Table 3.
Box 3
| Externalities |
|---|
| An externality is a cost or benefit that falls on people who are not directly involved in an activity. |
| The Internet exhibits what are know as positive externalities, or network effects, where the value of a good depends on the number of other people who use it. Thus, the more people who join the Internet, the more valuable an individual connection to the Internet becomes.6 Other networks exhibit similar positive externalities. The value of the fax or telephone changed enormously once the network of individuals owning one grew, resulting in a sustaining positive feedback cycle of network growth. So, with positive network externalities, the actions of others enhance the value of joining the network. |
| In contrast, pollution arising out of the production of a commodity is an example of a negative externality. It affects not just those who manufacture or consume the product but society as a whole.16 Since externalities are, by definition, not factored into prices, there is no economic incentive to deal with them by producers. The problem then is that negative externalities impose additional costs on others but can be ignored by the producer. If one could somehow internalize the externality—by factoring the cost of pollution into taxation, for example—then an incentive to minimize the negative effect would be introduced. So a tax based on the amount of pollution a producer generates has the effect of providing an incentive to minimize pollution. |
| The Internet also exhibits negative externalities. For example, when the number of users on the network exceeds its transmission capacity, congestion results. The resulting delay in the transmission of e-mail or retrieval of documents imposes a cost on individual users. As long as the cost remains external to the system, there is no incentive for individual users to deal with the problem. However, if Internet use became expensive at times of congestion, then the negative externality would become internalized into the calculations of consumers and they would have an incentive to use the system less at congested times.3 |