What is a Externality?

In Short

Within every market transaction there are buyers (demanders) and sellers (suppliers). Also, there are bystanders who are affected by the transaction that are not part of it. The effects on these bystanders are externalities. The costs and benefits to these bystanders are usually not taken into account when the market participants are making their deals. As a result a particular deal occurs either too often or not often enough (assuming the goal is to maximize total utility) (Total utility is personal utility + societal utility). One way these externalities can be addressed is by using taxes/subsidies.

Example of a Positive Externality

Getting a flu shot has a distinct personal benefit. It makes it less likely that you get sick. In addition, it has the benefit of making other people less likely to get sick. So in this case you are the demander, the person giving the shot is the supplier, and everyone else in society are the bystanders. When evaluating the costs and benefits of getting a flu shot, most people don’t consider the benefits to the bystanders (positive externality). As a result flu shots don’t happen as often as they should. Hypothetically, let’s say you getting the shot gives you 1 dollars of personal benefit and it causes society to receive 1 dollar of benefit. One solution is for the government to pay you a dollar for getting a flu shot (subsidize you). That would cause the demander to internalize the societal benefit and flu shots would occur more often.

Example of a Negative Externality

Let’s say you own a company that sells cigars. The smoke (from smoking the cigars) caused 200 dollars worth of damage to society (second hand smoke damage) (negative externality) but only 100 dollars worth of damage to the property of you and your customers. So in this case you are the supplier, the customer is the demander, and everyone else in society are the bystanders. Smoking causes damage that the market participants are not going to consider, so cigar sales occur more often than optimal. One solution is for the government to tax you $100 for selling cigars. That would cause the supplier to internalize the societal cost and cigar sales would occur less often. This idea is the underlying ideology behind sin taxes.

Fee Structure

Rate Assets Under Management
1.44% Below $125,000
1.00% Between $125,000 and $750,000
.85% Between $750,000 and $1,250,000
.80% Between $1,250,000 and $1,750,000
.75% Between $1,750,000 and $2,500,000
.70% Between $2,500,000 and $3,250,000
.65% Between $3,250,000 and $4,250,000
.60% Above $4,250,000

A single rate is applied to the entire account. So a person with a $750,000.01 account pays less than a person with a $750,000 account. I will waive personal tax return fees for accounts over $1 million. For accounts that are above $5,250,000, we’ll need to discuss a custom rate.

As I’m writing these to help my readers, I would be very appreciative of any input in regards to what I should write next. Please contact me if you want me to write about a particular topic. If you would like to submit a post to my blog, please contact me.

If anything that I mentioned above interests you, please consider downloading my free e-book. The book contains my thoughts on investment management and some information that I think everyone should know. You can also download it below.

E-Book Download

Questions for the comments

Did my explanation make sense? Do you agree or disagree with what I said?

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