“Externalities”: Handle with Great Care
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.
Thomas Lee Hutcheson
May 10 2021 at 7:28am
I agree with many of your criticism of “externalities” as a reason for government interventions in the market. The problem is, the “correct” way, the “great care” of dealing with an externality, in your view, is not clear.
The smoke from your fire and your neighbor’s clothes can be handled by face to face negotiation to discover if there is a change in ether the clothes hanging or fire building activities that is cost effective and a financial transaction carried out to induce that change.
But how do the multiple owners of clothes lines negotiate with the distant factory? A successful class action suit or political movement resulting in a court ruling or an administrative regulation that imposes a net cost-reducing action on the factory owner (whether a change in factory operations or a settled induced change in clothes hanging operations) or their failure that imposes the action on the close-line owners are both dependent on state interventions.
You may notice a familiar complaint here. I agree with many, almost all, negative judgements of state action that I find on this site — “lockdowns impose costs, minimum wages cause unemployment — but I do not usually find advocacy of the better alternative.
May 10 2021 at 9:44am
Order of externality fixes, from best to least bad – you only move down the list if the one above doesn’t work:
Do nothing (this works surprisingly often – costs of the solutions below are often greater than the benefits)
You tend to want to skip to step 3 without first trying 1 and 2.
Thomas Lee Hutcheson
May 11 2021 at 9:50am
I just want to know how Coasian bargaining works at scale. How do we bargain about net CO2 emissions. [We’ve already tried doing nothing.]
May 11 2021 at 11:05am
And doing nothing is working.
May 11 2021 at 10:36pm
… and the costs of “the solutions below” are being greater than the benefits …
… and the benefits much smaller than the benefits of actions with lower costs …
May 10 2021 at 11:22am
@Thomas: Thanks for your reminder. Note however that the transaction costs you invoke are very similar to transportation costs: it would be nice if they did not exist but they do and when an action has higher costs than benefits, it is efficient for the actor not to engage in that action. An alternative way of looking at this problem is that government action will often if not generally involve transaction costs (including coercion) greater than transaction costs on the market, so government intervention is not necessarily a solution to the existence of an externality. Dahlman’s paper cited by Jon above is a must-read on that topic.
May 10 2021 at 12:16pm
There are times when advocacy of a better alternative or replacement is something you should expect, but not always. It depends on the substance of the objection. Take, for example, medicine. Suppose someone is receiving a treatment for some medical condition. The treatment is effectively helping the initial condition, but is also coming with some unpleasant side effects. In such a situation, it’s pretty reasonable to say that the side effect themselves are not a good reason to stop the treatment, unless there is a better treatment available with fewer side effects.
But there can also be cases where a treatment produces side effects while failing to help the condition it was meant to treat, or when a treatment can cause side effect which are worse than the initial condition – the proverbial case of the treatment being worse than the disease. It these cases, you don’t need to suggest any “better alternatives” in order to advocate stopping the treatment. That would be a very odd thing to insist on! I mean, by all means continue searching for a better treatment or intervention, but you don’t need to continue harming the patient in the meantime! Stopping the treatment is a justified move here all on its own.
Many (most?) of the criticisms of interventions on this blog are of that second sort – the usual criticism isn’t merely that they have downsides, but that they fail the cost-benefit test, which is just a way of saying they do more harm than good. And if a policy is doing more harm than good, you don’t need to find a more effective replacement policy before you can advocate repealing it, just like if a medical treatment is doing more harm than good you don’t need to continue harming the patient until you find a more effective treatment to replace it with.
May 10 2021 at 12:59pm
True, or that the intervention doesn’t do what it was supposed to do in the first place.
But I see this post as part of a third category: definition. Is there even an externality here? He must be careful in defining them.
In this third category, the demanding of an alternative is even weirder. We’re at the diagnosis stage; discussing treatments is premature. It’s like the following scenerio:
Doctor 1: We need to put the patient on chemo! They have cancer!
Doctor 2: What evidence do we have that they have cancer?
Doctor 1: I agree we shouldn’t use chemo willy-nilly, but what alternative treatment do you suggest?!
It should be obvious that Doctor 1’s response is something of a non-sequitur.
May 10 2021 at 9:20am
Good stuff as always, Pierre.
Something that I think is worth emphasizing from your post is how squishy an externality can be. If we stick with the pretty standard definition, an externality is a cost (or benefit) imposed on an outside party without their consent. This definition seems straightforward, but can get tricky fast.
The key part of an understanding of “externality” is the word “cost.” Cost is “the best alternative you otherwise would have chosen” (Universal Economics, Alchian & Allen, pg. 33). Cost is tied to an action.
But there is also the consequence of an action. A consequence is part of an action, not the result of an action (pg. 34).
To use A&A’s example, studying results in eyestrain. Eyestrain is a consequence, not a cost of, studying. The cost of studying is what else you would have done with your time. So, it would be more complete to say “studying and getting eyestrain has the cost off going for a walk [or whatever the alternative would have been].”
So, what does this mean for externalities? Not everything negative (or positive) is a cost (benefit), and thus not an externality. The circumstances and expectations one finds oneself in matters.
Let’s use Pierre’s classic example: the smoke from the factory dirtying a clothesline. Is this an externality? Well, it depends. Let’s look at two cases.
Scenario A: A person builds a house with a clothesline in an open field. Some time later, a factory opens up some miles away and creates soot that dirties the clothes.
Scenario B: A factory exists and is blenching smoke. A person buys a house in the area.
In Scenario A, I’d argue there is a cost, and thus an externality.* The cost is borne by the homeowner in the form of reduced utility from their property.
In Scenario B, I’d argue there is no cost, but rather a consequence. The person bought the property knowing (or should have known) the factory produced smoke that would dirty laundry.
There is a tendency among both students of economics and economists to confuse the two scenarios. And, initially, they appear identical: a factory is belching smoke and dirtying the laundry. But they are very different beasts. Without understanding the process by which the order emerges, we cannot make a claim about externality. What appears as a classic externality may not be at all; the costs may be fully internalized in the form of lower property values or other outcomes.
I argue that this insight is a key part of Coase’s famous 1960 paper that a lot of people do not understand (Alchian is not one of them as my discussion here he already advanced. See page 150 of A&A). The Coasian bargaining may not be explicit, just like bargaining on price in a market may not be explicit. Costs are internalized, become expectations, and consequences take over.
*Whether or not there is a Pareto-relevant market failure is a different matter. See Carl Dahlman’s 1979 paper The Problem of Externality.
May 11 2021 at 4:54am
That is an interesting train of thought. Two questions about that.
Why not say it is the cost of studing not (!) to have eyestrain. Or the consequence of studying not to be outside. Sure, you don’t normally say that. But what speaks against it?
And the second point. The two scenarios A and B give a sequence (whoever comes first is right) a certain moral / legal value. Why should this rating be generalized?
How and why is the internalization in the price system indicated by those considerations ?
May 11 2021 at 8:48am
Eyestrain is part of the act, not part of the choice.
May 11 2021 at 6:26pm
Jens: If I partly understand your second point, my answer to Thomas Hutcheson below may be relevant.
May 11 2021 at 6:47am
Jon, good stuff. Maybe I’m picking a nit here, but is there not an opportunity cost, however small, to scenario B consequence of dirty laundry? To wit, the time and cost of washing those dirty clothes instead of going for a walk or watching television.
May 11 2021 at 8:49am
I’d not say that’s a nitpick. That’s an important question.
There is a cost to washing the laundry for B. But the point is that cost is “reimbursed” to B through the lower rent
Thomas Lee Hutcheson
May 11 2021 at 10:04am
But even in the case of the house coming second and the factory smoke being a know feature of the site the same issue exists. What is the better solution, the house owner manages the clothes hanging activity to mitigate the damage from the smoke or the factory manages the smoke emission to mitigate the damage. Coasian bargaining, court cases and regulation are all ways to reduce the harm from smoked clothes.
May 11 2021 at 6:22pm
Thomas: Two points. First, the homeowner who arrives second–in legal terms, he “comes to the nuisance”–is automatically compensated through the lower price of his land and house. So there is no externality.
Second, the problem with regulatory interventions (or laws that produce litigation) is that they require the government to know all production functions and all utility functions. As Buchanan wrote in a 1962 Economica article (“Politics, Policy, and the Pigovian Margins”),
The Dahlman article cited by Jon, “The Problem of Externality,” Journal of Law and Economics 22:1 (1979), is also useful in this respect.
May 10 2021 at 9:50am
Might the argument for “safe spaces” in campus and other settings be anchored in this expansive application of externalities?
May 10 2021 at 11:05am
Bill: Interesting question. The answer, I think, is yes for public universities. In private universities, property rights would normally solve any externality problem. In public universities, the argument would go this way: Students who, by their actions (say, expressing opinions others don’t like or manspreading or committing “microaggressions” or whatever), incidentally create a feeling of unsafeness for other students and thus submit them to negative externalities.
But note that the safe places also create unease for those who don’t like them or feel that they diminish their educational experience; consequently, the safe places generate an externality in the other directions. We encounter here an important idea developed by the critics of the mainstream conception of externalities: externalities are reciprocal, they are generated as much by the receivers as by the emitters. If they were no atheist to look at my photon-reflecting cross, there would be no externality. Government intervention in favor of one side or the other just reflects “the irreducible arbitrariness to be exercised by authority,” as de Jasay would say.
May 10 2021 at 3:47pm
People typically speak of negative externalities when discussing externalities. But just a reminder there are positive externalities as well. You buy a house because it has electricity, access to sewers, closeby to a grocery store, a school…..of course one can be too close to these things which is why we make sure they are in the Professor’s back yard. NiMBY!
May 10 2021 at 3:54pm
Those aren’t positive externalities. Not everything bad is a cost and not everything good is a benefit. This is the constant problem that infects discussions of externality
May 10 2021 at 6:36pm
@Jon (and Craig): Indeed, a positive externality is something you do not pay for and which is not intentionally directed at you. My Regulation article will give a general overview which will cover this sort of issue.
May 10 2021 at 5:55pm
Un premier achète une maison dans un champs et quelques années après la ville construit une autoroute: sa ma maison perd de la valeur.
Son voisin a acheté sa maison alors que l’autoroute est construite: il a payé moins cher cette maison pcq’il y avait du bruit.
C’est la même externalité et les deux voisins font « cause commune » pour se faire compenser par la ville. Dans ce cas, est-ce vraiment la nature de l’externalité qui est importante?
May 10 2021 at 10:41pm
@Pierre: Boudreaux and Meiners discuss similar cases and (persuasively) argue that externalities that have been compensated by lower asset prices are not externalities, for the very reason that they have been compensated.
May 10 2021 at 6:57pm
Your expensive car is a negative externality on other drivers, especially the poor. It causes their insurance to go up. It seems to me that once one starts looking for negative externalities, there will be no end of them. Much like the woke culture looking for discrimination, which is everywhere if one looks hard enough and expands the definitions.
May 10 2021 at 8:23pm
While I don’t understand how one’s having an expensive car causes other’s auto insurance premiums to rise, more generally, it’s important to distinguish between pecuniary and technical externalities.
May 10 2021 at 10:38pm
@Bill: The distinction is important and it is what Laffont and the standard definition mean by saying that an externality does “not work through the price system.” Another example: if I invent a new hula hoop, consumers jump on them (as it were), and your hula hoop factory goes bankrupt, this is a pecuniary externality that works through the price system and it does not count as a real (“technological”) externality. (Laffont however argues that some pecuniary externalities should count, showing the malleability of the concept!)
May 11 2021 at 11:20am
Buying more tomatoes (or more insurance coverage) will yield an increase in tomato prices, albeit infinitesimal after one individual does it. It is not a real (“technological”) externality because it goes through the price system; it is merely a pecuniary “externality.” See also my hula hoop example above.
May 11 2021 at 4:02am
If I damage your expensive car, it will cost my insurance company far more to fix than if I damage your cheap car. So my rates go up.
May 11 2021 at 8:53am
So if the penalty for damaging (or stealing?) an expensive property were greater than the penalty for damaging a less expensive property, this difference would represent an external cost borne by the perpetrator of the damage?
May 11 2021 at 3:24pm
If anyone damages your car my insurance rates go up. It’s not just the one that does the damage. In some cases it prevents poorer people from having a car as they can’t afford insurance to operate it. Which in turn causes many to drive without it.
Thomas Lee Hutcheson
May 12 2021 at 12:24pm
No. Your purchasing an expensive car raises the cost of accidents (through their insurance rates) to other drivers. But that is price-mediated effect, not an externality.
May 11 2021 at 12:07pm
One notion not yet mentioned here is “political externality.” I find it ironic that advocates of government action aimed at internalizing externalities do so with no recognition/acknowledgement that many government actions involve political externalities BY DESIGN, i.e., seek to provide benefits to the Joneses at the expense of the Smiths.
May 11 2021 at 6:08pm
Bill: “Externalities by design” are usually not considered as externalities because then virtually any cost would be an externality. (I charge $3.00 to purchase my widget: externality!) Externalities, even in the broad mainstream sense, are the unintentional by-products of a legitimate activity. (More of this in my forthcoming Regulation article.) What you call “political externality” seems to be simply the cost imposed by the government on some citizens in order to benefit other citizens.
We can think of “political externalities,” though. There, you are right. Anything that the government does to help some people and that happens to unintentionally hurt some other people would be a negative externality. Increasing the risk of tyranny would be one such externality.
May 11 2021 at 8:02pm
An example I had in mind was eminent domain. I take your point to be that when government uses eminent domain to knowingly plunder a property right, the damage is not unintentional, and, therefore, not an externality?
May 11 2021 at 9:04pm
Bill: Indeed. Theft, for example, is not an externality (even in the mainstream wide concept). The only externality involved there might be the fear of being a victim when thefts are frequent. But then, you could also say that his fear is a negative externality imposed on the thieves, who know that it will lead potential victims to better protect their property! Caught in this proliferation of externalities, many economists would restrain them to spillover costs unintentionally imposed on others in the process of pursuing a legitimate activity. The appeal to legitimacy further blurs the concept of externality, which is as much a moral or legal concept as an economic concept.
Thomas Lee Hutcheson
May 12 2021 at 12:14pm
Eminent domain is a kind of collective action problem, how to distribute of the surplus generated by a public investment, not an externality.
I suspect most of the real life eminent domain issues arise when the public investment does not generate a surplus and eminent domain results in redistributing some of the loss to the original land owner.
May 11 2021 at 8:11pm
May 11 2021 at 8:17pm
The worst example I can think of, is an economist by training (to add insult to injury) defending rent control because some people being price out of the rental market was an “externality”.
Comments are closed.