In economics, a spillover is a positive or a negative, but more often negative, impact experienced in one region or across the world due to an independent event occurring from an unrelated environment.
For example, externalities of economic activity are non-monetary spillover effects upon non-participants. Odors from a rendering plant are negative spillover effects upon its neighbors; the beauty and pleasing scent of a homeowner's flower garden is a positive spillover effect upon neighbors. The concept of spillover in economics could be replaced by terminations of technology spillover, R&D spillover and/or knowledge spillover when the concept is specific to technology management and innovation economics. Moreover, positive or negative impact often creates a social crisis or a shock in the market like booms or crashes.
In the same way, the economic benefits of increased trade are the spillover effects anticipated in the formation of multilateral alliances of many of the regional nation states: e.g. SAARC (South Asian Association for Regional Cooperation), ASEAN (Association of South East Asian Nations).
In an economy in which some markets fail to clear, such failure can influence the demand or supply behavior of affected participants in other markets, causing their effective demand or effective supply to differ from their notional (unconstrained) demand or supply.
Another kind of spillover is generated by information. For example, when more information about someone generates more information about people related to her, and that information helps to eliminate asymmetries in information, then the spillover effects are positive (this issue has been found constantly in the economics and finance literature, see for instance the case of local banking markets).
History of the concept 19th century economists John Stuart Mill and Henry Sidgwick are credited with founding the early concepts related to spillover effects. These ideas extend upon Adam Smith's famous ‘Invisible Hand’ theory which is a price that suggests prices can be naturally determined by the forces of supply and demand to form a market price and market quantity where buyers and sellers are willing to make a transaction. Spillover effects, also known as externalities in market theory are the costs associated with a transaction borne upon a party/parties that are non participants in the transaction (i.e., Production costs do not consider the cost of pollution on society at large). Furthermore, Mill argues that Government intervention in the market can be a useful tool when necessary to prevent or mitigate spillover effects when necessary as opposed to Adam Smith who believed a competitive market with little to no intervention provides the most adequate outcome.
These ideas on spillover effects later became extended upon further by other economists, notably Arthur Pigou. Pigou developed the concept of externalities in 1920 through ‘The Economics of Welfare’. Essentially, Pigou argued negative externalities (spillover) of an activity should incur an extra cost or tax while activities that produce a positive externalities (spillover) should be subsidized to further encourage this activity. Taxes on these activities that create negative externalities are commonly used in the 21st century through taxes including excise tax on purchasing alcohol and cigarettes which can cause damages to the health and wellbeing of citizens.
Types of spillover effects There are different types of spillover effects which can take place. According to the Corporate Finance Institute, spillover effects can be categorised in the following ways: 1. Social Interaction Spillover Effect 2. Context Equilibrium Effect 3.General Equilibrium Effect 4. Externalities Spillover Effect
Social interaction spillover effect Social interaction spillover effect occurs when community programs and initiatives have the effect of benefiting the welfare of people and in turn the community at large. For example, free education, social welfare payments and other public goods are designed to improve the social behaviour, education and employability of citizens which in turn could lower crime rates and poverty in the community in theory.
Context equilibrium effect
Context equilibrium effect emerges from interventions that influence social norms or behaviors within a specific context, such as a local area where the interactions take place.
General equilibrium effects General equilibrium effects can happen when there is an impact in the market either positively or negatively creating a spillover effect through interdependence of firms and households in the economy. This occurs as entities do not operate in a bubble, hence when there is a financial shock or boon to a business or industry, this impacts factors including pricing, costs and wages for other entities. Rather, entities experience shocks or boons in relation to other entities. For example, if there were to be a global shortage of oil production, global supply and demand would interact to put upward pressure on oil and in turn fuel prices. This occurs as consumers are effectively bidding for the remaining oil which is more scarce than before, forming a new equilibrium price in the market. Hence fuel stations and consumers are impacted by the spillover effect of oil shortages.
Externalities spillover effect External spillover effects are similar to general equilibrium effects in that they impact third parties which are not directly participating in the transaction. However, the key difference is that externalities are represented by social costs that are not reflected in a price change without government intervention. An example of an externality may be pollution resulting from production of goods and services. This cost does not appear in the cost of production, rather it exists outside of the market supply and demand schedule.
Positive and Negative Spillover Effects
Positive Spillover
Positive spillover occurs when changes in one behavior influence favorably changes in subsequent behaviors. An example can be free public education offered by the government. Students become smarter, gain knowledge and experience. This leads to more educated population, which can move out to the other countries.
Negative Spillover
Negative spillover is the opposite of positive spillover, meaning unwanted social, political, and economic impacts. An example is pollution caused by industrial plants, releasing smoke, carbon dioxide gas, oil wastewater, and other harmful waste materials into the atmosphere. As we know, pollution leads to global warming, which affects all of us. Global warming causes the melting of ice, which leads to raising sea levels. Another example could be demand for commodities (such as palm oil or osy) in one country that cause deforestation in other countries. Negative spillovers impact both the participants and non-participants.
Graphical representation Externalities in the supply and demand curve: Note the graph representing a negative externality below. To illustrate this concept the ‘marginal social cost’ (MSC) is used in comparison to the ‘marginal private cost’ (MPC). Marginal social cost is the line which includes all externalities including the social cost of pollution in addition to regular production costs. Alternatively, marginal private cost also considers the regular production costs used in a transaction.
Thus, in the diagram below, if the market was functioning properly by accounting for negative externalities, society would produce at quantity 2 (Q2) and a higher price (P2). Without considering negative externalities, society would produce at Quantity 1 (Q1) and at a lower price (P1). Hence, due to negative externalities (social costs) being excluded from transactions, society overproduces products with negative externalities and underprices them.
For positive externalities, see the diagram below. Note there are no social costs (negative externalities) that have been excluded from the private cost as there is a single cost line. In this case, social benefit (MSB) exceeds private benefit (MPB). In effect, this means the private benefit of a transaction (i.e., profit for a newly established business) is only part of the benefit accrued as an additional social cost (i.e., Surrounding cafes and restaurants gain more customers as employees from the newly established business buy lunch). Hence if the market was functioning properly to include social benefits, the market would produce at quantity 2 (Q2) and at price 2 (P2) which represents the true equilibrium quantity and prices.
Difficulties in quantifying spillover effects Quantifying spillover effects presents a number of challenges. Firstly, it is important to identify and measure the presence of these externalities: for instance, the spillover effects which result from the process of production often necessitate robust data collection and analysis. In order to assign a monetary value to the spillover effects of production it might be necessary to estimate such variables as healthcare costs from pollution or the value of clean water access. This presents a challenge because some of these variables lack direct market valuation. Moreover, subjectivity and uncertainty can intervene with the process since a conflict may arise among varying stakeholder perspectives. Lastly, ethical dilemmas are likely to arise in the process of quantifying spillover effects since this process involves placing a value to inherently invaluable aspects like biodiversity. It can therefore be argued that the process diminishes the intrinsic worth of these aspects.FasterCapital. (n.d.). Challenges in Quantifying and Valuing Externalities. FasterCapital. Retrieved from https://fastercapital.com/topics/challenges-in-quantifying-and-valuing-externalities.html
Methods of measuring spillovers There are three main categories which contains methods for assessing international trade-related spillovers.
Multi-Regional Input-Output (MRIO) MRIO is one of the categories of analysis which combines internationally harmonized input-output tables and trade statistics for sectors or groups of products or services of environmental use (e.g. land, water, timber), pollution (e.g. reactive nitrogen), or socioeconomis impacts (e.g. child labor, labor accidents, gender pay gap). The biggest advantage is the relative ease with which analyses can be performed for different countries. The disadvantage could be the fact that MRIO does not consider context-specific technologies, efficiencies or resource- or pollution- intensities but instead use average impacts. So, MRIO methods are best suited to asssessing spillover effects of aggregate sectors or product groups at country level.
Life-Cycle Assessments (LCA) These assessments are used to evaluate the environmental impact of individual products and their production processes across geographic and temporal scales. Moreover, they can also measure socieconomic impacts. These assessments are provided with a bottom-up method, which is an opposite to the top-down method in MRIO. The LCA are less suitable to assess spillover effects. They have to face the "truncation problem" and also requires vast volumes of data, which can be hard to get.
Material-Flow Analyses (MFA) These analyses track specific material flows along supply chains and across countries. The tracking is primarily done for raw or less processed commodities. It cannot be as globally comprehensive as MRIO, because it also suffers from the truncation problem like LCA.
MFA is based on the quantification and measuring of matter and substances in relation to the processes in a system such as a city or country. It is confined to a specific period of time. Flows are expressed in kg/year or, alternatively, in kg/capita/year. MFA is based on the principle of matter conservation.