Home >Opinion >Views >Covid shortages: A black swan pecuniary externality

An externality is an effect on a third party that is not directly related to a transaction or an economic activity. That effect can be negative or positive. The classic negative example is when a factory pollutes, and the smoke settles as soot on people living in its locality. Their cost of laundry goes up. Worse, they suffer lung diseases. These negative costs have not been factored into the factory’s production costs. A positive externality is, say, when a bee-keeper contributes to increased pollination of surrounding crops, thus increasing their yield. Her gains off this apiary business don’t include the benefit to surrounding farmers. Both of these are called market failures, to fix which we have government intervention. Either the factory is asked to install a scrubber to reduce its emissions to zero, thus internalizing the cost fully, or a tax is imposed for redistribution to the local community. Similarly, an apiary business may be given a subsidy to encourage it, by taxing surrounding crop producers. An externality is an example of market failure. But not all market failures need to be fixed by regulation, taxes or subsidies. Defining property rights clearly creates conditions for parties to negotiate prices to internalize these costs or benefits. This market-based solution is the essence of the famous theorem by Nobel Laureate Ronald Coase.

Examples of externalities abound. For instance, road congestion is caused by an external cost imposed by individual drivers on all others. Underinvestment in training occurs if companies fear that trained workers will be poached and its benefits will go to rivals. It must be noted that there is a difference between pure market failures and cases of anti-competitive behaviour, such as the exercise of monopoly power and use of predatory pricing or asymmetric information enabled by imperfect competition.

There is, however, another kind of externality in which the effect on a third-party works through the market mechanism. Thus, it is not a market failure, but rather the market working too well. This is called a pecuniary externality. An example of this is when city dwellers rush into rural areas to buy a second home or farmhouse, driving local prices sky-high and making housing unaffordable for locals. The negative externality on the local folk has worked through the price mechanism, i.e. demand shooting up. There can be no market solution to such an externality. Many economists might even hesitate to call such a phenomenon an externality. After all, in a market-based economy, almost all interactions between supply and demand affect all consumers and producers through the price mechanism, even though not everyone is a party to every transaction.

In February, the state of Texas in the US experienced unprecedented sub-zero cold weather, which caused a huge imbalance in the demand and supply of electricity. Normally, the electricity market works smoothly in Texas, and it is one of the most sophisticated markets, with real-time price discovery and frictionless adjustments of supply and demand, which get equilibrated. Yet, because of inadequate winterization, half the supply had frozen in gas pipelines, which could not come online. Second, the sudden freeze created a spike in demand for home heating, which in Texas is mostly based on cheap electricity and is hardly used. In earlier weather episodes, such as Hurricane Harvey of 2017, the utility regulator was able to balance demand and supply without any outages. Even in extreme conditions, the situation is tackled with controlled and well-rotated outages (i.e. rationing). But this February’s storm caused controlled outages of more than 20% of demand, and everything went haywire. Many households were without water and electricity for days. At least 100 people died of cold, and gas prices spiked more than 4,000%—the market mechanism was working. This was a black swan event and an extreme form of a pecuniary externality.

What we are seeing in India’s second wave of covid is something similar. A sudden and steep spike in infections has created huge demand for antiviral drugs, hospital beds and oxygen. There’s a shortage of all three. As a result, prices have shot up, especially in the black market. There are whispered stories of hospital beds being made available for a few lakh rupees, or a vial of Remdesivir selling for tens of thousands of rupees. To make matters worse are stories of the police finding caches of life-saving drugs being hoarded, patients not finding beds, or dying for lack of oxygen. Whose fault is this? Should hospital administrators not stock up adequate quantities of drugs? Should they not plan excess capacity of oxygen supplies and beds? That’s not as facetious as it sounds, and it works in normal times. In fact, not too long ago, there was excess supply of Remdesivir. But we are now in a black swan setting. Markets won’t work. The government has to solve this shortage on a war footing. Centralized allocation of oxygen cylinders is being done. Industrial oxygen has been diverted to hospital use. More companies have been given licences to produce Remdesivir. Vaccine production has being stepped up, and so have imports.

This illustrates that when it comes to an extreme situation like the covid crisis, or like a more mundane lack of affordable housing, a pecuniary externality is addressed only by an intrusive and redistributive public-policy response. Worsening inequality, whether in access to healthcare, housing or education, is a market failure for which there is no easy ‘market solution’.

Ajit Ranade is chief economist at Aditya Birla Group.

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