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.