I live in Asheville, North Carolina. Asheville is a major hub of craft beer production, something which I greatly enjoy. I like to go to the pizza place down the road from me, order a pizza to-go, sit at the bar, and try different brews on tap. Ordinarily, I do not pay too much attention to the bill. The prices for the beers are all uniform, and my pizza order doesn’t tend to vary much, so I know what the bill will be.
However, my last trip was different. As I was waiting for them to run my card, I was looking over the receipt they gave me and noticed a charge at the bottom for the pizza: “Take-out container fee.” I paid my tab and went home and did a little exploring. I wanted to see if this fee was something imposed by the city or county or just something the restaurant wanted to do to try to discourage food and take-out waste. Turns out, it was the latter: the restaurant imposed that fee to discourage people from using take-out containers that would just end up in landfills or as litter on the side of the road.
The pizza place’s actions demonstrate the economic solution to externalities. An externality is a cost imposed on individuals external to (i.e. not participating in) the commercial transaction. The solution is to get the people internal to (i.e. participating in) the commercial transaction to take into account these external costs. In technical terms, the solution is to have the externality internalized.
Most economics textbooks will discuss various government solutions for internalizing the externality: cap & trade, taxes, and regulation tend to be the most discussed. In his famous 1960 article The Problem of Social Cost, Ronald Coase pointed out that government solution need not be the only, or even primary, way to solve externalities. Coase pointed out that property rights developed so that people can negotiate and internalize the externality themselves in a similar manner to my story above. Coase did point out that transaction costs can prevent these negotiations from taking place, and that the government can act as a sort of “super-firm” to reduce the transaction costs. Many textbooks will touch on Coase, but then glibly dismiss him by saying some variation of “but transaction costs are high and thus government must step in.”
But are the transaction costs as high as one might think? The issue of transaction costs is usually just asserted, taken as self-evident, and rarely (if ever) proven. One thing that is generally not taken into consideration is a parallel set of virtues that developed along with property rights: social virtues (or the lessons we learn on how to live in a society).
Typical externality analysis assumes that the people internal to the transaction do not care about anyone but themselves; the candymaker and their patrons do not care that the noise from their machines prevents the doctor next door from being able to hear his patients (to use Coase’s example). But humans do not live in such a world. Adam Smith and other moral philosophers discuss at length how we learn and care about each other. We want to be both loved (i.e. we want people to like us) and be lovely (i.e. we want to deserve to be liked). Consequently, we take into account the external costs of our actions, at least to some extent. We want to be good neighbors, good stewards, good people. Even in the abstract, we take “other people” into account in our decision-making processes. I should note this point is not wholly original to me: I read James Buchanan’s discussion in Chapter 5 of Cost and Choice as laying the foundation of this point.
The pizza restaurant in Asheville is trying to do what they consider to be “the right thing.” And they are using economics to accomplish it. Their behavior, as well as the general moral sentiments we all exhibit, suggest to me that the transaction costs of internalizing an externality are not as large as interventionists assume. Consequently, discussions of taxes or other interventions are prima facie premature. Even in the face of highly complex issues such as global warming, we should not assume high transaction costs. Just as property and property rights evolved to solve the highly complex (and high transaction cost!) problem of dealing with other people, so too did other virtues develop to help deal with other externalities as well.
Pigouvian taxes are probably not the optimal (or even a welfare-improving) solution to externalities. Given moral sentiments and the already existing internalizing effects they develop, already existing implicit taxes, and public choice issues, taxation would likely be suboptimal. The burden of proof is on the interventionist to show that their solution would work, not merely assume that it would.
Jon Murphy received his PhD in economics from George Mason University and is an Instructor at Western Carolina University.
READER COMMENTS
Thomas Lee Hutcheson
Sep 12 2022 at 11:23am
The example of the restaurant is not very clear as an “externality” if the noisome dumpster is nearby.
But the main point is quite correct. In any estimate of the kind or amount of taxation/regulation that could be optimal for reducing an negative externality, would certainly need to account for any private actions that had already been undertake voluntarily as well as other existing taxes and regulations. In the presence of lots of suboptimal existing taxes and regulation (and in the case of CO2 emissions into the atmosphere, these suboptimal measures are growing), a shift to optimal taxation could be very low cost (conceivably negative cost) indeed.
Jon Murphy
Sep 12 2022 at 1:14pm
There are three assumptions here that need to be justified:
1: Why do you assume the current level of behavior changes is suboptimal?
2: Why do you assume taxation would be more optimal than what currently exists?
3: Why do you assume shifting to taxation would be low cost?
nobody.really
Sep 12 2022 at 3:10pm
Thanks to the many people who labor on this blog to help present economic lessons in tangible form; I appreciate it.
That said, at the risk of looking a gift horse in the mouth, I’m not sure this post presents the most compelling illustration.
Murphy indicates that this “take-out container fee” is new. What prompted it now? Theory 1: Take-out containers now cause some new level of harm. Theory 2: People are becoming more environmentally aware, and thus more sensitive to the old levels of harm. Theory 3: The vendor is coping with inflation.
The last time I bought a car, after agreeing on a price, the car dealer presented me with paperwork that included “processing fees.” I didn’t dispute that the dealer incurred costs related to processing—as well as costs related to property taxes, utilities, building maintenance, etc. But I rejected the idea that I should have to pay extra line item for each of these costs; I argued that those were his overhead costs, and he should have taken them into account when negotiating the price of the car. In short, these fees were simply an effort to pad his profit margin. The stated rationale was irrelevant.
Returning to Murphy’s post, I know of no new development that would increase of harm of using take-out containers. Perhaps people are becoming more environmentally sensitive, and thus more concerned about the adverse consequences of using take-out containers. But DEFINITELY we live in an inflationary period—and vendors everywhere are looking for ways to cut costs and/or raise prices. So perhaps the economic phenomenon being illustrated by this example is “price stickiness.” That is, this “take-out container fee” may be nothing more than a vendor’s effort to find a way to raise prices that is least likely to provoke consumer objections because the fee is 1) relatively inconspicuous and 2) clothed in the mantel of virtue-signaling.
Of course, the vendor’s motivation for charging the additional fee—the actual motivation and the stated motivation—may have no relevance to the fee’s power to motivate a change in consumer behavior. But after reviewing what little data we have—that is, Murphy’s own account—we observe that the fee has had the effect of padding the vendor’s profits, but not in altering consumption patterns. Draw what conclusions ye may.
Jon Murphy
Sep 12 2022 at 4:34pm
New to me. I just moved here a month ago. I just noticed it the other day. I have no idea how long it has been around.
Recall that the purpose of a fee for an externality is not necessarily to change behavior but to make the parties incorporate the external cost into their decision-making. If the consumer is on the margin, then the fee would change their behavior. But for me, I value the pizza higher than the fee. I just internalize the cost fully now.
Now, whether they are imposing the fee to pad profits or to respond to inflationary pressures, the result is the same: internalization of the externality. In my argument, I am making a “do the right thing” claim, but even if that claim is false the overall lesson holds: despite traditional textbook models, firms do face an incentive to try to internalize externalities.
nobody.really
Sep 12 2022 at 6:27pm
To clarify, I understand you to argue that SOME firms face SOME incentive to internalize externalities.
I guess we might find some benefit to reminding people of the complexity of human motivation. That said, we could also simplify the discussion by defining “externality” to refer only to consequences that befall third parties. These consequences would presumably already exclude those results that firms have remediated due to the incentives they face to remediate.
To say that you have “internalized the cost fully now,” I would think that you’d need to 1) measure the externality caused by using pizza boxes and 2) compare that cost to the fee assessed. As far as you’ve disclosed, you’ve merely chosen to pay whatever the vendor chose to charge. The relationship between the charge and the (alleged) externality is merely alleged by the vendor who has a self-interest in making the allegation.
The larger question: If the effort to internalize an externality merely results in a transfer of wealth from one private party to another, without any behavior change, does it internalize anything? Sure, if the policy results in transferring wealth to the harmed third party or his agent—a government, for example—then we might speculate that the transfer might generate some economic efficiency even if there’s no reduction in the quantity demanded. But how does a policy that merely transfers additional wealth from pizza consumers to pizza vendors remediate society for the (alleged) harm of using pizza boxes? If anything, this policy would seem to incentivize the pizza vendor’s behavior.
As far as I can tell, if the policy change does not motivate any behavior changes, then I conclude that it does not function to internalize an externality. It’s just a plain ‘ol price increase wearing a fancy hat.
Jon Murphy
Sep 12 2022 at 10:42pm
I will respond in detail tomorrow, but the short version to answer your objection is you are erroneously assuming I’m the marginal consumer of takeout. I’m not. That my behavior doesn’t change just indicates I value Friday night pizza higher than the price.
Jon Murphy
Sep 13 2022 at 10:13am
All firms and all consumers face the incentive to internalize externalities. The question is whether or not the benefits exceed the costs. The traditional argument is that the costs (typically transaction costs) almost always exceed the benefits and thus no internalization can occur without some sort of government intervention. My contribution is that the transaction costs may be much lower than is typically assumed because of our desire to “do the right thing.”
That is the definition of an externality. They are external costs that fall on third parties (some textbooks add that the externality requires compensation, but that’s not really necessary as almost no policy calls for compensation). In the case of the pizza place, the externality is litter or pollution from landfills.
Not necessarily as it would assume the optimal level of an externality is 0. That is not always (if ever) the case.
Just someone would have had to estimate the cost and taken action.
No. My demand for pizza is not perfectly inelastic. Indeed, given there are many pizza places in Asheville, my demand is very elastic. If they were to raise the price considerably, I could substitute away.
To make my story clearer: the pizza price did not change from one week to the next. I am just now noticing the breakdown.
He does have a self-interest, though perhaps (indeed unlikely) the one you assume. Again, given the number of substitutes around Asheville, the demand curve for this pizza place is likely quite elastic. That means he could not willy-nilly raise prices as customers could leave (note this holds true no matter how he chooses to advertise the cost increase). Indeed, if he is raising prices on certain customers and demand is relatively elastic, he is probably easting much of the cost!
Yes. It internalizes the cost. Now, it does not change my behavior, but it does change behavior on the margin of the marginal customer. I do not know exactly how things changed, but I do know that increasing the price of a complementary good (pizza box) will cause the demand of take-out pizza to fall. On the margin, people may substitute by eating in, eating takeout less, or something else. I am not a representative agent here. I am just some dude who likes a beer and a pizza and noticed something neat.
nobody.really
Sep 13 2022 at 1:32pm
Putting aside semantic quibbles, let me acknowledge that contribution and affirm that point.
That said….
Again putting aside semantic quibbles, I suspect firms/customers face these incentives only to the extent that they 1) know about the effect they’re having on others and 2) care about those effects. Vegans may regard the practice of eating eggs as imposing undue burdens on chickens and the chicks that might otherwise be born. But if don’t know where eggs come from, or simply don’t care about these consequences of egg production, I doubt that you’d face an incentive to internalize those consequences.
More specifically, what externalities result from pizza boxes—and who should we regard as generating that externality? MAYBE the restaurant charges the same price to dine-in and take-out customers, and this results in dine-in customers subsidizing the cost of the box for take-out customers. But there are so many differences between dining in and taking out—each method of dining generating its own set of social costs—that it would be difficult to make such a claim. Maybe the cost of table service/cleaning, etc. is being subsidized by the take-out customers; who knows?
Fine; we can use that definition.
Now we get to the semantic quibble.
We have not been discussing whether firms have an incentive to internalize externalities; rather, we have been discussing whether firms have an incentive to internalize potential consequences to third parties. To the extent that a firm internalizes any portion of those consequences, by definition, that portion does not qualify as an externality. The issue of “the optimal level of an externality” really doesn’t enter into it.
Again, I raise the issue merely to suggest that focusing on consequences to third parties makes the discussion simpler, because we can skip over the magnitude-of-mitigation issue.
Again, we can refine our definition of “externality” in this manner. But this still leaves the question of whether anyone HAS estimated the cost of the externality. I suggested the possibility that the vendor is NOT estimating the cost of any externality, but merely seeking to make a price increase more palatable to customers.
In any event, this refinement of the definition emphasizes the idea that the measure of externality is subjective: Different people would observe the same circumstances but assign different values to them, or draw different conclusions about causation.
1: Great—we now agree that, at least where there’s no effort to compensate the injured party, internalizing externalities must, at a minimum, change behavior.
2: That said, does even this suffice?
Imagine that it costs the pizza vendor $5 to make each pizza. You order 10 pizzas to go, and then take them without paying. This results in an externality imposed on the vendor of, say, $5 x 10 = $50 (wholesale). You then take the pizzas to a remote trail and sell them to hikers. You would normally sell each pizza for $10—but to internalize the externality you caused by stealing the pizzas, you sell them for $15.56. This price increase causes the quantity demanded to fall from 10 to 9—that is, you have to forego the sale of one pizza. (Fortuitously, the incremental charge of $5.56 per pizza x 9 pizzas sold = $50.04, thereby recovering the value of the externality.)
Would we say that your practice of increasing the price of the stolen pizza has offset the externality of stealing the pizzas? Somehow it seems to me that, unless there’s some plausible mechanism to compensate the harmed third party, this doesn’t qualify as internalizing the externality.
Maybe part of the subjectivity imbedded in the concept of externality includes the choice to mitigate externalities using the standard of either Pareto-efficiency or Kaldor-Hicks efficiency.
Jon Murphy
Sep 14 2022 at 7:58am
Agreed. Part of my point here is there are many socially built mechanisms that convey that knowledge and information.
The externality is litter/waste from the boxes. As to who is generating it, one of Coase’s big points in The Problem of Social Cost is that is an irrelevant question. It takes two to tango. An externality comes about from the interaction between parties. No single party generates an externality.
Those are two ways of saying the same thing. An externality is a cost faced by third parties.
Sure it does. That’s the whole point of internalizing an externality.
Obviously they have, thus the fee. The mere presence of the fee is an estimate.
While that is possible, it is highly unlikely for reasons I highlighted: the firm likely has limited market power to raise prices willy-nilly. And even if they could, the result is the same as if it was deliberately targeting the externality.
Again, we’re not redefining anything. We’re using the textbook definition. And yes, externalities are subjective since they are costs. Costs are subjective.
No. That is not an externality. It’s theft. Your example is built on a false premise.
vince
Sep 12 2022 at 6:17pm
” whether they are imposing the fee to pad profits or to respond to inflationary pressures, the result is the same: internalization of the externality.”
How is padding profits internalizing an externality?
nobody.really
Sep 12 2022 at 6:33pm
vince obviously has a wonderful economy with words, and beat me to the point.
Jon Murphy
Sep 12 2022 at 10:37pm
It’s internalizing the cost.
Jon Murphy
Sep 12 2022 at 10:45pm
To internalize the cost means that one or both parties involved in the transaction bear the full cost of the transaction, thus resulting in a higher price. If the increased costs are paid entirely by the consumer, the firm’s profits would rise in the short run.
vince
Sep 13 2022 at 2:43pm
The pizza vendor pays for the container. That cost of the container gets into the price somehow, whether separately stated or not. I don’t see the connection with externality, other than lowering takeout consumption in general.
Besides the additional cost for takeout, the vendor has other motives to raise the price. One is to encourage dinining in, which provides extra profit from the purchase of other items such as beer. Another is that it gives the owner status as an employer, for example of waiters. Another is that it might increase profit even at lower volume.
Stating that the purpose of the fee is to reduce trash may or may not be the true motive, but it sure makes for good PR.
Jon Murphy
Sep 14 2022 at 8:01am
The cost of the container not the externality. The externality is the litter/waste caused from disposing of the box.
And the consumer has the incentive to not pay higher prices. Supply and demand form prices, not just supply.
vince
Sep 14 2022 at 4:01pm
Why assume the fee for the container is for litter and not for sometheing else, for example the cost of the container?
Jon Murphy
Sep 14 2022 at 5:21pm
It’s irrelevant. The increased cost internalizes the externality.
Jon Murphy
Sep 14 2022 at 5:22pm
Any tax on an externality is not a tax on the externality, per se. A carbon tax falls on the producer. The supply curve shifts to the left, and the price of the good produced rises. Same thing going on here.
vince
Sep 14 2022 at 6:04pm
The price increase may have been (likely was?) implemented with no concern about externality. You presume the price increase is a private solution to a public externality. You ignore that consumers might respond to the price (profit?) increase by purchasing takeout from a competitor, who didn’t raise the price, and continue to toss empty containers in the road, just as before. Litter is unchanged. Anyway, we can agree to disagree, and you can have the last word.
Maniel
Sep 12 2022 at 6:51pm
Dr. Murphy,
Thank you for the thought-provoking post. By virtue of time travel – I am an alumnus of Asheville High School (known in my time as “Lee H. Edwards” HS) now living in San Diego – I take the liberty of buying a pizza like your own, but without the take-out container. I expect to pay less than you did since I expect that no fee will be added for a container. Moreover, I infer that, although you are relatively new to Asheville, and because the pizza restaurant owner wants your business, does not want to appear to overcharge you, and has no firsthand knowledge of your view on landfills, he is merely trying to recoup his own cost of procuring, storing, itemizing, and handling take-out containers.
I agree with you that, as Bastiat explained to us long ago, Pigouvian taxes are rarely optimal since it is only with the greatest difficulty that the payer of any taxes is able to “follow the money.” In the case at hand, could our owner simply be doing good by doing well?
BTW, off topic, but have you read Look Homeward Angel?
Richard W Fulmer
Sep 12 2022 at 8:01pm
Is the “fee” actually a tax that Asheville will use to hire people to pick up litter?
Jon Murphy
Sep 14 2022 at 8:05am
That was my initial thought, but I did some research and neither the city, county, nor state have such a tax.
Knut P. Heen
Sep 13 2022 at 5:59am
In Norway, the government has done exactly the opposite. If you eat at the pizza place, it is defined as a service. If you bring the pizza out, it is defined as food. The sales tax on services are 25 percent. The sales tax on food is 15 percent.
Why? Almost twenty years ago, the farmers wanted lower taxes on food to support the prime minister.
Political trades also lead to negative externalities, and you never see them cleaning up their mess.
Walter Boggs
Sep 13 2022 at 12:49pm
As a SC native, your use of the term “pizza place” confirms that you really do live in the deep South. I never heard the word “pizzeria” until I moved way up north to Tennessee.
robc
Sep 13 2022 at 3:52pm
There are at least 3 places with the word “pizzeria” in their name in Mt Pleasant, SC.
I am sure there are others in the state. I checked it because I lived in MtP for a short while.
Walter Boggs
Sep 13 2022 at 9:25pm
I left the state in 1978. There were no pizzerias then.
Jon Murphy
Sep 14 2022 at 8:04am
To Walter’s point, that change could simply be as more of us Yanks have gone South, we have taken our words with us.
robc
Sep 14 2022 at 10:32am
My neighborhood in MtP was about 50% Yankee transplants, so possible.
Jon Murphy
Sep 14 2022 at 8:04am
Oh? I grew up in Massachusetts and spent most of my life in New England. I’ve always used the term “pizza place.”
Mark Brady
Sep 13 2022 at 8:48pm
“The pizza place’s actions demonstrate the economic solution to externalities. An externality is a cost imposed on individuals external to (i.e. not participating in) the commercial transaction. The solution is to get the people internal to (i.e. participating in) the commercial transaction to take into account these external costs. In technical terms, the solution is to have the externality internalized.”
I was surprised that Jon does not begin with an acknowledgement that externalities can be positive as well as negative. Indeed, Bryan Caplan recognizes that in the first paragraph of the entry on externalities to which Jon links. If we consider an example of a positive externality which firms try to capture, might it help us understand the issues involved in the example of a negative externality that Jon discusses in his post.
Jon Murphy
Sep 14 2022 at 8:02am
Externalities can be positive or negative, of course. But this story was about negative externalities. I didn’t want to introduce irrelevant content that would muddy the waters.
Mark Brady
Sep 15 2022 at 11:05pm
I understand why you did not choose to explore the topic of positive externalities, but I believe it is important to acknowledge that externalities can be either positive and negative–if only for those readers unfamiliar with the topic.
I would add that an event can simultaneously generate both negative and positive externalities. The example I give in class is smoky pollution that is regarded as a negative externality for those who live nearby and inhale the smoke but as a positive externality for those who live further away and admire the extra glow of the sunrises and sunsets.
Grand Rapids Mike
Sep 14 2022 at 10:06pm
Another example is that back in time, the paper companies in Kalamazoo, Michigan had to pay a fee for the waste water they sent to the main city water treatment plant. The fee was based on the pulluted content of the pulluted water. To reduce the cost for the paper companies they combined their effluent and conducted primary and secondary stages. The city made the final tertiary process. As a result, the total treatment cost was reduced.
Pierre Lemieux
Sep 15 2022 at 12:44pm
Jon: Yet, in a Great Society (to use Hayek’s term for an impersonal, non-tribal order), we cannot but “economize on love,” as Dennis Robertson said. Perhaps some rules develop leading us to behave like “good citizens” or, more exactly, good neighbors. I am not persuaded how and why such rules would regulate commercial-pizza containers. And what about rules protecting the jobs of garbage collectors?
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