“Externalities”: Handle with Great Care
By Pierre Lemieux
The economic concept of externalities has been used to explain or justify all sorts of government interventions. For example, Tyler Cowen suggests that rich old individuals who spend on health care to postpone their deaths are imposing externalities on their heirs. (Tyler qualifies by adding “at least according to economic standards,” but this only reinforces a suspicion that these mainstream economic standards are irrelevant for public policy.) A commenter to a recent post of mine argued that murders committed with guns are an externality of the Second Amendment. Many other such examples exist and the sky is the limit.
The standard definition of externalities in mainstream economics does support such overreach. In the New Palgrave Dictionary of Economics (1987), Jean-Jacques Laffont defined an externality as an indirect effect of a consumption activity or a production activity on third parties which can be either consumers or producers—where “indirect” means that the effect does “not work through the price system.”
The late E.J. Mishan of the London School of Economics, a well-known welfare economist and expert in cost-benefit analysis, noted that a consumption externality can arise “from an awareness of what is happening to others” (emphasis in original; see his Introduction to Normative Economics, Oxford University Press, 1981, p. 135). This makes sense because a consistent definition of the externalities requires to include consumption externalities as well as production externalities. The smoke of your neighbor’s fireplace can dirty the clothes on your clothesline as much as the smoke from a distant factory. The photons deflected to your atheist neighbor’s windows by the cross erected on your property are physical pollution as much as smoke.
A caricature, but not much exaggerated, of today’s concept of externality looks as follows. If I don’t like what you do, that’s an externality you impose on me. And if you don’t like that I don’t like it, it is also an externality I impose on you. Thus, the government has to decide—perhaps by putting its bureaucrats to work on some cost-benefit analysis—who will be imposing an externality on whom, with which citizens and against which other citizens the state will take sides.
The justification of government intervention to correct externalities with the help of cost-benefit analyses–having some pay the costs of others’ benefits–is not easy to defend. This sort of justification often looks like voodoo policy or state levitation. It is seriously damaged by Anthony de Jasay’s theory of the state:
The long and short of it is that objective and procedurally defined interpersonal comparisons of utility… are merely a roundabout route all the way back to the irreducible arbitrariness to be exercised by authority… [T]he two statements “the state found that increasing group P’s utility and decreasing that of group R would result in a net increase of utility,” and “the state chose to favor group P over group R” are descriptions of the same reality [emphasis in original].
Instead of normative and nearly magic justifications, de Jasay focuses on the real, positive reason for any government intervention :
Wen the state cannot please everybody, it will choose whom it had better please.
That is, it will reward its supporters with privileges in return for their support. The government very legally buys votes.
Even if one does not go as far as de Jasay (but reserve your judgment until you read his masterpiece, The State), there are many reasons to challenge the mainstream concept of externalities and its justification for government intervention. A good summary of these reasons is given in Donald J. Boudreaux and Roger Meiners, “Externality: Origins and Classifications,” Natural Resources Journal 59:1 (2019). I will review the whole issue in a forthcoming issue of Regulation. My paper “Public Health Models and Related Government Interventions: A Primer” (Reason Foundation, March 2021) offers some criticisms of the standard externality argument in the context of epidemics.