Capitalism, with its intrinsic focus on competition and profit, has long been credited with fostering innovation within economic systems. The dynamism of capitalist economies, where businesses constantly vie for market dominance, serves as a catalyst for inventive solutions and advancements. The very nature of competition propels companies to differentiate themselves through superior products, services, or more efficient processes, driving a continuous cycle of innovation.
However, while capitalism can be a powerful driver of innovation, it does not guarantee equitable distribution of the benefits of innovation. Issues such as income inequality, access to resources, and the potential negative externalities of unregulated capitalism also need consideration in assessing its overall impact on society.
“You can look at any of the big issues we suffer today—any of them—and it points to the fact that you’ve got the wrong metric,” said Bill McGlashan, co-founder of the impact investment fund The Rise Fund and the nonprofit Y Analytics. “Because we don’t price externalities, because they’re not factored in, you by definition end up with something that runs amok.”
“Pricing for externalities” involves factoring in the costs associated with external impacts or consequences into the economic calculations of a system. Externalities refer to the side effects or consequences of economic activities that affect parties not directly involved in those activities. These effects can be positive or negative and may include environmental, social, or public health impacts.
In a traditional economic model, businesses most often do not bear the full cost of these external impacts. For example, a factory emitting pollutants might contribute to environmental degradation, impacting air and water quality, and affecting public health. In the absence of effective pricing for externalities, the business does not account for these costs in its economic calculations. If the true cost of this environmental impact were factored into the pricing of products or activities causing it, the economic system might better reflect the actual costs and consequences associated with certain practices.
According to McGlashan, capitalism has proven time and again it has the potential to solve some of the most pressing and complex issues facing not only the United States, but the world. “You look at GE’s invention of the microwave venture, invention of refrigeration, the light bulb, all the radiation therapy machines—all this stuff coming out of these innovation engines that have driven incredible impact in the world, positive impact.”
In order for capitalism to reach its full capabilities, economic measurement must be recalibrated to account for these externalities it has historically ignored.
The hidden costs of unpriced externalities
The inherent challenge with externalities lies in the fact that their costs or benefits are not reflected in the market prices of goods and services. As a result, unpriced externalities can distort resource allocation and decision-making. Contemporary industries are rife with examples of externalities that, when left unpriced, can have far-reaching consequences.
Perhaps one of the most blaring examples can be seen in the energy sector, where the extraction and combustion of fossil fuels generate greenhouse gas emissions, contributing to climate change. The costs associated with environmental degradation, health issues, and the societal impacts of climate change are often not factored into the price of energy, creating a distortion in the market.
In tech, the rapid advancement of electronic devices and the digital economy has led to the generation of electronic waste (e-waste). Improper disposal and management of e-waste result in environmental pollution and health hazards, impacting communities far removed from the initial point of consumption. The costs of managing and mitigating these externalities, such as recycling programs and environmental cleanup, are typically not borne by the producers or consumers but are externalized to society at large.
Unchecked externalities lead to environmental degradation, public health crises, and social inequalities. The agricultural industry’s reliance on pesticides may enhance crop yields, but it can also result in soil degradation, water contamination, and adverse health effects for nearby communities. If these externalities are not priced into the cost of agricultural products, the industry may continue to operate in a manner that is economically efficient but socially and environmentally unsustainable.
“You look at [the fact that] 52 percent of all of our soil has been destroyed because of the Green Revolution during World War I when we started creating synthetic fertilizers—we basically nuked the soil and have killed the microbiome and it’s now dirt. As a result, in order for you to get the same Vitamin C in an orange that your grandfather got, you have to eat eight oranges to his one orange,” said McGlashan.
Environmental impact accounting
Numerous case studies underscore the economic implications of environmental degradation caused by unpriced externalities. As already discussed, the fossil fuel industry’s emissions contribute to climate change, and the resulting extreme weather events inflict billions of dollars in damages annually. Further economic fallout from these events include increased insurance costs, infrastructure damage, and disruptions to supply chains. Similarly, industries that exploit natural resources without accounting for environmental externalities often face long-term economic challenges as ecosystems degrade, affecting their resource base and long-term viability. “And so we’re basically killing ourselves today globally,” McGlashan quipped.
The conventional metrics used to gauge economic health often fall short in capturing the full spectrum of impacts associated with economic activities. The current focus on GDP as the primary measure of economic success neglects critical factors such as environmental degradation, social inequality, and the long-term consequences of unchecked economic growth. Recognizing this deficiency, economists and policymakers are advocating for a more comprehensive approach to economic metrics.
A number of proposals have emerged to integrate externalities into economic metrics that will provide a more accurate reflection of economic well-being. One approach involves the development of alternative indicators that encompass a broader range of factors, including environmental sustainability, social equity, and overall quality of life. Additionally, efforts to quantify and price externalities through innovative economic models seek to internalize the hidden costs associated with various economic activities.
“My view was that there were sort of two missing ingredients in the space. One was scale that needed to be much bigger because for it to matter, for it to move the needle, the world needed a lot of capital directed this way. Secondly, we had to keep everybody honest by coming up with an objective way of measuring impact,” said McGlashan.
McGlashan’s work at TPG saw him co-found The Rise Fund, the largest impact investing fund to ever be raised. He also co-founded the public benefit corporation Y Analytics concurrently which conducts impact assessment work. Since its founding in 2016, The Rise Fund has been widely recognized as shifting perception on the effectiveness of impact investing.
Understanding and addressing the hidden costs of unpriced externalities is crucial for creating a more sustainable and equitable economic system. By incorporating these external impacts into economic calculations and decision-making processes, we can work towards a more comprehensive and responsible approach to resource allocation and market dynamics.
“If we measure externalities effectively and we’re intentional, there’s no better model to create scalability, durability, and impact than a commercial model,” said McGlashan.