CHAPTER 15 One Man Gathers What Another Man Spills ON EXTERNALITIES, POSITIVE AND NEGATIVE THE THEORY OF EXTERNALITIES

BRITISH ECONOMIST A.C. Pigou was instrumental in developing the theory of externalities. The theory examines cases where some of the costs or benefits of activities “spill over” onto third parties. When it is a cost that is imposed on third parties, it is called a negative externality. When third parties benefit from an activity in which they are not directly involved, the benefit is called a positive externality. The study of externalities, a part of welfare economics, has been an active area of research since Pigou’s efforts early in the twentieth century.

There are standard examples that illustrate each type of externality. Pollution is a typical case of negative externality. Let’s say I operate a factory along a river, making foozle dolls. As a by-product of my manufacturing, I dump lots of foozle waste into the river. That imposes a terrible cost on the people downriver, because, as everyone knows, foozle waste stinks to high heaven. If neither my customers nor I have to pay that cost, our choice as to how many foozle dolls should be made will be, in a sense, incorrect. If I had to pay those costs, I would have chosen a smaller number of dolls. Instead, I chose to produce “too many” dolls while the people downriver are forced to foot the bill for part of my activity.

Pigou recommended taxing activities that produce negative externalities. Emission taxes on factories are an example of his approach. Another common policy adopted has been to regulate the amount of the activity legally permitted, for example, laws that forbid loud parties after a particular time of night.

A positive externality will arise when some of the benefits of an activity are reaped by those not directly involved. A typical example would be improving the appearance of one’s property. If I paint my house, not only do I benefit, but so as well do all of my neighbors, who now have a nicer view. When such a positive externality exists, it can be contended that I will produce “too little” of the activity in question, since I don’t take into account the benefits to my neighbors.

The traditional policy responses to positive externalities have been for the state to subsidize or require the activities in question. For example, the U.S. government subsidizes research into alternate energy sources. Primary education, often said to have positive externalities such as producing informed citizens, is mandatory (as well as subsidized) in most countries.

Lionel Robbins challenged Pigou’s analysis in the 1930s. Robbins pointed out that, since utility is not measurable, it is invalid to compare levels of utility between different people, as Pigou’s theory required. Robbins recommended using the criterion of Pareto improvement, which we met in Chapter 11, as the basis of welfare economics. A policy had to make at least one person better off (in that person’s own estimation) and none worse off before economists could say it was unambiguously better. But Robbins held that if we just assume people have an equal capacity for satisfaction, economists still can recommend certain state interventions.

The notion of justifying economic intervention on the basis of welfare analysis was dealt a severe blow in 1956, with the publication of Murray Rothbard’s paper, “Toward a Reconstruction of Utility and Welfare Economics.” Rothbard showed that it is only through preference demonstrated in action that we can gauge what actors really value, and that to try to deduce values from mathematical formulas, without the evidence of action, is a hopeless cause. Only when people demonstrate their preferences by exchanging can we say with any certainty that both parties felt that they would be better off in the subsequent state than in the prior one. Since Pigou’s solution involves imposing taxes and subsidies by fiat, without voluntary exchange, the numbers it relies on are mere guesswork.

Nobel Prize-winner Ronald Coase further undermined interventionist welfare analysis with the publication of his paper, “The Problem of Social Cost,” in 1960. Coase demonstrated that as long as property rights are clearly defined and transaction costs are low, the individuals involved in a situation can always negotiate a solution that internalizes any externality. Consider the case of river pollution from the foozle factory, which we noted above. If the people downriver from the factory have a property right in the river, the factory will have to negotiate with them in order to legally discharge waste through their property. We can’t say what solution the participants might arrive at—the factory might shut down, the people downriver might be paid to move, the factory might install pollution control devices, or it might simply compensate those affected for suffering the pollution. What we can say is that, within a system of voluntary exchange, each party has demonstrated that it prefers the solution arrived at to the situation that existed before their negotiations. (After all, either party can maintain the status quo by refusing to negotiate.)

Furthermore, we should note that negotiating between the parties affected allows them to use the “particular circumstances of time and place,” with which they alone are familiar, to arrive at a solution. The factory owner may be aware of an alternative foozle input that does not pollute the river. The people downriver might know that the river is stinky anyway, and it’s best to move. Regulators generally cannot take such specific knowledge into account in their drafting of edicts.

If transactions costs are high, it may be difficult to negotiate a solution. In those cases, the best solution again is to have clear property rights. For instance, it is hard for a factory creating air pollution that spreads over a wide area to negotiate with each person affected. In such a case, we might want to define property rights so that each person has a right to be free of airborne pollutants that exceed a certain level on his property.

Case studies have illustrated the resourcefulness of voluntary exchange in accounting for potential externalities. A common example of a positive externality in economics was the production of fruit trees and beekeeping. The growers of fruit trees provide a benefit to beekeepers: flowers. And beekeepers provide a benefit to the growers: pollination. However, the standard analysis contended that neither party had an incentive to take account of the benefit to the other. Thus, there would be “too few” orchards and beekeepers. However, economist Steven Cheung studied those markets and found that the parties involved had accounted for the externalities quite well, through contracting with each other to raise production to preferable levels. As Cheung pointed out, previous economists had only to look in the Yellow Pages to find “pollination services,” rather than simply assuming that the market had failed.

Social pressure also plays a role in handling potential externalities. If I don’t paint my house, my neighbors will start to grouse. I may not get invited to the next block party. Hayek contends that those who value liberty should prefer social pressure directed against “deviant” behavior to outright bans. (“Deviant,” in our case, meaning simply behavior of which many people disapprove, but which does not violate anyone else’s right to life or property.) If I highly value having a house painted mauve, I can ignore my neighbors’ mocking glances and jeers. But if the government regulates house colors, I’m stuck.

Loyola University economist Walter Block has continued work on externalities in the tradition of Rothbard. Block has challenged the traditional distinction between public goods, which must be produced collectively because of the positive externalities they create, and private goods, the production of which may be left to the market. The proposed list of public goods has included such items as postal delivery, roads, schools, garbage pickup, parks, airports, libraries, museums, and so on—just think of the activities your city government undertakes. The consensus has run that unless such goods are provided through government action, people will attempt to become free riders, enjoying some of the benefits of such goods while letting other people pay for them.

Block points out that the flaw in such analysis is that almost any good might be viewed as providing some benefit to third parties. What about socks? Doesn’t the fact that other people wear socks, and I don’t have to smell sweaty feet all day, provide me with a benefit for which I’m not paying? Must socks, therefore, be considered a public good, that only the government can supply in adequate quantities? Such logic, followed to its conclusion, would lead to a centrally planned economy, as the price and quantity supplied of all goods would be set based on the state’s cost-benefit analysis, not on consumer evaluation.

WHO COOKED THE JAM?

PAUL KRUGMAN ADDRESSED energy policy and traffic problems in his 2001 New York Times article, “Nation in a Jam,” saying:

But you don’t have to be an elitist to think that the nation has been making some bad choices about energy use, and about lifestyles more generally. Why? Because the choices we make don’t reflect the true costs of our actions.

We’ll let his contention that “the nation” makes choices slide. Krugman contends that “the nation” does too much driving, since each additional driver produces negative externalities for other drivers. We’ll also set aside the question of how Krugman can tell what the cost of those externalities is, apart from market prices. We’ll grant him his estimate that the cost of traffic congestion in Atlanta was $2.6 billion in 1999. Each additional person’s decision to drive cost other people $14 in lost time.

Krugman fails to ask why those costs are not borne by the drivers in question. We don’t go to the opera expecting to find several other people vying for our seat. We never encounter two-hour delays in the checkout line at the supermarket. Those resources are privately owned, and, in the interest of making a profit, the owners have a strong incentive to ensure that their customers have a pleasant experience. While it is true that private businesses usually desire more customers and sometimes fail to plan adequate capacity for those who show up, such situations are most often corrected quickly. No one wants to own the business that’s “so crowded that no one goes there anymore.” If a private road owner found that his road was overcrowded, he would simply raise the price of using the road.

Recall the last time you met unexpected highway construction on the way to work. In my area, encountering such a project can easily add an hour to one’s commute. Multiply that hour by the number of people stuck in the jam, and you can see that a whole heap of costs have been imposed on drivers by the road operator: the government.

Why is the government free to impose those costs? Both because we pay for government roads whether or not we use them and because the government has made it very difficult for private companies to build roads, the government has a near monopoly on routes for car travel. With the market process for evaluating the relative importance of roads, travel speeds, established property uses, pollution, and so on severely crippled, the government cannot rationally allocate scarce means among desired ends. Political pressure comes to dominate the allocation of resources.

For example, John Rowland, the governor of Connecticut as I write this, commented on the state’s branch rail lines in 1997: “Given the ridership on these lines, it is by no means outrageous to say it would be cheaper for the state to purchase cars each year for most of the riders.” On some lines each passenger was being subsidized more than $18 per trip. But when his plan to eliminate those lines was faced with strong opposition, mostly from wealthy individuals who relied on the lines for access to New York City, the plan was dropped. We are entitled to wonder if the campaign contributions of the individuals in question didn’t play a role in calculating the “cost” of closing those lines.

As Sanford Ikeda points out, such interventions also have the effect of making political action increasingly attractive, when compared to voluntary exchange. The more my economic well-being is determined by the political process, the more likely it is that I’ll increase profits by lobbying than that I’ll increase profits by producing. Further, the more my neighbors are using political pressure, the less resistant I will be to the idea of doing so. If no one else is using politics to achieve his personal ends, then I may be very reluctant to become the first to do so. But if many other people are pursuing that avenue, my resistance to joining them is likely to decline dramatically—after all, I can tell myself, I’m only trying to “even the score.”

The state has repeatedly intervened in the transportation market. Roads are often provided at no extra cost to the users. The property on which the roads were built was often seized by eminent domain, so that the supposed construction cost did not reflect the true cost of acquiring the needed land. The supply of taxis and jitneys, which can to some extent substitute for having one’s own car, has been artificially limited. Of course, other modes of transportation have had their own history of interventions. We have no idea of what a transportation market that had developed unhampered for the last several centuries would look like.

But it might strike us as odd that the very process that created the externalities in the first place—interventionism—is usually what is offered as the solution to them. Instead of seeking ways to allow the market in transportation to do its job, most recommendations call for further interventions intended to clean up the unwanted effects of past interventions.

For instance, Thomas Sowell, in his book Basic Economics, suggests that a law requiring mud flaps on cars is justified, because:

Even if everyone agrees that the benefits of mud flaps greatly exceed their costs, there is no feasible way of buying those benefits in a free market, since you receive no benefits from the mud flaps you buy . . . but only from mud flaps that other people buy.

But Sowell’s problem arises only because roads are publicly owned. The owner of a private road could internalize the benefit by requiring mud flaps and advertising the fact. Those who preferred that they pay for mud flaps as long as everyone else does, as well, can make use of roads requiring them.

Krugman does not explicitly call for a particular policy in his column. But when he says that the government should place a high priority on “getting those incentives right,” we are to understand that he means imposing new taxes on fossil fuels, on car ownership, and other interventions into the transportation market.

But there is no way for the government to “get incentives right” without market prices, the very thing eliminated by intervention. It is simply not possible for the government to guess the prices that might have arisen on an unhampered market. Each subsequent intervention intended to fix an earlier one will add new distortions and generate new unintended consequences.

Regulations that require a certain average miles-per-gallon figure for a manufacturer’s sold cars led directly to the explosion of sport utility vehicle (SUV) sales. Since SUVs are considered to be trucks, not cars, they are held to less stringent fuel-efficiency standards. Government efforts to increase overall gas mileage steered consumers into buying less efficient trucks, instead of station wagons, which were subject to the regulations. The general response has been, predictably, a call for new regulations on SUVs. Ford, for one, has tried to head off new legislation by increasing the fuel efficiency of its SUV fleet.

Often, some proponent of new regulation will contend that following the regulation will actually increase profits, and is the right thing to do for purely business reasons. For example, Steve Gregerson of the Automotive Consulting Group said of Ford’s decision in the Houston Chronicle: “It’s a smart business decision. They’re creating a vehicle that is going to be accepted in the marketplace and has better fuel economy but offers some of the utilitarian functions of the SUVs.”

But if it really is a smart business decision—and perhaps it is!—then surely some entrepreneur will do it without legislative pressure. Only if one believes that our best entrepreneurs just happen to be legislators does the argument make sense.

The free market is not a panacea. It does not eliminate old age, it won’t make babies’ poop smell good, and it won’t guarantee you a date for Saturday night. Private enterprise is fully capable of awful screwups. But both theory and practice indicate that its screwups are less pervasive and more easily corrected than those of government enterprises, including regulatory ones.