The Threat of Externalities: The concept and its underlying theory have problems that policymakers often ignore.

• Author: Lemieux, Pierre

Externality is a well-known concept in academic journals of economics and law as well as among government bureaucrats and consultants. In a nutshell, an externality is a spillover cost that is not compensated or a spillover benefit that is not paid for. The existence of externalities (once called "external effects") is often used to justify government intervention to either diminish the spillover costs or increase the spillover benefits.

The nature of externality is not well understood by the general public and intelligent laymen. Even policymakers and non-specialized scholars are often confused as they think through the concept. As we will see, the theory behind externalities is shakier than is generally recognized.

AN IDEALIZED ECONOMY

Standard (neoclassical) economic theory suggests that if externalities did not exist, free and perfectly competitive markets would be sufficient for economic efficiency and maximizing "social welfare." Economic efficiency has a more precise definition in terms of "Pareto optimality," after Italian economist Vilfredo Pareto (1848-1923). Pareto optimality means that the economic system is so efficient that there is no way to increase the utility of one person without reducing the utility of someone else. (Remember that in modern economics, "utility" refers to subjectively preferred situations.) In other terms, net social benefits, which are the "sum" of net private benefits, are maximized because every individual strives to maximize his own private benefits.

Externalities, it is argued, prevent the realization of this happy world. The concept of externality goes back to A.C. Pigou's book The Economics of Welfare (1920 for the 4th edition). The British economist theorized that some economic activities carry a social cost greater than their private cost. Today, the main example would be pollution. Other activities, such as creating or maintaining private parks (an example used by Pigou) or other neighborhood amenities, have social benefits greater than their private benefits. We thus have, respectively, negative and positive externalities.

Externality is a major form of market failure. The market fails because some costs or benefits are not "internalized" (taken into account) by their originators, who do not pay those costs or are not compensated for those benefits. To solve this problem, Pigou proposed to tax negative externalities (a "Pigovian tax"), which would force a reduction in the originating activity, thereby reducing social cost. Inversely, he would subsidize activities generating positive externalities, thereby increasing their level and increasing social benefits.

In the New Palgrave Dictionary of Economics, Jean-Jacques Laffont gives a formal definition of what is today considered an externality: an indirect effect of a consumption activity or a production activity on third parties, where "indirect" means that the effect does "not work through the price system." To repeat: an externality is a spillover, either good or bad for its receiver, that is not compensated or paid for, and thus not internalized by private actions.

Pollution, defined as the unwelcomed projection of physical objects on somebody else's property, is a form of negative externality. For example, a papermill discharges chemicals into a river and thus reduces the production of services (swimming, fishing, canoeing) offered by a resort hotel downstream. For a positive externality, think of a nice house and lawn that (like Pigou's private parks) make the neighborhood more enjoyable for neighbors. Note that the direct effect in this last case is from consumer to consumer.

MARKET SOLUTIONS TO EXTERNALITIES

The first problem with this standard theory of externalities is that they can often be solved through private bargaining and trade of the relevant property rights, which means the market can internalize them. This idea, which is commonly called the Coase Theorem, was demonstrated in a famous 1960 article by Ronald Coase, who later won a Nobel economics prize. (See "The Power of Exchange," Winter 2013-2014.)

Take the above example of the papermill and the hotel. Assume that property rights on the river are well-defined: it is clear who has the right to the river water. Assume also that the emitter and the receiver of the pollution externality are in a position to exchange--that is, to make mutually beneficial deals with one another. We will distinguish four possible cases, as shown in Table 1.

In Quadrant I of Table 1, the hotel owns the property right to the river water. We further assume that the conditions of market demand and production imply that the hotel can create the most value, measured by its value added, which is equivalent to its profits. Assume that without pollution from the papermill, the hotel can sell its services for a profit of $5 million a year, while it would only earn $2 million with a polluted river. Assume that the papermill only creates a value of $1 million. It follows that the papermill will not be able to buy the right to pollute the hotel because it would have to pay the equivalent of at least $3 million a year. So, only the hotel will operate after it enjoins the papermill from polluting the river. (For now, it is assumed that there is no economical way for the papermill to clean its effluent.)

Quadrant II shifts the property right to the papermill, which becomes free to discharge effluents into its river. It is in the interests of the hotel to offer up to $3 million per year to incentivize the papermill to stop production. Suppose the price of this side-payment is negotiated at $2 million. The papermill owners accept because they make more profit by selling their input (the clean water) than they would earn producing paper. The hotel earns less profit, but still more than if it were polluted by the papermill. Despite its initial locus, the property right has been exchanged. It is still the producer who produces the most value--the hotel--that operates without any pollution or externality.

Note that the profit numbers in Table 1 include those from the sale of the input "river water" whenever this transaction occurs (in Quadrants II and III). In Quadrant II, the papermill does not operate; its owners make their profits by selling their right to pollute.

This sort of bargaining happens in the real world. Outside the externality framework proper, companies often sell themselves to a competitor because the latter, being more efficient, offers shareholders of the former more than they can make from their own company. Even more often, companies poach employees from their competitors because the poachers can use the talents more profitably and thus offer the employees an enticing remuneration. Companies occasionally sell brand names. Pieces of land are purchased by the most efficient users; so are licenses to use frequencies on the electromagnetic spectrum, an idea directly influenced by Coase. More generally, the price of any input--say steel--is bid up on the market (which is a continuous and invisible auction) until only the buyers who value it enough get it.

Within the externality-pollution framework, businesses pay waste disposal companies in exchange for accepting their waste. Last December in Detroit, Marathon Petroleum offered to purchase a patch of neighboring residential properties that could be adversely affected by the expansion of its refinery; nobody would be forced to sell, but the purchase would create a pollution buffer (DBusiness Magazine, December 18, 2020). Manufacturers generally buy pieces of land large enough to create some buffers around their factories. Oil and gas producers buy the right to use the land where they install their rigs. And so forth.

Conservation organizations often purchase pieces of land or easements...