Tag: Tragedy of the Commons

Externalities: Why We Can Never Do “One Thing”

Reading Time: 8 minutes

No action exists in a vacuum. There are ripples that have consequences that we can and can’t see. Here are the three types of externalities that can help us guide our actions so they don’t come back to bite us.

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An externality affects someone without them agreeing to it. As with unintended consequences, externalities can be positive or negative. Understanding the types of externalities and the impact they have in our lives can help us improve our decision making, and how we interact with the world.

Externalities provide useful mental models for understanding complex systems. They show us that systems don’t exist in isolation from other systems. Externalities may affect uninvolved third parties which make them a form of market failure —an inefficient allocation of resources.

We both create and are subject to externalities. Most are very minor but compound over time. They can inflict numerous second-order effects. Someone reclines their seat on an airplane. They get the benefit of comfort. The person behind bears the cost of discomfort by having less space. One family member leaves their dirty dishes in the sink. They get the benefit of using the plate. Someone else bears the cost of washing it later. We can’t expect to interact with any system without repercussions. Over time, even minor externalities can cause significant strain in our lives and relationships.

The First Law of Ecology

To understand externalities it is first useful to consider second-order consequences. In Filters Against Folly, Garrett Hardin describes what he considers to be the First Law of Ecology: We can never do one thing. Whenever we interact with a system, we need to ask, “And then what? What will the wider repercussions of our actions be?” There is bound to be at least one externality.

Hardin gives the example of the Prohibition Amendment in the U.S. In 1920, lawmakers banned the production and sale of alcoholic beverages throughout the entire country. This was in response to an extended campaign by those who believed alcohol was evil. It wasn’t enough to restrict its consumption—it needed to go.

The addition of 61 words to the American Constitution changed the social and legal landscape for over a decade. Policymakers presumably thought they could make the change and people would stop drinking. But Prohibition led to numerous externalities. Alcohol is an important part of many people’s lives. Few were willing to suddenly give it up without a fight. The demand was more than strong enough to ensure a black-market supply re-emerged.

Wealthy people stockpiled alcohol in their homes before the ban went into effect. Thousands of speakeasies and gin joints flourished. Walgreens grew from 20 stores to 500, in large part due to its sales of ‘medicinal’ whiskey. Former alcohol producers simply sold the ingredients for people to make their own. Gangsters like Al Capone made their fortune smuggling, and murdered his rivals in the process. Crime gangs undermined official institutions. Tax revenues plummeted. People lost their jobs. Prisons became overcrowded and bribery commonplace. Thousands died from crime and drinking unsafe homemade alcohol.

Policymakers did not fully ask, “And then what?” before legislating. Drinking did decrease during this time, on average by about half.  But this was far from the hope of a total ban. The second-order consequences outweighed any benefits.

As economist Gregory Mankiw explains in Principles of Microeconomics,

In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers who participate in the market; it also includes the well-being of bystanders who are affected indirectly…. The market equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize the total benefit to society as a whole.

Negative Externalities

Negative externalities can occur during the production or consumption of a service or good. Pollution is a useful example. If a factory pollutes nearby water supplies, it causes harm without incurring costs. The costs to society are high and are not reflected in the price of whatever the factory makes. Economists often view environmental damage as another factor in a production process. But even if pollution is taxed, the harmful effects don’t go away.

Transport and manufacturing release toxins into the environment, harming our health and altering our climate. The reality though, is these externalities are hard to see, and it is often difficult to trace them back to their root causes. There’s also the question of whether we are responsible for externalities or not.

Imagine you’re driving down the road. As you go by an apartment, the noise disturbs someone who didn’t agree to it. Your car emits air pollution, which affects everyone living nearby. Each of these small externalities will affect people you don’t see and who didn’t choose them. They won’t receive any compensation from you. Are you really responsible for the externalities you cause? If you’re not being outright careless or malicious, isn’t it just part of life? How much responsibility do we have as individuals, anyway?

Calling something a negative externality can be a convenient way of abdicating responsibility.

Positive Externalities

A positive externality imposes an unexpected benefit on a third party. The producer doesn’t agree to this, nor do they receive compensation for it.

Scientific research often leads to positive externalities. Research findings can have applications beyond their initial scope. The resulting information becomes part of our collective knowledge base. However, the researcher who makes a discovery cannot receive the full benefits. Nor do they necessarily feel entitled to them.

Blaise Pascal and Pierre de Fermat developed probability theory to solve a gambling dispute. Their work went on to inform numerous disciplines (like the field of calculus) and transform our understanding of the world. Probabilities are now a core part of how we think. Pascal and Fermat created a positive externality.

Someone who comes up with an equation cannot expect compensation each time it gets used. As a result, the incentives to invest the time and effort to discover new equations are reduced. Algorithms, patents, and copyright laws change this by allowing creators to protect and profit from their ideas for years before other people can freely use them. We all benefit, and researchers have an incentive to continue their work.

Network effects are an example of a positive externality. Silicon Valley understands this well. Each person who joins a network, like a marketplace app, increases the value to all other users. Those who own the network have an incentive improve it to encourage new users. Everyone benefits from being able to communicate with more people. While we might not join a new network intending to improve it for other people, that is what normally happens. (On the flipside, network effects can also produce negative externalities, as too many members can decrease the value of a network.)

Positive externalities often lead to the “free rider” problem. When we enjoy something that we aren’t paying for, we tend not to value it. Not paying can remove the incentive to look after a resource and leads to a Tragedy of the Commons situation. As Aristotle put it, “For that which is common to the greatest number has the least care bestowed upon it.” A good portion of online content succumbs to the free rider problem. We enjoy it and yet we don’t pay for it. We expect it to be free and yet, if users weren’t willing to support sites like Farnam Street, they would likely fold, start publishing lower quality articles, or sell readers to advertisers who collect their data. The end result, as we see too frequently, is low-quality content funded by page-view advertising. (This is why we have a membership program. Members of our learning community create a positive externality for non-members by helping support the free content.)

Positional Externalities

Positional externalities are a form of second-order effects. They occur when our decisions alter the context of future perception or value.

For example, consider what happens when a person decides to start staying at the office an hour late. Perhaps they want a promotion and think it will endear them to managers. Parkinson’s Law states that tasks expand to fit the time allocated to them. What this person would otherwise get done by 5pm, now takes until 6pm. Staying late becomes their norm. Their co-workers notice and start to also stay late. Before long, staying at the office until 6pm becomes the standard for everyone. Anyone who leaves at 5pm is perceived as lazy. Now that 6pm is the norm, everyone suffers. They are forced to work more without deriving any real benefits. It’s a lose-lose situation for everyone.

Someone we know once made an investment with a nearly unlimited return by gaming the system. He worked for an investment firm that valued employees according to a perception of how hard they worked and not necessarily by their results. Each Monday he brought in a series of sport coats and left them in the office. He paid the cleaning staff $20 a week to change the coat hanging on his chair and to turn on his computer. No matter what happened, it appeared he was always the first one into the office even though he often didn’t show up from a “client meeting” until 10. When it came to bonus time, he’d get an enormous return on that $20 investment.

Purchasing luxury goods can create positional externalities. Veblen goods are items we value because of their scarcity and high cost. Diamonds, Lamborghinis, tailor-made suits — owning them is a status symbol, and they lose their value if they become cheaper or if too many people have them. As Luca Lambertini puts it in The Economics of Vertically Differentiated Markets,

The utility derived from consumption is a function of the quantity purchased relative to the average of the society or the reference group to whom the consumer compares.” In other words, a shiny new car seems more valuable if all your friends are driving battered old wrecks. If they have equally (or more) fancy cars, the value of yours drops. At some point, it seems worthless and it’s time to find a new one. In this way, the purchase of a Veblen good confers a positional externality on other people who own it too.

That utility can also be a matter of comparison. A person earning $40,000 a year while their friends earn $30,000 will be happier than one earning $60,000 when their friends earn $70,000. When someone’s salary increases, it raises the bar, giving others a new point of reference.

We can confer positional externalities on ourselves by changing our attitudes. Let’s say someone enjoys wine but is not a connoisseur. A $10 bottle and a $100 bottle make them equally happy. When they decide to go on a course and learn the subtleties and technicalities of fine wines, they develop an appreciation for the $100 wine and a distaste for the $10. They may no longer be able to enjoy a cheap drink because they raised their standards.

Conclusion

Externalities are everywhere. It’s easy to ignore the impact of our decisions—to recline an airplane seat, to stay late at the office, or drop litter. Eventually though, someone always ends up paying. Like the villagers in Hardin’s Tragedy of the Commons, who end up with no grass for their animals, we run the risk of ruining a good thing if we don’t take care of it. Keeping the three types of externalities in mind is a useful way to make decisions that won’t come back to bite you. Whenever we interact with a system, we should remember to ask Hardin’s question: and then what?

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What Competition in Nature Should Teach Us about Markets

Reading Time: 1 minute

“Though the free-market faithful have long preached that competition creates efficiency, as if it were a law of nature, nature itself teaches a different lesson.”

No tree can afford to not compete in the height competition. However, if somehow the trees could arrange a pact of friendship to limit their heights, each tree, and the forest as a whole, could save energy. This is obviously not possible for trees, but if it were, Dawkins concludes, the “Forest of Friendship [would be] more efficient as a forest.”

Systems of self-interested agents, responding only to local incentives, can easily evolve energy-wasting, unfruitful competitions. Dawkins doesn’t make the obvious connection between free-market theory and freely evolved systems, but you should. Once a way of competing is established, it’s very difficult for individuals not to play along. If we let our economies imitate trees, and the majority of nature, in practicing unguided free competition, the results will often be suboptimal, for each and for all. Worse, we will miss the main benefit of being human, which is to use reason to coordinate better outcomes.

[…]

The way wasteful competition gets entrenched is a worrying example of an entire class of errors in which what passes for rational decisions can create undesirable outcomes. These include the tragedy of the commons, Prisoner’s Dilemma-type games, and Nash equilibria. Applying a narrowly self-maximizing logic yields suboptimal results for everybody.

Still curious? Try reading The Darwin Economy.

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The Tragedy Of The Commons

Reading Time: 4 minutes

What is common to many is taken least care of, for all men have greater regard for what is their own than for what they possess in common with others. — Aristotle

The rules pay you to do the wrong thing. — Garrett Hardin

The Tragedy of the Commons is a parable that illustrates why common resources get used more than is desirable from the standpoint of society as a whole.

Garrett Hardin, introduces us to the The Tragedy of the Commons:

Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy.

As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me of adding one more animal to my herd?” This utility has one negative and one positive component.

1) The positive component is a function of the increment of one animal. Since the herdsman receives all the proceeds from the sale of the additional animal, the positive utility is nearly +1.

2) The negative component is a function of the additional overgrazing created by one more animal. Since, however, the effects of overgrazing are shared by all the herdsmen, the negative utility for any particular decision-making herdsman is only a fraction of 1.

Adding together the component partial utilities, the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another. . . . But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit–in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.

Greg Mankiw, in his Microeconomics text says:

Consider life in a small medieval town. Of the many economic activities that take place in the town, one of the most important is raising sheep. Many of the town’s families own flocks of sheep and support themselves by selling the sheep’s wool, which is used to make clothing.

As our story begins, the sheep spend much of their time grazing on the land surrounding the town, called the Town Commons. No family owns the land. Instead the town residents own the land collectively, and all the residents are allowed to graze their sheep on it. Collective ownership works well because land is plentiful. As long as everyone can get all the good grazing land they want, the Town Common is not a rival good and allowing residents’ sheep to graze for free causes no problems. Everyone in the town is happy.

As the years pass, the population of the town grows and so does the number of sheep grazing on the Town Commons. With a growing number of sheep and a fixed amount of land, the land starts to lose its ability to replenish itself. Eventually, the land is grazed so heavily that it becomes barren. With no grass left on the Town Common, raising sheep is impossible, and the town’s once prosperous wool industry disappears and, tragically, many families lose their source of livelihood.

What causes the tragedy? Why do the shepherds allow the sheep population to grow so large that is destroys the Town Common? The reason is that social and private incentives differ. Avoiding the destruction of the grazing land depends on the collective action of the shepherds. If the shepherds acted together, they could reduce the sheep population to a size that the Town Common could support. Yet no single family has an incentive to reduce the size of its own flock because each flock represents only a small part of the problem.

In essence, the Tragedy of the Commons arises because of an externality. When one family’s flock grazes on the common land, it reduces the quality of the land available for other families. Because people neglect this negative externality when deciding how many sheep to own, the result is an excessive number of sheep.

If the tragedy had been foreseen, the town could have solved the problem in various ways. It could have regulated the number of sheep in each family’s flock, internalized the externality by taxing sheep, or auctioned off a limited number of sheep grazing permits. That is, the medieval town could have dealt with the problem of overgrazing in the way that modern society deals with the problem of pollution.

In the case of land, however, there is a simpler solution. The town can divide up the land among town families. Each family can enclose its allotment of land with a fence and then protect it from excessive grazing. In this way, the land becomes a private good rather than a common resource. This outcome in fact occurred during the enclosure movement in England in the 17th century.

The Tragedy of the Commons is a story with a general lesson: when one person uses a common resource, he diminishes other people’s enjoyment of it. Because of this negative externality, common resources tend to be used excessively. The government can solve the problem by reducing use of the common resource through regulation or taxes. Alternatively, the government can sometimes turn the common resource into a private good.

This lesson has been known for thousands of years. The ancient Greek philosopher Aristotle pointed out the problem with common resources: ‘What is common to many is taken least care of, for all men have greater regard for what is their own than for what they possess in common with others.’

The Tragedy of the Commons is a Farnam Street Mental Model.

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Why You Are Not As Ethical As You Think

Reading Time: 3 minutes

Ethical infractions are rooted in the intricacies of human psychology rather than integrity. We are wired far more strongly for unethical behavior than for integrity.

Max Bazerman and Ann Tebrusnel’s book: Blind Spots covers the ways in which we overestimate our ability to behave ethically.

Briefly, here are some of our takeaways.

  • We engage in behavioral forecasting errors. We believe we will behave a certain way in a certain situation. Yet, when actually faced with that situation we behave differently.
  • When we behave in unethical ways, we are experts at deflecting blame and rationalizing our behavior. For instance, a used car salesman may view selling a car that leaks oil as perfectly ethical because the buyer failed to ask. (bias from self-interest).
  • People often judge the ethicality of actions based on the outcome (outcome bias). We tend to be far more concerned with and show more sympathy when the actions taken affect “identifiable victims”.
  • We may experience motivated blindness when we have an incentive to overlook the consequences of an action. (when one party has an interest in overlooking the unethical behavior of another party)
  • People who are mentally overloaded are more likely to cheat on a task than those who are not. Why? Because it takes cognitive effort to skip the temptation to cheat. Our brains are designed to make quick decisions. This means they can fail to consider outside influences, such as ethical concerns. We’re also more willing to cheat to avoid a loss than for gain.
  • When making snap decisions, we are especially prone to unconscious bias. The less time we have to think, the more we default to in-group preferences along racial lines.
  • Research shows that most people view their own input into a group, their division’s input to the overall organization, and their firm’s contributions to a strategic alliance to be more important and substantial than reality can sustain. Over-claiming this credit is, at least partly rooted in our bounded ethicality. That is, we exclude important and relevant information from our decisions by placing arbitrary and functional bounds around our definition of a problem (normally in a self-serving manner). This is part of the reason we fail to see eye to eye in disagreements — we pay attention to different data.
  • The difference in the way information is processed is often not intentional. Confirmation bias helps our minds absorb information that is in agreement with our beliefs and discount information that may contradict our thoughts. (We can’t remember our previous intentions either; How Our Brains Make Memories).
  • Egocentrism is dangerous when playing a Tragedy of the Commons game (Social Dilemma) such as the one we’re currently playing with debt and the environment as it encourages us to over claim resources.
  • In the end the kindergarten rule of fairness applies: one person cuts the cookie and the other has first pick on which half to eat.
  • In social dilemmas the easiest strategy is to defect.
  • A whole host of societal problems result from our tendency to use an extremely high discount rate regarding the future. One result is that we save far too little for retirement. Over-discounting the future can be immoral too as it robs future generations of opportunities and resources.
  • Compliance programs often include sanctioning systems that attempt to discourage unethical behavior, typically though punishment. Yet these programs often have the reverse effect, encouraging the behavior they are supposed to discourage. Why? In short because it removes the ethical consideration and makes it a business decision. (The number of late pick ups at daycares increase when there is a fine.)
  • When your informal culture doesn’t line up with your formal culture you have blind spots and employees will follow the informal culture.
  • Of course, we’re overconfident so informing us about our blind spots doesn’t seem to help us make better choices. We tend to believe that while others may fall prey to psychological biases, we don’t. Left to our own devices we dramatically understate the degree to which our own behavior is affected by incentives and situational factors.

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Still curious? Check out Blind Spots. This book will help you see how your biases lead to your own immoral actions. And if you’re still curious try: Bounded Ethicality: The Perils of Loss Framing.

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Social Dilemmas: When to Defect and When to Cooperate

Reading Time: 3 minutes

Social dilemmas arise when an individual receives a higher payoff for defecting than cooperating when everyone else cooperates. When everyone defects they are worse off. That is, each member has a clear and unambiguous incentive to make a choice, which if made by all members provides a worse outcome.

A great example of a social dilemma is to imagine yourself out with a group of your friends for dinner. Before the meal, you all agree to share the cost equally. Looking at the menu you see a lot of items that appeal to you but are outside of your budget.

Pondering on this, you realize that you’re only on the hook for 1/(number of friends at the dinner) of the bill. Now you can enjoy yourself without having to pay the full cost.

But what if everyone at the table realized the same thing? My guess is you’d all be stunned by the bill, even the tragedy of the commons.

This is a very simple example but you can map this to the business word by thinking about healthcare and insurance.

If that sounds a lot like game theory, you’re on the right track.

I came across an excellent paper[1] by Robyn Dawes and David Messick, which takes a closer look at social dilemmas.

A Psychological Analysis of Social Dilemmas

In the case of the public good, one strategy that has been employed is to create a moral sense of duty to support it—for instance, the public television station that one watches. The attempt is to reframe the decision as doing one’s duty rather than making a difference—again, in the wellbeing of the station watched. The injection of a moral element changes the calculation from “Will I make a difference” to “I must pay for the benefit I get.”

The final illustration, the shared meal and its more serious counterparts, requires yet another approach. Here there is no hierarchy, as in the organizational example, that can be relied upon to solve the problem. With the shared meal, all the diners need to be aware of the temptation that they have and there need to be mutually agreed-upon limits to constrain the diners. Alternatively, the rule needs to be changed so that everyone pays for what they ordered. The latter arrangement creates responsibility in that all know that they will pay for what they order. Such voluntary arrangements may be difficult to arrange in some cases. With the medical insurance, the insurance company may recognize the risk and insist on a principle of co-payments for medical services. This is a step in the direction of paying for one’s own meal, but it allows part of the “meal’ ‘ to be shared and part of it to be paid for by the one who ordered it.

The fishing version is more difficult. To make those harvesting the fish pay for some of the costs of the catch would require some sort of taxation to deter the unbridled exploitation of the fishery. Taxation, however, leads to tax avoidance or evasion. But those who harvest the fish would have no incentive to report their catches accurately or at all, especially if they were particularly successful, which simultaneously means particularly successfully—compared to others at least—in contributing to the problem of a subsequently reduced yield. Voluntary self-restraint would be punished as those with less of that personal quality would thrive while those with more would suffer. Conscience, as Hardin (1968) noted, would be self-eliminating. …

Relatively minor changes in the social environment can induce major changes in decision making because these minor changes can change the perceived appropriateness of a situation. One variable that has been shown to make such a difference is whether the decision maker sees herself as an individual or as a part of a group.

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Footnotes
  • 1

    Dawes RM, Messick M (2000) Social Dilemmas. Int J Psychol 35(2):111–116

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