In this blog post, we explain the concept of locational externality, how interactions between competitors affect their performance and rewards, and the resulting economic inefficiency.
Tennis player Steffi Graf earned a fortune by winning the 1992 tournament, but she continued to lose to her archrival, Seles. As a result, Steffi Graf became increasingly concerned about her matches against Seles, even though she was maintaining her performance level. Every match against Seles was a big challenge for her, and she constantly strived to improve her skills. However, despite her efforts, her losing streak against Seles put a lot of pressure on Steffi Graf. She began to doubt her abilities and even considered new strategies to escape the competition with Seles.
However, when Seles suffered an accident the following year and was unable to continue playing, Steffi Graf’s winning percentage nearly doubled, despite no significant change in her playing ability. This was a major turning point for Steffi Graf, and a new chapter in her tennis career began. With the rivalry with Seles behind her, Steffi Graf no longer felt the same psychological pressure and was able to play freely. As a result, not only did her prize money increase significantly, but she also gained additional income from advertising appearances. This phenomenon can be explained by the concept of “positional externality.”
Externalities refer to situations in which one person’s reward is affected by the actions of another person, but neither receives nor pays compensation for it. In particular, positional externalities refer to situations in which one’s reward depends in part on the relative performance of competitors whose rewards are determined by their relative positions. Steffi Graf’s case is a good example of how her positional rewards increased significantly due to the performance of her competitors. Due to Seles’ absence, Steffi Graf had more opportunities, which allowed her to strengthen her own competitiveness.
In situations where positional externalities are involved, people tend to behave in ways that improve their position. For example, if one competitor increases spending to improve performance, this affects the position of other competitors, who then also increase spending. In this competition, each competitor invests more resources to achieve better performance, which results in relatively greater rewards for individual efforts and investments. However, if all competitors repeatedly increase their spending to improve their position at the same time, the actual positions of the competitors are unlikely to change. And the greater the positional rewards for each competitor based on the relative performance of other competitors, the greater the incentive to invest.
When positional externalities exist, people competitively increase their investments to improve their performance. However, if the benefits of a competitor’s position are limited and the investment has little effect on each competitor’s position, the expenditure is likely to be wasteful. In such a situation, competition is an essential process for individuals, but from the perspective of society as a whole, it can lead to a waste of resources. This type of investment behavior is likened to an arms race and is called a “positional arms race.”
Positional arms race leads to economic inefficiency from the perspective of society as a whole, which stems from the difference between individual incentives and societal incentives. From an individual’s perspective, one’s own interests take precedence over the interests of society as a whole in all decision-making. In a capitalist society, if the outcome of competition contributes to society as a whole to some extent, it is desirable for all members to compete for their own interests.
However, if competition becomes excessive and no longer contributes to the interests of society as a whole, excessive investment for the benefit of individuals leads to inefficiency in the allocation of resources. Furthermore, when positional externalities between individuals are strong, the problem of inefficiency caused by unnecessary competition becomes even more serious from a social perspective. When society reaches the stage where it recognizes the seriousness of this problem, social norms that restrain competition emerge, or binding social agreements are established to restrict competition. Such norms and agreements play an important role in maintaining social stability and can contribute to increasing social efficiency by curbing excessive competition among individuals.
