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Why Businesses Need to Embrace Externalities

April 2, 2012, 12:00 AM

What is the Big Idea?

The working conditions at Foxconn is about to get a lot better. At least that is the idea behind purported reforms announced last week, some of which include shorter work hours and higher wages. These changes were prompted by a critical investigation of its factories after the public outcry over unsafe working conditions at Foxconn, which makes over 40 percent of the world's electronics. Their brands include Apple, Amazon, Dell and Hewlett-Packard.

This story of how Apple inspired positive change in their supply chain underscores how businesses today must take responsibility for externalities order to thrive in this current global economy. 

Externalities is "the term economists use when they talk about industry's side effects or, more positively, spillover effects --- the various changes that a business contributes to in its broader milieu that do not show up on its books," Christopher Meyer writes in his book Standing on the Sun: How the Explosion of Capitalism Abroad Will Change Business Everywhere.

With that said, not all externalities are bad, as businesses oftentimes produce benefits for society that never show up on their books. The simplest example Meyer offers is a when a company employs a security guard to monitor its building and the guard wards off threats to its neighbors as well. Wikipedia is another example of a business with positive externalities. 

Unintended side effects produced by businesses have been around long before Steve Jobs was even born. Steel mills have been sending soot into the atmosphere since the 1850s. So why is it now so important that businesses respond to externalities produced by their products?

The answer is ubiquitous feedback, according to Meyer.

The first stake we put in the ground is that greater accountability for negative corporate impacts is unavoidable. Think about what's involved in an externality: it's a situation wherein one party takes action that has effects on others who did not have a choice in the matter and whose interests were not considered. How long can that persist before feedback starts impinging on the actor? Perhaps indefinitely, if the effect is too small to notice; or if the effect is noticeable but it's difficult for the affected party to trace it to a cause; or if the affected party doesn't make any objection known. But with every passing year, each of those 'ifs' becomes more unlikely.

He identifies three major forces that drives business to recognize externalities:

Scale - Some effects that were once small have grown too large to ignore. Eureka Iron Works, a steel mill that opened in Michigan in 1854 probably wasn't very clean or efficient. But with a one furnace it wasn't going to have much of an effect on the atmosphere as a whole. Before 1850, global fossil carbon emissions were negligible. It was at 2 billion metric tons in 1950 and doubled twice more to 8 billion in 2005. 

Sensors - The ability to measure social and environmental impact makes it easier to trace accountability. A hundred years ago, it wasn't possible to measure pollutants in the atmosphere. Now technology enables us to measure all kinds of pollutants. 

Sensibilities - Tools on the Internet enables us to learn about the problems around us. Within seconds, we can learn about the biggest polluters in our area on Scorecard.org and take action if we so choose. In the last few months, the poor working conditions at Foxconn drew protests, petitions while labor organizations scrutinized Apple's suppliers. Advocacy groups sent letters to the company to "ensure decent working conditions at all its suppliers."

What is the Significance?

In response to negative feedback or press, businesses often find themselves involved in what Meyer calls "disconnected and sometimes inconsistent initiatives related to corporate social responsibility, sustainability, 'giving back' through pro bono work, cause branding, going green and philanthropy."

There is a better way for companies to focus their efforts. First of all, Meyer argues that businesses don't have to be responsible for society, only for themselves and their own externalities. There is a simple framework that helps companies deal with externalities. 

The Ripples of Responsibility

Start by drawing four concentric circles: the core is the business you manage today, the rings beyond are impacts on the world for which you haven't had to account. 

  • Core - Your business today
  • Take ownership - Impacts that can be directly traced to your operations. 
  • Take action - Impacts that you contribute to and in relation to which you have particular problem-solving competence.
  • Take interest - These are distance ripple effects and you have no special competence to fix them. Channel your efforts to other parties. 

Watch Christopher Meyer talk about firms that made waves in the Ripples of Responsibility:

Image courtesy of Shutterstock


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