams is well-defined only for one set of exogenous changes at a time. More advanced, multidimensional economic models use generalized versions of economic surplus, based on multidimensional versions of our indifference curve diagrams. The link between economic surplus for a community and indifference curves for each individual in the community is discussed below. Those generalized models lead to a mathematical finding known as the first theorem of welfare economics, which says that perfectly competitive market structures lead to the highest attainable sum of all individuals’ welfare in that market. That result is derived using advanced math in multidimensional models. In economic surplus terms for each individual market, it can be demonstrated geometrically as in Fig. 4.7 where free trade within and between communities yields the highest attainable total economic surplus. The practical application of this theorem is through its corollary, which is that imperfections in market competition ensure that highest attainable social welfare has not been reached, pointing to opportunities for improvement.

Fig. 4.7

Linking society’s economic surplus to individuals’ indifference curves

The exact definition of ‘perfect’ competition refers to the mathematical structure of a model, but the kinds of perfection required can readily be seen from our graphical models. In general, ‘perfect’ competition requires that (a) many different producers and consumers can freely enter or exit the market with infinitesimally small units of additional production and consumption, and also that (b) no barriers limit exchange among them of a product whose uniform quality is known to everyone. Because any real situation involves imperfections, economics consists of discovering how real-world market structures create opportunities to improve social welfare.

A first concern is whether different producers and consumers can freely enter and exit, moving along supply and demand curves with infinitesimally small changes in quantity. As we have seen, individual choices may span regions of increasing returns that create discontinuities, so activities shut down or jump up in size and scale when prices cross specific thresholds. In the toy model of Alphabet Beach, where each producer can catch two fish but each consumer wants only one, the only consequence of this imperfection is that prices for the sixth fish could vary between 2 and 3. In markets where just a single company sets the quantity, the result is market power of the type presented in the next chapter. Innovations and policies that facilitate small increments from new producers or consumers generally help move towards the highest attainable total welfare, although other imperfections might cause unintended side effects such as externalities discussed in the next section.

A second kind of imperfection concerns barriers to exchange of a product whose uniform quality is known to everyone. As we have seen there can be many barriers to exchange, including both policy decisions such as licensing that could be reduced through political mobilization, and also technology or infrastructure that could be reduced through innovation and investment in less expensive ways of making transactions. Many of these barriers are obstacles to information flow, as the underlying attributes of something may be unknown or misleading. As we will see, differences in both visible and invisible attributes of each item are central to food economics, including especially the impact of each item on the consumer’s future health discussed throughout the later chapters of this book.

Using economic surplus to investigate market failures such as externalities and market power is useful, but in so doing it is important to keep in mind that the model shows only one specific market at a time. The interests of other people are not shown on the diagram, unless they are included in assessments of a specific externality such as greenhouse gas emissions. And the diagram shows conditions at a given level of all other things, which could change and therefore shift the lines and curves. Economists using these diagrams are typically well aware of these limitations and redraw the diagrams differently around each decision, much as maps used when traveling are redrawn around each step in navigation. As with travelers using maps for navigation, economists using models must also look up and out to experience the world itself more directly, providing the contextual knowledge needed to use the model appropriately for decision-making in the real world.

4.1.2.6 Linking Economic Surplus to Consumers’ Interest in Policy Change

Economic surplus is defined as the area between prices up to a society’s demand and supply curves, which in turn are derived from each person’s indifference curves and production possibilities. Focusing on the links between the population’s consumer surplus and each individual’s indifference curves provide helpful insight into the meaning of economic surplus, as shown in Fig. 4.7.

The illustration in Fig. 4.7 links societal response in each market to individual wellbeing. In this example, an exogenous rise in price from P_x to P_x’ traces out the shaded loss of consumer surplus on the left panel for the market as a whole and for each person on the right panel. Each individual in the population will have their own indifference curve and level of income, but everyone using the same marketplace will face the same food price change that rotates their budget downward. As shown on the right panel of Fig. 4.8, the price change reduces each person’s purchasing power for everything and also induces substitution away from this specific product towards other things. Those two effects were first noted in Chapter 2. Now we can see how a price change’s income and substitution effects matter for decision-making, by creating a difference between how a change in food prices is experienced after it has occurred and how it is anticipated beforehand. The distinction between how a change is experienced and anticipated can be quantified by comparing the compensating variation in real income after a change has occurred to the anticipated equivalent variation in real income before the change, as shown in the two panels of Fig. 4.8.

Fig. 4.8

Definition of compensating and equivalent variation in wellbeing

The two panels of Fig. 4.8 show the experience of a price change after it has occurred (on the left) and the anticipation of a price change before it has occurred (on the right). The difference has practical importance because the compensation needed to restore equity after a price change differs from each person’s interest in a policy change before it occurs. On the left each person’s compensating variation experienced from the change is shown as the vertical gap in real income from the dotted to the dashed budget lines, measuring the compensation needed to restore their earlier level of wellbeing. In contrast, the right panel shows the equivalent variation in real income anticipated before the price change occurs, shown as the vertical gap from the solid to the dashed budget line.

As shown on the right panel of Fig. 4.8, each person’s anticipated effect of a price change, as measured by their equivalent variation in real income, depends on the anticipated curvature of their indifference curve when their real income is lowered by the price rise. If the double-line indifference curve were anticipated to be highly bowed, there would be little ability to substitute away from the product with a higher price, and the vertical intercept of the dashed budget line would be lower. That would indicate a larger equivalent variation and greater anticipated harm. In contrast, as shown on the left panel, each person’s experience of harm after the price change depends on their actual degree of substitution.

For any actual price change, both compensation required after the change and anticipated effects before it occurs are determined primarily by the magnitude of price rise and the initial budget share of the item whose price has risen, as shown by the shift from solid to dotted budget lines. Curvature of the two indifference curves also matters for the magnitude of both compensating variation and equivalent variation, especially if the anticipated curvature of the lower indifference curve differs from its actual curvature after people have adjusted. In situations where people anticipate that they will have fewer other options and hence less flexible response at the new higher prices than they would really have after the change occurs, they will have greater interest in the price change and hence more political engagement to influence proposed changes in policy.

4.1.2.7 Linking Gains from Trade to Wellbeing, Separability and Comparative Advantage

The link between societal outcomes and each person’s wellbeing is reflected in how gains from trade in a market relate to choices among production possibilities, which in turn determines the level of each budget line and the highest level of indifference they can reach. Comparing the analytical diagrams used for markets and for individuals is especially helpful to revisit the concept of separability that was introduced earlier in Chapter 3, and to define and use the concept of comparative advantage as shown in Fig. 4.9.

Fig. 4.9

Definition of comparative advantage and separability, for societies and individuals

The three scenarios shown in Fig. 4.9 are all drawn with the same prices and the same demand curve, to illustrate how differences in market supply and individual PPFs determine differences in comparative advantage for that society and for each individual. A society or person’s ‘comparative advantage’ is the relative value to them of doing one thing, relative to the value of doing other things. Comparative advantage affects decision-making in ways that may seem obvious and intuitive in some ways, but closer examination reveals the concept’s surprising implications.

In the left panel of Fig. 4.9, this community’s initial supply curve S meets their price in trade at point A, which corresponds to the individual’s point a on the right panel. At the prevailing price in trade, the whole society exports this product and the individual is a net seller, as shown by how their quantity produced exceeds quantity consumed. The changes shown are declines in quantity produced at the given price in trade, for example due to worsening environmental conditions. One decline could be to point B for society which corresponds to point b for this individual, and a further decline could lead to point C for the community and point c for this person.

These scenarios illustrate the concept of separability between production and consumption that was introduced in Section 3.2. Separability in a market and for a person is the difference between quantities produced and consumed that arises for things traded or exchanged with others. In the case shown on Fig. 4.9, there is no change at all in quantity consumed. On the left panel, the environmental degradation that shifts the supply curve in this market leftward causes no change in the trade price, which is our familiar representation of how changing the quantity traded of a small community has small and often imperceptible effects on the price they pay or receive from the large rest of the world. On the right panel, the leftward shift in PPFs and hence budget lines cause no change in quantity consumed, which arises because this person’s preferences happen to leave the quantity of this product unchanged at each level of real income. In real-world applications, a more advanced version of this model could allow for both trade price changes and income effects on consumption, without altering the results of separability and comparative advantage.

The scenarios in Fig. 4.9 show how people might initially have a strong comparative advantage in the product shown, leading to large exports from the initial point A. Environmental degradation or other changes that cause a leftward shift in supply and each individual’s PPF might reduce the degree of comparative advantage and exports at B, and further shifts in that direction could eliminate and then reverse their comparative advantage, leading to imports at C. The corresponding change for each farm is their shift from being a large net seller of this product at point a, to a smaller quantity sold at point b, and reversal to becoming a net buyer at point c. In each case, separability means that production and consumption have different causes, resulting in the degree or direction of comparative advantage for the product shown.

The example shown in Fig. 4.9 is designed to be readily understood, as an example of comparative advantage and separability that is typically consistent with intuition formed by personal experience and stories about other people. In this case, environmental factors reduced a community’s comparative advantage and even reversed it, with little or no change in consumption. A typical example might be apple production in Massachusetts, if local weather shifts production and hence quantities shipped in or out, with little impact on consumption. Later in this book we will see many other applications of these models which lead to more surprising results, building intuition about how to take account of causal mechanisms behind observed outcomes.

4.1.2.8 Conclusion

This section introduced the concept of economic surplus as a measure of social welfare, and demonstrated its relationship to each individual’s wellbeing and interest in policy change. The sum of those interests drives whether a group of people experiences improvements or worsening over time in their ability to achieve their goals, as measured by economic surplus in each market and the corresponding equivalent or compensating variation in each individual’s wellbeing.

Analyzing social welfare in economic terms helps explain, predict and assess changes in the living standards of entire societies. This section showed how some of those changes are due to gains from trade with other people, but those gains are unevenly distributed with systematic differences in who gains and who loses. Those distributional effects drive not only the equity outcomes of each change, but also determine how changes are experienced or anticipated, and hence each person’s interest in mobilizing efforts to influence policies. The analytical models presented in this chapter provide clear qualitative predictions about relative magnitudes, guiding application of economic principles to empirical analysis of food system change.

The growing toolkit of economic models presented so far in this book reflect the underlying principle that observed outcomes are selected from a limited set of options by each person, and that they have learned from experience and chosen the actions that are best for them. Our market diagrams use a variety of elements to explain, predict and assess those choices, with different market structures that specify the shape and position of each line and curve that leads to individual points of price and quantity, tracing out areas of economic surplus from each change. Subsequent chapters show how alternative market structures lead to different outcomes, and affect the impacts of policy intervention, environmental change or technological innovation.

Before we turn to the impacts of policy or other changes in alternative market structures, it is helpful to introduce how economists take account of the unintended side effects of choices in each market. Those side effects are captured by adding a new element to our diagrams that does not alter the predicted outcome of each market, but does affect the total economic surplus and wellbeing that results from that outcome, with important implications for decision-making.

4.2 Externalities: Unintended Side Effects of Market Activity

4.2.1 Motivation and Guiding Questions

The previous sections of this book have shown how economic principles help explain observed outcomes within each market, tracing how individual choices drive response to changes in production and consumption. But what if each person’s choices have unintended side effects? Almost every activity causes some kind of pollution or depletion of environmental resources, and food choices can have large impacts on a person’s future health. How can we account for those impacts on societal wellbeing, and how do these side effects of market activity affect decisions about policy intervention?

The unintended side effects of market activity are known as externalities. By definition, an externality is unintended, meaning that it was not accounted for in the decisions of the person choosing how much to produce or consume. Side effects typically involve a different dimension of life not shown on each market diagram, such as climate change or health and longevity. In many situations we know that some such effect must exist but we do not know its magnitude. In other settings we can estimate the magnitude of external costs or benefits from each unit of production or consumption, and take that into account. Whether or not the magnitude of an externality is measurable, we can see its qualitative implications for societal welfare by including externalities as an additional area of economic surplus loss or gain from each unit produced or consumed.

When economists account for externalities in our market diagrams, we are taking an outside view of society that includes market failures. We are identifying gains or losses that market decision-makers do not consider in their own decisions, and we can add those external costs or benefits to construct our own measure of total social welfare. Including the costs or benefits of externalities allows us to determine the specific market failure caused by those unintended side effects, and identify that choices that would have generated the highest level of social welfare if the externalities were taken into account. Throughout this book we will label those socially optimal outcomes with an asterisk, for example Q*, to show its special status as a benchmark to which policy interventions can aspire.

The actual value of Q* in a real-world market cannot be observed directly and is usually not even estimated, precisely because externalities are unintended consequences not counted by anyone in society. For example, when farmers apply manure and fertilizers to their fields, only some of the nutrients are taken up by crops to increase yield. Some nutrients will be taken up by plant roots or residues and remain in the soil as organic matter, while other nutrients are lost into the air or leach down into groundwater and run off into surface water used by other people. Each farmer’s choice of how much fertilizer to use is based on their observations of how it affects their crop growth and soil profile, but nutrients flowing through the air and water are not typically observed by anyone. Farmers and water users know some flows exist because their effects are plain to see in local rivers and ponds, and some flows from fields to specific destinations have been quantified by soil scientists and hydrologists, but mapping all flows and their impacts on all water users is not feasible. Our goal in this section is to gain qualitative insights, identifying how externalities affect socially optimal outcomes such as Q* relative to observable quantities such as market equilibrium Q and potential outcomes with policy interventions such as Q’.

Externalities occur all around us. Once we start thinking about them it can be hard to stop, because every activity has some degree of unintended side effects. Many externalities are positive, for example when farming and farmers’ markets enhance a community’s appeal, while other externalities are negative. The impact of externalities on each person depends on that person’s preferences, and may be difficult to define let alone to measure. For example, William worked for many years at Purdue University, near a corn processing plant that often emitted a strong sweet odor. Visitors were surprised and many local people objected, but when asked about the odor some locals would smile and say it was the smell of money. Eventually, air-quality regulations led the company to pay for a new kind of thermal oxidizer that reduced pollution without reducing production, thereby revealing how externalities can sometimes be addressed directly so each activity has less side effects. As shown in this section, regulation and innovation to address externalities directly can be much more cost-effective than altering the level of the activity itself, because interventions that alter market outcomes have their own unintended side effects.

Many externalities involve relatively small effects like occasional noise outside a restaurant, but other externalities pose existential threats such as greenhouse gas emissions. A variety of policy interventions may be used to address each one. In this section we focus on policy interventions in each market that aim to ‘internalize’ the externality, showing how producers and consumers can be induced to take side effects into account so the new quantities, denoted Q’, are closer to the socially optimal quantities, Q*. In Chapter 6 we will address decisions by governments and organizations to address externalities and other market failures through their own actions. Those are called collective actions delivering a public good, in contrast to the individual actions for private goods and services discussed in this section. When we get to Chapter 6, we will distinguish between two different aspects of externalities: first that they are non-excludable, meaning that their creator cannot exclude some people from experiencing them, and second that they are non-rival, meaning that each person who experiences them does not stop others from also experiencing that same externality. The distinction between non-excludability and non-rivalry affects decisions about how public goods are provided, but for this section the relevant observation is that most externalities are both non-excludable and non-rival in the affected community.

By the end of this section, you will be able to:

• 1. Define and provide examples of marginal external costs and marginal external benefits caused by food production and consumption activities;

• 2. Draw the total marginal social costs and marginal social benefits of production or consumption activities, and show how those affect socially desirable quantities produced and consumed in markets with and without trade;

• 3. Draw and describe consequences of externalities in terms of economic surplus; and

• 4. Use diagrams to show how a policy change that takes account of externalities could intervene to alter quantities and change the population’s total economic surplus.

4.2.2 Analytical Tools

Externalities are unintended side effects of market activity that harm or help specific people. In the case of odor and air pollution from processing plants or manufacturing facilities, there may be significant harm to nearby residents downwind of the facility. Introducing pollution to a neighborhood worsens quality of life and lowers property values. New activities that might harm local residents are often placed where people are unlikely or unable to object, and low-income people with few other options may move to places that are affordable in part because of negative externalities that lower housing costs at that location. Understanding externalities helps us see how income distribution and equity is related to environmental justice based on impacts of the externality itself, in addition to the externality’s role in society’s total economic surplus. The magnitude of externalities discussed in this section may be difficult to quantify but our analytical diagrams are helpful to see the relative direction of their effects.

4.2.2.1 Externalities and the Full Social Cost or Benefit of Each Activity

Externalities can arise from either production or consumption, and can involve both negative and positive side effects. When production activities generate harmful externalities such as air or water pollution, the marginal external cost of each unit produced can be added to the producers’ own marginal costs along their supply curve, to show the marginal social cost of each addition unit in production. When it is consumption that generates a harmful side effect, such as higher medical costs for an insured population, those marginal external costs are subtracted from willingness to pay along the demand curve, to show the marginal social benefit of each additional unit consumed. In both cases, the social cost or social benefit curves are not observable in the marketplace, but are constructed for the purpose of identifying policy goals regarding both market efficiency for total economic surplus, and social equity regarding economic surplus and environmental justice.

Similarly when production activities generate beneficial side effects such as attractive businesses that improve the quality of life for others in a neighborhood, those marginal external benefits would be subtracted from the company’s own private marginal costs along their supply curve to show the marginal social cost of each additional unit. And when consumption generates beneficial side effects, such as one’s own education that helps other people, those benefits are additional to each person’s willingness to pay along their demand curve to show the marginal social benefit of additional learning.

For local services where quantities produced are immediately consumed, there may be no need to distinguish whether externalities come from production or consumption, because the quantity supplied is exactly equal to the quantity demanded. For example, if we are concerned about the negative externalities from late-night alcohol service at bars and restaurants, we could draw those harms as a higher marginal social cost of selling drinks above the supply curve, or a lower marginal social benefit of buying drinks below the demand curve, as shown in Fig. 4.10.

Fig. 4.10

Definition of external costs from production or consumption

The example shown in Fig. 4.10 provides two perspectives on the same market failure, which is the external costs of a local bar’s late-night service. On the left panel, external costs experienced by neighbors and others are added vertically to the bar’s supply curve, while the left panel shows the same external costs subtracted vertically from the drinker’s demand curve. Both ways of analyzing the problem lead to the same conclusion, which is a socially optimal amount of late-night drinking (Q*) below the free-market equilibrium quantity (Q). On the left panel that social optimum is found by showing where the entire population’s marginal social cost curve (MSC), composed of the supply curve (S) plus the marginal external cost (MEC) of supply to other people, just equals the population’s demand curve (D). On the right panel, the same result is found by showing where S meets the entire population’s marginal social benefit curve (MSB), which is composed of D plus the MEC of demand for other people.

Externalities are shown in Fig. 4.10 using dark vertical arrows whose height is magnitude of MEC, representing the cost to other people (not the sellers or the drinkers) of each additional late-night amount of bar service. In this example, for visual clarity those vertical arrows have the same height for each unit, starting at zero out to Q that would be observed in a free market. It would be difficult or even impossible to measure the harm to other people of late-night drinking, but we might imagine some kind of market experiment or observational analysis among the neighbors and other affected members of this society to estimate the height of MEC. Tracing that vertical cost over each unit along the horizontal axis, from zero out to Q, is the environmental harm to others in society shown here as area ABC.

A first surprising finding from Fig. 4.10 is that the social optimum is not necessarily to have zero late-night drinking. For the value of Q* to be zero, the height of the MEC would need to be the entire gap between S and D at their vertical intercepts. This result occurs because the social optimum considers not only the negative side effects of late-night drinking, but also the interests of sellers and buyers in the market for drinks. Both panels of the figure show how a reduction in late-night drinking from Q towards Q*, if it could be achieved, would trace out area C of societal gains. Every step away from Q opens up area B where demand exceeds supply. The social optimum can be found where further reductions in quantity no longer add to area C, so it forms a triangle similar to our gains from trade.

A second finding from Fig. 4.10 is that at the social optimum, there may still be a lot of negative external cost shown by area A. Those magnitudes are difficult to measure, but they are evident to anyone who has lived in the vicinity of neighborhoods with many late-night bars and are sufficient to mobilize local property owners to have their city governments impose noise ordinances and strict licensing of bars and restaurants, including limits on late-night opening. Such policies would need to be enforced using fines or police action because at any quantity below Q, the drinkers’ willingness to pay exceeds the bars’ marginal costs, so they would want to keep drinking back to Q.

A third result from these findings is that policies or innovations to shrink the height of the MEC could yield much more total benefit to society than regulating the quantity sold. For example, if the externality is just noise, then ordinances that require noise-proofing the space might sharply reduce all of area A, and be a preferable solution than any effort to reduce drinking. Noise is just one of several possible externalities from late-night drinking, however, and it might be impossible to address each one directly. Real-life policymaking involves a combination of interventions, each responding to the political interests mobilized for or against each intervention.

Finally, a fourth insight from Fig. 4.10 is that reaching the social optimum involves tradeoffs between the interests of different groups. When quantity is reduced from Q to Q*, the further pursuit of one group’s interests delivers gains to them that are just equal to costs imposed on others. In this diagram, Q* is the intersection of lines accounting for all three interest groups, counting the MEC as well as S and D. If policymaking represented all interests proportionally to their economic surplus in monetary terms, then governments would routinely guide societies towards their Q* outcomes. But as we have already seen from the contrast between imports and exports, individuals in different constituencies have very different degrees of motivation to mobilize politically. Economic analysis can help reveal which groups are getting more favorable policies and can help amplify the interests of groups with less influence on observed policies.

The example above focused on a simple kind of external harm in food systems. Other externalities involve beneficial side effects, which would be drawn by subtracting the marginal external benefit from sellers’ marginal costs to obtain a social marginal cost curve below the supply curve, or adding the marginal external benefit to buyers’ willingness to pay to obtain social marginal benefit above the demand curve. An example is shown in Fig. 4.11.

Fig. 4.11

Definition of external benefits from production or consumption

The two panels of Fig. 4.11 tell the same story as the previous diagram, but with external benefits instead of external costs. Compared to Fig. 4.10, the only difference is that we scale the price axis slightly differently in the two panels just to give space for the labeling.

Many different examples of externalities could be discussed around the diagrams in Figs. 4.10 and 4.11. That same market structure applies to any product without trade. An example of an externality in a market with trade is shown at the end of this section, in Fig. 4.16. We introduce that later because trade can be imports or exports, so there would potentially be an additional eight diagrams to show each kind of externality, in addition to the four externality diagrams shown so far. The eight diagrams would show two kinds of activity (production and consumption) each having two kinds of side effects (harms and benefits) in each of two kinds of markets (exports and imports). Fortunately there is no need to enumerate all twelve kinds of externality diagrams, because the principles of economics play out similarly in each one.

When introducing trade to markets in autarky, our central insight was that supply and demand become separated from each other. Production is where supply meets the price in trade, and consumption is where demand meets the price in trade. For that reason, drawing externalities with trade in the diagrams is straightforward. If there is an externality in supply, then socially optimal production would be where our community’s MSC meets the price in trade, but socially optimal consumption is still the market equilibrium quantity. Conversely, if there is an externality in demand, then socially optimal consumption would be where our community’s MSB meets our price in trade, but socially optimal production is still the market equilibrium quantity.

For example, using the left panel of Fig. 4.11, we have space to imagine drawing a horizontal price line for imports somewhere below the lines’ intersections, so that the price in trade meets demand at a high quantity consumed. The presence of the MEB so that MSC is below supply has no effect on the level of consumption that would be socially optimal, but does imply that socially optimal production would be where the MSC meets the price in trade. Areas A, B and C of the diagram then trace out the difference between private and social cost curves, up to the horizontal supply of imports line, which replaces the demand curve in determining production.

We could also introduce the role of trade to the right panel of Fig. 4.11, where we have space to imagine drawing a horizontal price line for exports somewhere above the lines’ intersections. Again, separability would ensure that the externality in consumption affects only the socially optimal quantity consumed, as socially optimal production remains where the supply curve meets the price in trade. It is preferable not to enumerate all twelve of these externality diagrams with trade, because nothing is learned from each additional one, and privileging just a few might misleadingly suggest that externalities are found only under certain market structures. In fact they exist in all kinds of markets, and our one representative example in a market with trade is Fig. 4.16 at the end of this section.

4.2.2.2 Related Terminology: Pecuniary Externalities, Network Effects and Congestion

The term externality can mean any side effect of market activity on other people, leading to a variety of special cases with specific uses of the term.

A first kind of ‘externality’ that is already captured in our diagrams, operating through market prices, is pecuniary externalities from additional sales or purchases that alter the market price for that person and all other market participants. For example, as we saw in Alphabet Beach village, the entry of Gio to sell one fish to Cat drove down the price received by Fio when selling to Ana and Bob, and then Gio’s sale of the second fish to Deb further reduced the price paid and received. That side effect of market activity was historically called a pecuniary externality, because it reduces the monetary price received and paid to others. The change in price has a large effect on equity and the distribution of income or wealth, but those gains and losses offset each other and have no impact on the society’s total economic surplus.

Another specific use of the term is network externalities, in which one person’s use of something makes it more valuable for others. In food systems a simple example is popular bars and restaurants, where people want to be seen by others all enjoying the same thing. This is a kind of scale economy in which popularity is difficult to predict because it might depend on just a few influencers on social media. The reverse is congestion costs, in which one person’s presence uses up space and makes the thing less valuable for others. Both give rise to opportunities for coordination, and use of shared signals about what certain kinds of people are likely to do in the future. The push and pull of networking and congestion was beautifully captured long ago by Yogi Berra, a quick thinker who famously said of a popular bar he no longer liked that ‘Nobody goes there anymore, it’s too crowded’.

The balance between network effects that bring people together and congestion costs that spread people apart was transformed by the internet, which reduces the importance of physical movement and hence congestion costs, while opening new opportunities for attracting people through network externalities. The result has been to concentrate users on just one or a few providers for each type of online service, even as congestion effects remain important when physical travel or transport is needed. For example, in the food system there is profound concern that online ordering for home delivery will have network externalities and other scale economies, leading to just a few platforms to match buyers with sellers. To the extent that occurs, these platforms could exercise market power against both buyers and sellers on their platform as shown in Chapter 5.

Long before the internet, the main example of network externalities and congestion costs was urbanization. For centuries, rural people have migrated into cities, attracted by network effects and scale economies in many activities. Those forces of agglomeration attract people until diminishing returns and congestion costs make it unattractive for additional migrants to move. That kind of internal migration plays a major role in the agricultural transformation and associated dietary transition discussed in the final chapters of this book.

4.2.2.3 Equity and Sustainability Effects of Externalities in the Food System

As we have seen, each externality is a kind of market failure in which observed outcomes differ from socially optimal quantities. This is important for understanding how policy interventions might raise a society’s overall average living standards by moving from the equilibrium Q towards the socially optimal Q*. Understanding externalities also offers important insights about the distribution of wellbeing, inequities and social or environmental justice. These issues arise in all kinds of markets, many of which have exports or imports, but it is visually convenient to focus on markets without trade as in Fig. 4.12.

Fig. 4.12

Externalities can cause inequity as well as inefficiency

The four panels of Fig. 4.12 differ from previous externality diagrams only in that each activity’s marginal external cost or benefit is drawn as a proportional addition or subtraction from the supply and demand curve, rotating each MSC or MSB curve away from its corresponding S or D curve. Representing externalities as a proportion of price is a plausible representation of some externalities, but as noted earlier the actual magnitude of externalities is difficult or impossible to measure. The purpose of our analytical diagrams is to see their qualitative implications, which are the same whatever their size and whether the externality per unit is proportional to quantity as shown in Fig. 4.12, or is a specific constant per unit as shown in other diagrams.

Putting four externality diagrams in one figure is helpful to see what they have in common and to begin discussion of how interventions might lead to improved outcomes. In all cases the dashed MSC and MSB curves are not themselves any kind of supply or demand. Externalities are non-market side effects that do not influence decisions until policy interventions lead to a new Q’ that might approach Q*. In later diagrams, we will see a variety of such interventions and show how they alter the distribution of economic surplus among buyers and sellers. Some interventions change the extent of externalities by changing the quantity of the product shown, while other interventions alter the process by which that product is made or consumed thereby addressing each externality directly. Intervening to change how a product is produced or consumed can shrink external costs over the entire quantity, thereby improving equity and sustainability as shown in each of these four examples.

On the left of Fig. 4.12, the example of pollution from concentrated animal feeding operations, known as CAFOs, shows how the socially optimal quantity Q* would be to the left of the observed quantity produced if people were to choose their own production and consumption in a free market whose observed outcome would be Q_free. The externalities that make social costs higher than the supply curve include air pollution that harms people downwind of the CAFO, and water pollution that harms people who are downstream or use the groundwater affected by CAFOs. Those side effects can potentially be observed directly and have clear impacts on identifiable populations. Other externalities that are even harder to quantify include fostering antimicrobial resistance that makes it harder to control infectious disease in the future and worsening animal welfare that is valued by many people in society. Each of those externalities could be addressed directly by regulations which would shrink the height of area ABC. If we were to draw these regulations, compliance would raise the cost of production to a new supply curve denoted S’ which would meet D at a new Q’ to the left of Q, while lower social costs be shown as a lower MSC’ curve and a smaller ABC’ area of harm to other people. Sketching different versions of this diagram around each kind of livestock operation, and talking with stakeholders about the relative magnitudes of each effect, can help analysts participate in the many contentious debates about each of these interventions.

The next diagram in Fig. 4.12 shows the example of healthcare costs from sugar sweetened beverages (SSBs). There may be production externalities involved in making SSBs, but the main harm comes from consuming them which can lead to earlier and more severe diabetes and other metabolic disease over time. Each consumer takes their own future health into consideration only to some degree, first because the effects of SSBs on disease are visible only through epidemiological and clinical studies, and then even if people are told about those effects in dietary guidelines or other advice, there are many limits on how consumers might act on that knowledge. An externality that affects the consumer themselves is sometimes known as an internality, but even if people did take their own future health fully into account, there would still be important harms to other people. One group that might experience harm is family and friends, employers and others who have a personal interest in the SSB consumer’s future health. More generally, at least some of each person’s health care costs are paid by other people through health insurance and public services. Each individual’s disease risk can have significant external costs, and in the case of SSBs those costs may be directly proportional to quantity consumed leading to interventions such as restrictions on sales to children or in schools, warning labels, soda taxes and other efforts to reduce consumption.

A third diagram in Fig. 4.12 illustrates how farms might provide multi-functional benefits beyond the outputs they produce. The clearest example is how wine and dairy or cheese creates opportunities for tourism, as an attractive amenity that helps whole regions create employment and manage their local economic development. Almost everyone appreciates the landscape and connection to the natural world as well as local history offered by well-managed farms and farmers markets, including roadside farmstands and urban gardens, which can provide a variety of ecosystem services such as pollination and biodiversity. These positive externalities in production exist even for people who do not consume the produce itself, so they are often addressed directly in ways that focus on the services provided instead of just the output produced. For example, many peri-urban areas have educational farms which bring together a wider range of species in one location than would be chosen by commercial farms, supported by philanthropy and government. Other places have various kinds of community-supported agriculture that customers can visit personally in addition to buying their produce. All of these benefits are shown as area ABC on the diagram, and generate a wide variety of efforts to support beneficial farming activities in addition to commercial production along the supply curve.

The fourth example in Fig. 4.12 is shown regarding this book and education more generally. When people spend their time and money to be students, the resulting demand for education is met by a supply of schools and other services. Purely commercial activity might lead to an equilibrium number of semesters and other measures of quantity at Q, but throughout history people have recognized than at least some of the benefit from schooling are externalities so its MSB is above the demand curve. Those benefits include internalities that help the student and their own family, especially because students with high potential but low wealth cannot pay as much as education would be worth to them. More generally there are externalities that help other people, including family and friends, employers and others who have a personal interest in student’s future skills. Historically, these externalities were especially big in rural education for farm families, but even in urban areas today there are many missed opportunities to expand education. Almost all countries do this partly through regulation as compulsory schooling for example through age 16, complemented by government and philanthropic funding as well as subsidized lending. It is difficult for students to know ahead of time whether any given program is worthwhile for them, so there are situations where people have enrolled in programs that they subsequently wish they had not done, but much of economic and social development consists of increased schooling towards personally and socially optimal levels of education.

Each of the examples shown could be investigated in many different ways, at any scale of observation. The diagrams could be drawn for a small community over a single year, or for the world as a whole over an entire century. In markets for products that are traded with others, then externalities in production involve only producers and do not alter socially optimal consumption, while consumption externalities involve only consumers and do not alter socially optimal production. These general principles provide a valuable framework in which to see causal mechanisms behind the inequities and unsustainability of some activities and guide intervention to improve outcomes.

4.2.2.4 Internalizing Externalities: Regulation, Taxation and Allocation of Legal Rights

Externalities are a type of market failure that affects almost all activity to some degree, creating opportunities for intervention to improve production and consumption in many different ways. Some externalities are minor local nuisances, regulated through social conventions and local ordinances such as litter or noise, but the main focus of economics research and practice is externalities that threaten survival through climate change, pollution and other determinants of human health.

Addressing externalities is among the oldest concerns of government. About 1600 years ago the Greek philosopher Plato described an imaginary ‘philosopher-king’ who somehow discovered what people should do, using the idea of a benevolent dictator to discuss how governments might compel people to do the right thing. Even today many activities are governed by direct regulation, by which some authority sets standards and requirements for specific products. In 1920, the English economist Cecil Pigou published The Economics of Welfare which established modern terminology around externalities, and showed that governments could reach socially optimal quantities by setting taxes or subsidies equal to their marginal external cost or benefit. Later in 1960, the American economist Ronald Coase published an article titled ‘The Problem of Social Cost’, showing how externalities could sometimes be addressed by policing the harm, giving rights to people so that externalities occur only with the consent of all those affected.

Policies to address an externality can be said to ‘internalize’ it, leading decision-makers to take each side effect into account. The three types of policy described above serve as a useful framework to catalog interventions, as either direct regulation, ‘Pigouvian’ taxes and subsidies, and ‘Coasian’ rights. All three approaches can be used to address beneficial externalities, but we start with their use to address harmful side effects of various activities as illustrated in Fig. 4.13.

Fig. 4.13

External costs can be limited by direct regulation, taxation or legal rights

The diagrams in Fig. 4.13 show the same kinds of intervention that we first introduced in Chapter 3, focusing on how intervention alters the quantity of each thing, potentially leading society closer to optimal outcomes. Later diagrams in this section will focus on equity, using areas between the curves to show how interventions would alter the distribution of economic surplus and external harms. Other diagrams could address sustainability by showing shifts in each curve over time. Here we begin with the mechanism by which interventions act on producers and consumers to alter their decisions.

On the left of Fig. 4.13, we draw a scenario like licensing of bars and restaurants, in which governments set quantity directly. Direct regulations might be informed by scientific evidence about the location of Q*, but the actual regulatory process involves political representatives of each constituency mobilizing to influence legislation, executive actions, judicial decisions and enforcement mechanisms. The result is that a regulator might specify the total number of units allowable at Q’ and find some way to prevent additional sales despite the gap between demand and supply. People who have a quota or license for their share of Q’ can charge along the demand curve and earn more than their cost of supply, creating strong incentives for quota or license holders to maintain those restrictions. Some of the most impactful rules in the food system include building permits, zoning and land use regulation, as well as occupational licensing, visas for immigration and labor law. These and other regulations on total quantity of land and labor typically also regulate how each license can be used, ideally bringing the MSC curve closer to S in addition to any movement of Q’ closer to Q*.

In the center diagrams, we show two different kinds of Pigouvian taxes. Both show an external cost that is proportional to quantity so MSC is a line rotated above S. The left shows an ad valorem tax that is a fixed proportion of price, such as 5%, while the left shows a specific tax that is a fixed amount per unit, for example $5/ton. Pigou’s insight was that government officials could move society towards Q* based only on information about the externality itself, and imposing a tax that equals the harm to society. This can be especially important for equity, as the tax revenue can be used to compensate people who might be harmed by the externality, or harmed by intervention itself. ‘Sin taxes’ whose revenue has targeted uses can be helpful for city, state and even some national governments, for example when governments introduce a soda tax whose revenue is to be spent directly for the communities affected. These interventions are controversial, however, partly because of the clearly identifiable losses that they cause, but also because the magnitude of market failure that they are intended to remedy is so difficult to measure.

The right side panel in Fig. 4.13 shows the example of Coasian transactions from the initial Q to Q’ which could potentially approach Q*. Coase’s insight was that some side effects from production were historically or could potentially be remedied with a rights-based approach. One of his examples was the relationship between ranchers and farmers, or more generally any livestock producers operating near crop growers, in places where animals might enter fields before harvest and harm the crop. In Fig. 4.13, the diagram would show output from livestock, and the external cost is experienced by crop growers. In reality, there are potential benefits of livestock for nearby crops and many different ways of managing crop-livestock interactions. Coase set aside the details of agricultural production, and focused on the insight that governments can improve outcomes, even without direct regulation or taxation.

The Coasian approach is potentially the most confusing of the three policy remedies for an externality. One reason for confusion is that Coasian ideas were introduced as philosophical arguments with anecdotes or parables but little empirical data. Another cause of confusion is that Coase focused only on property rights, whereas the same arguments would actually apply to the rights of workers or other citizens. Coase was awarded the Nobel Prize for economics in 1991, after which computerized data allowed economists in Chicago and elsewhere to become much more empirical, and economics itself expanded to become more diverse and global. The economics toolkit in this textbook includes Coasian mechanisms as they have been used since the 1990s, as a way to address external harms in a rights-based approach generally, including worker protection and civil rights.

Coasian mechanisms as illustrated in Fig. 4.13 could involve legal rights for farmers to keep livestock off their fields. The government would need to actively monitor and defend farmers’ rights, perhaps sending police to enforce the law. Coase’s insight was that farmers might be willing to allow livestock damage in exchange for compensation from the livestock owner. Coase saw that in a frictionless world, where farmers can get livestock owners to pay for damages with no transaction costs, and the government can monitor and defend farmers with no enforcement costs, legal rights for farmers might lead them to accept damages all the way to Q*. In that hypothetical thought experiment, the compensation payments would become costs of livestock production that raise S all the way to the MSC curve. In real-life settings with some transaction costs the improvement might stop at Q’, but the basic idea is that external side effects become a market of their own.

Real life offers various examples of Coasian mechanisms, as people offer and accept compensation for help or harm. For example, in agriculture there are payments for the positive externality between farmers and beekeepers. Plants feed the bees which make honey, and in exchange the bees pollinate the crop. Which person should pay the other? A payment might not be needed if the benefits to each are roughly equal. In practice we observe farmers paying beekeepers for pollination services. If honey were extremely valuable we might imagine beekeepers paying farmers for the right to use their fields, but either way the equilibrium quantity of both honey and crops moves from Q towards Q*.

The idea that legal rights and private transactions could address externalities long predated Coase’s writing. What Coase did was to focus on external harms and notice the potential symmetry between a farmer’s right to keep livestock away, and a rancher’s right to let animals graze freely. Coase noted that when ranchers have those rights, farmers might pay them to stay away. In terms of Fig. 4.13, ranchers would be paid by farmers to reduce quantity supplied, and move from Q to Q’. In a frictionless world with costless enforcement from the government and no transaction costs between farmers and ranchers, farmers would pay ranchers to stay back all the way to Q*.

The potential symmetry in compensatory payments between farmers and ranchers is the Coase theorem, which states that if enforcing and trading rights were costless, initial assignment of rights to either party would lead to transactions towards the same outcome that yields the highest level of total or average income. Whether farmers are given the right to keep livestock off their fields, or ranchers are given the right for their animals to graze freely, frictionless transactions would lead to the quantity we call Q*.

One corollary to the Coase theorem is that rights are valuable and shape the distribution of income and wealth. If farmers have the right to keep livestock off their fields, payments from ranchers to let them in becomes an additional source of income beyond crop sales. Conversely, if ranchers have the right for their animals to graze freely, they receive payments from farmers and become richer. Assigning rights to the community with lower initial income or wealth can therefore improve both equity and efficiency.

Another corollary to the Coase theorem is that frictions matter, so assigning rights in ways that lower enforcement and transaction costs will make a big difference to the outcome. Regarding disputes between farmers and ranchers, it is easy to imagine how protecting the land use rights of farmers would work. Farmers can readily see which animals are on their fields and then ask government for help in forcing livestock owners to pay compensation for that, but the reverse is not feasible in practice. Giving ranchers the right to graze freely and expecting farmers to pay them to stay away would not work, if only because that would give ranchers an incentive to extract payments by repeatedly threatening the farmer’s fields with additional animals.

In practice, the Coase theorem provides guidance for how governments might use a rights-based approach to externalities, by focusing attention on opportunities to protect people who suffer from external harms. Doing so can improve both equity and efficiency, up to the limit of enforcement and transaction costs. One of the most fundamental examples is worker protection through employees’ civil rights. If enforced through lawsuits and criminal penalties, those rights can stop exploitation and create high-wage opportunities for the few who are willing to do dangerous work. A food system example is higher wages offered to the waitstaff in smoking clubs. Those are Coasian transactions between workers and customers, by which the staff accept the harms of second-hand smoke in exchange for pay.

Coasian transactions involve payment for what would otherwise be a nonmarket harm or benefit, often raising ethical questions about the nature of consent or entitlement. Many societies today ban smoking in public places, but allow private smoking clubs in which workers are paid to accept second-hand smoke. Do others in society agree to allow that type of work? Consent is often tied to the age of the worker, as all kinds of child labor are increasingly banned, but are farm families allowed to have their own children work on their own farms? Ongoing ethical debates about what should be allowed are ultimately settled in legislatures or the courts, where economic analysis can be helpful to track who gains and who losses from regulation.

The interventions to address externalities discussed so far focus on limiting external harms, but there are equally important opportunities for intervention to expand activities that create external benefits. We have already mentioned the Coasian example of beekeepers being paid to make honey near orchards and fields, and other instruments can be illustrated using Fig. 4.14.

Fig. 4.14

External benefits can be expanded by direct provision, subsidies or property rights

In Fig. 4.14, the quantity chosen by buyers and sellers when deciding for themselves and interacting in a competitive market would be Q, but there is an external benefit to each unit consumed that makes socially optimal quantities Q*. Each diagram in the figure shows a different kind of intervention that could potentially increase average wellbeing per person in this society. The actual policy-induced outcome at Q’ is determined by the interaction of market responses with government interventions, which in turn are determined by many factors other than the limited available evidence about externalities. In any real-life application of these models, Q’ might be very far from Q*, and the purpose of economic analysis is to support improvements in how governments intervene. We will return to each kind of intervention in more detail, but it is helpful to see different policy instruments to address positive externalities all together here.

The first diagram shows direct public provision by government, using funds obtained from taxation as well as money creation and borrowing from investors. The government’s sources of funds are discussed later in Chapter 9, and its spending on the food system is done through multiple agencies that conduct research, provide education and information as well as public infrastructure and institutional arrangements which underpin markets. These goods and services are public because they have benefits to people in society above market demand, as shown by MSB above D, as the value created by each unit helps people other than the buyer and seller. We have already referred to these external benefits as potentially non-excludable and perhaps also non-rival, and we will return to those concepts in Chapter 6 which focuses on the provision of public goods.

The next two diagrams contrast direct provision by government with subsidies to individual buyers and sellers, first as a proportional payment (for example, an agency might pay 50% cost-sharing to farmers who make environmentally favorable investments, or a 50% rebate that doubles the quantity of fruits and vegetables a shopper can buy), and then as a fixed payment (for example, paying $5/dose to vaccinate livestock, or a voucher for $5 of fruits and vegetables). The three diagrams on the left of Fig. 4.14 illustrate the many ways that governments can boost use of externally beneficial activities. In each case, public provision or assistance raises the society’s total or average wellbeing per person as long as the MSB of each additional unit exceeds its marginal cost along the supply curve, and that requires public intervention because private buyers have a lower willingness and ability to pay along their demand curve as shown in each diagram.

The various ways that public agencies intervene to expand use of beneficial goods and services can be illustrated by all the meals purchased each day with U.S. government funds. The exact number of such meals is unknown, but could be at least 50–80 million meals each day. Some of these are served by government employees in public schools, military facilities and other institutions, while other meals are prepared by private company staff under grants and contracts to different government agencies. Many such meals are made by individuals for themselves using foods bought with benefit cards from the U.S. Supplemental Nutrition Assistance Program (SNAP) and the related program for Women, Infants and Children (WIC) as well as overseas food aid delivered through the United States Agency for International Development (USAID). Each of those programs provides food tailored to support the relevant agency’s mission, intervening in ways that take account of different needs to differing degrees. Some meals prepared with U.S. government funds aim to improve health and are mandated to follow the latest Dietary Guidelines for Americans, while other meals are designed for different objectives, with frequent debate about the magnitude and nature of the beneficial externalities that justify public provision and subsidies from government agency.

The fourth diagram in Fig. 4.14 shows how Coasian transactions can sometimes address externalities without government payments, as in the example of how beekeepers are paid directly by farmers for pollination services. In that situation the diagram’s horizontal axis might show the number of commercial hives in a country, and the vertical axis shows the price received and costs incurred by beekeepers for maintaining each hive. Consumers’ demand for honey does not take the benefits of pollination into account, and the MSB of additional beehives can be quite high. Farmers who benefit from those externalities are willing and able to pay beekeepers for bringing hives onto their farmland, signing pollination agreements that provide additional revenue above the demand for honey. If the entire value of pollination by beehives were captured by local farmers, these Coasian transactions could fully internalize the side effects of producing honey, but in practice pollination promotes biodiversity desired by other people beyond the one farmer who paid for their field to be pollinated. Other landowners might contract for pollination of wildflowers and trees, but there are clear limits to how far Coasian contracts can go to internalize the side effects of each activity.

So far we have analyzed externalities in terms of production and consumption quantities that would take account of their side effects, in addition to the total economic surplus from market transactions. The toolkit of economics is designed so that analysts can draw diagrams tailored to many different kinds of intervention, in the context of many different market structures. To see how changes in economic surplus and external costs or benefits can be altered by policy, we must choose a specific example and draw the corresponding diagram as in Fig. 4.15.

Fig. 4.15

Economic surplus can be used to add up gains and losses from policy intervention

The example of Fig. 4.16 is well-known to agricultural policy analysts in the U.S., because it reflects a large and longstanding policy debate. The U.S. first restricted sugar imports in 1789 using tariffs, as one of the few available ways for the new government to raise revenue. Over time sugar production within the U.S. increased, first using the forced labor of enslaved people and later with mechanized production. During the twentieth century the government developed more cost-effective ways of taxing property and income instead of tariffs on trade, and the rising influence of domestic producers and sugar refiners, as well as the reduced need for tax revenue, led to a policy switch from tariffs to quotas in 1934. The switch of import restriction instrument from tariffs to quotas occurred as one of many agricultural policy changes at that time, and ever since then sugar companies have been allocated import licenses for fixed quantities which drive the market outcomes shown in Fig. 4.16.

Fig. 4.16

Policy effects depend on market structure, as in the example of U.S. sugar policy

The case study shown in Fig. 4.15 is a common real-world example, showing municipal licenses for street food vendors to use public space in potentially congested areas of a town or city. Almost all cities have such vendors, and they are almost always regulated to some degree. The diagram refers to food trucks that have their own small kitchen for hot meals. The same diagram could also be used for food carts, sidewalk vendors, or even the use of street space by nearby restaurants.

If there were no government restriction on the number of food trucks, they would be parked during the day at many locations around the city at Q, where demand for meals meets their marginal cost of supply. The side effects of having so many food trucks parked around town would lead to complaints from other people, driving city government to pass ordinances regulating where the food trucks can park and how they can operate thus limiting their quantity to Q’. Cities differ in the restrictiveness of their regulations, but historically in many cities automobile drivers and local businesses were more influential than pedestrians, leading to a low or even zero number of food trucks allowed despite high demand by food consumers. In those settings, Q’ might be below the socially optimal Q*, and popular demand might lead a government to relax their restrictions and allow more food trucks up to Q”.

In the scenario of Fig. 4.15, policy changes to allow more food trucks provide a helpful example of how change alters income distribution and the population’s overall average wellbeing. Analysis of these changes in equity and effect focus entirely on the change from one potentially observable price and quantity to another. The remainder of the diagram outside the boundaries of observed Q’ and Q” is shown in Fig. 4.15 for visual clarity, but plays no role in our analysis which focuses only on the shaded areas labeled as A, B, C and D.

When government issues additional licenses, new vendors enter bringing in additional units at the same or higher cost along their supply curve, allowing consumers to buy more along their demand curve. When the limited number of licensees operate competitively, as quantity rises from Q’ to Q” the market price per meal falls from P’ to P”, and consumer surplus expands by the gap between those two prices out to the demand curve which is area AB. Producers who had licenses before the change lose from the lower price up to their quantity supplied which was Q’, so they lose area A. Meanwhile the entering food truck vendors gain the area between their selling price at P” and their supply curve, so they gain area BCD. Area D is also a harm experienced by the other people who would have used the public space. Putting all the pieces together, the city’s population experiences a net gain of BC and important distributional changes in equity and employment.

The results of Fig. 4.15 provide qualitative insights that can help decision-makers anticipate political mobilization of each interest group around any given policy change, based on any available information about the magnitudes of gains and losses per person. For example, if there were about ten new entrants and ten thousand customers who gain from the policy change, but a hundred existing vendors and a hundred other local businesses who lose from it, some research into likely changes in price or profitability would quickly reveal the politics of the situation. To know how much each group might gain or lose, analysts would need to consider not only the baseline situation, but also the plausible elasticities of response. This kind of contextual knowledge may be difficult to assemble but is often hiding in plain sight as revealed by our Fig. 4.16.

The case study of sugar policy is useful here partly because it offers a national-scale contrast to the local food policy example in Fig. 4.15, and partly because it illustrates the difference in outcomes and welfare effects caused by market structure. Sugar is easily stored and transported, so it is commonly traded over long distances. For simplicity we draw its price in trade as a fixed horizontal line at P_t, recognizing that changes in the quantity imported by the U.S. might alter that price slightly with no effect on the qualitative results of our analysis. The external effect of sugar on health is a negative externality in consumption, so we draw the MSB curve below the demand curve. The socially optimal level of consumption, Q_c*, is where MSB curve meets the opportunity cost of buying or producing sugar, which is its price in trade. There might be externalities in production, for example when cane fields are burned or processing plants emit air pollution, but for simplicity the diagram shows only sugar’s health effects on consumption. Many other subtleties about sugar policy are also omitted, such as differences between cane and beet sugar, but none of those refinements would alter the basic results shown here.

Figure 4.16 is drawn to show the effects of the quota relative to a hypothetical policy of free trade, as a way of explaining why the U.S. government instituted its import quota in 1934 and has continued to maintain that restriction each year since then. Due to the policy, instead of the free trade quantity imported between Q_c and Q_p, only the gap between Q_c’ and Q_p’ is allowed into the country. The observed quantity sold is domestic production along S plus the quota, and the resulting price is where that market supply S’ meets D at the observed domestic price P_d which sustains quantities Q_c’ and Q_p’.

The impacts of U.S. sugar policy on economic surplus and social welfare are shown as letters for each of the differences between the without-policy benchmark and the with-policy observed outcomes. The policy comes at the expense of U.S. consumers who lose area ABCD, which is the price difference out to their demand curve. The policy benefits U.S. producers who gain area A, which is the price difference out to their supply curve, and also benefits sugar companies issued import licenses, who gain C from buying at P_t and selling for P_d over the quantity imported from Q_p’ to Q_c’. Taking account of health externalities, to the extent that those could potentially be measured, would be a gain to the U.S. of DD’, because consumption has fallen from Q_c to Q_c’, resulting in lower rates of diabetes or other metabolic disease. Since D was a loss in consumer surplus but a gain in health, the net effect to U.S. welfare is the gain of D’ minus the loss of B.

The results of Fig. 4.16 offer a powerful example of how sketching an analytical diagram can reveal economic mechanisms behind the headlines, in ways that are readily understood once we have practiced drawing these lines and curves. Empirical estimates of each slope and position would be needed to calculate magnitudes, but economic principles are sufficient to see how basic contextual facts about the policy and numbers of people involved help explain policy choices and societal outcomes. These principles play out as visible features of the food policy landscape, illustrated vividly by the example of U.S. sugar policy.

First, the impact of policy on consumers often goes unnoticed by the general public. In this case, their loss of area ABCD is spread over more than 300 million people, whose quantity per person is small enough for the slightly higher price to be of little interest, even each person were told everything about the policy. Even more strikingly, the health gains of DD’ are typically not known even to public health nutritionists. Many other factors intervene to influence sugar consumption and disease, and demand for raw sugar is probably quite inelastic so area DD’ is relatively small. That fact that health advocates in the U.S. have recurring debates over sugar taxes, without needing to know or mention that U.S. policy already raises the price of raw sugar using trade policy, clearly demonstrates that policies towards retail products like sugar sweetened beverages are formed in very different ways than policies around agricultural commodities like sugar.

Second, the policy’s net impact on efficiency for the country as a whole is much smaller than its distributional effects. To explain why the U.S. instituted this policy in 1934 and has maintained it for almost a century, one must look to how much those who benefit are gaining from the policy, and hence their willingness and ability to mobilize political support. In the U.S., the annual gain of areas A and C go to small number of sugar growers and refiners who are geographically concentrated, each of whom sells a large quantity and is highly motivated to maintain the import quota, so they maintain very active engagement with legislators targeting this narrow issue.

Finally, existing policies may have long histories and be supported by powerful interests, but also come to be challenged by new groups that form political coalitions in surprising ways. Legislation to relax the import quota and lower the price of raw sugar is frequently introduced in the U.S. Initiatives to allow more imports are promoted by the confectionery and dairy industries that buy sugar as an ingredient, and are opposed by sugar growers and refiners who sell raw sugar. Environmental groups sometimes join to support reform and reduce harm to the Everglades and other places in Florida where sugar is grown. Understandably, public health groups have other priorities and do not typically participate in these debates.

4.2.2.5 Conclusion

This section summarized how the toolkit of economic analysis can be applied to account for unintended side effects of market activity. These externalities are a kind of market failure, by which even a perfectly competitive market is inefficient in the sense of not reaching the society’s highest potential total economic surplus or other metrics of wellbeing.

Almost all activity generates externalities, ranging from minor nuisances to fundamental drivers of societal wellbeing, including greenhouse gas emissions that threaten all life on earth. Externalities are generated by the ways food is produced and consumed, affecting both sustainability and health, and can be either beneficial or harmful. The harms from negative externalities often disproportionately affect those who are least able to prevent or escape their effects, while the benefits of positive externalities are amenities sought out by those who can afford to take advantage of them. The resulting environmental injustice and health disparities compound the inefficiency caused by externalities, creating opportunities for intervention to improve both equity and efficiency.

Interventions that lead decision-makers to take externalities into account involve regulation, taxes or subsidies and legal rights. Policies often combine multiple interventions and vary greatly in the distribution of their effects among groups in society. The interventions we actually observe are those that attracted sufficient support to be implemented. Altering policies to addressing externalities is contentious in part because those unintended side effects of each activity are not normally quantified as part of anyone’s decision-making. Scientific efforts to measure each kind of beneficial or harmful externality would be needed to quantify their magnitude, and then they could be taken into account in economic models.

In this section we analyzed the qualitative effects of externalities on society, showing how interventions could alter those outcomes in ways that could potentially improve economic efficiency as well as equity and sustainability. Each market model is a slightly different analytical diagram, drawn around a specific type of externality in a specific market structure based on contextual knowledge of the situation. The relevant market model can then be used to show the impact of each kind of intervention being considered, revealing how economic principles help explain the diversity of experiences and potential for change to improve outcomes.