What are externalities, in the economic sense of the word? In what ways can they be addressed?

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Art Carden is Associate Professor of Economics at Samford University’s Brock School of Business and a Senior Fellow with the American Institute for Economic Research. He is also a Research Fellow with the Independent Institute, a Senior Fellow with the Beacon Center of Tennessee, and a Senior Research Fellow with the Institute for Faith, Work, and Economics. His main areas of research are southern economic history, the history and philosophy of economic ideas, and the effects of “Big Box” retailers like Walmart and Costco. He is a regular contributor to Forbes​.com and a number of other outlets.

You yawn, stretch, and walk to the coffee shop, where you order an espresso and settle in to read some Lib​er​tar​i​an​ism​.org articles your friend recommended. After your first sip, you wonder at the marvel of your cup of coffee: having read something like Leonard Read’s classic “I, Pencil” or having seen the short films about it, you know that no single mind contains all the knowledge embodied in a simple cup of coffee. It all comes together through decentralized exchange that lets a coffee grower in South America cooperate with a truck driver in New England he doesn’t know and will never meet.

Wait a second, you think. I’ve driven behind large trucks before. They burn diesel fuel and stink up the air with formaldehyde and sulfur dioxide and stuff like 3‐​methyl‐​2‐​cyclopentene‐​2‐​ol‐​one . I don’t even know what 3‐​methyl‐​2‐​cyclopentene‐​2‐​ol‐​one is. Then there are carbon emissions, which affect people on the other side of the world who might not even drink or grow coffee. Is there something missing from the “I, Pencil” story?

There is, sort of. You’ve just described externalities, or costs and benefits of your actions that spill over onto people with whom you’re not trading. Let’s do the “I, Pencil” thing with your cup of coffee, but let’s highlight the externalities.

You’re drinking your coffee out of a paper cup and thinking about everything that led to it when your concentration is shattered by the coffee grinder and the espresso machine behind the counter. You look down at your cup again and think that’s one spillover. I’m sure a lot of people in this place were disturbed by the noise when the barista was making my espresso.

And so you think further. The cups and coffee beans were shipped on an exhaust‐​belching truck, and maybe they were shipped from the other side of the world on an exhaust‐​belching container ship. Other people breathe that stuff, so there’s another spillover. The cups were made in a factory. What got dumped into streams and lakes and oceans that are now not‐​so‐​safe for swimming or fishing? You think about noise again. Trees have to be harvested to make paper cups. Then you stop and think but firms grow trees like they grow corn. If there’s an uncompensated spillover, it’s that timber companies are cleaning the air for us by planting so many trees—assuming that they aren’t displacing other, more complex ecosystems…Harvesting timber, though, is noisy and messy. Chainsaws are loud, and logging trucks burn fuel just like delivery trucks and container ships. There are even more negative spillovers.

You’re distracted again by a wonderful smell. Someone has just ordered a croissant. You love the aroma, and it reminds you of how much you enjoy walking by bakeries and restaurants and coffee shops and how in a city like Memphis, when the wind is right, the whole city seems to smell like barbecue. A bakery or a barbecue joint can’t charge passersby for enjoying wonderful smells. Externalities. therefore, aren’t only negative: there are positive externalities, too.

I see the problem, you think. When I buy a cup of coffee, I get coffee and a lot of people get paid. There are a lot of others, though, who have nothing to do with the coffee but who incur uncompensated costs in the form of diesel exhaust and others who enjoy benefits they don’t have to pay for because coffee and croissants smell delicious and because the trees that are planted to make the cups and the coffee that is planted to make the coffee convert carbon dioxide into oxygen.

You’ve hit on a pretty knotty social problem. In his book The Undercover Economist , Tim Harford describes a competitive market as a “world of truth” in which our attention to our own interests leads us to produce the right things the right way for the right people and in the right proportions. Externalities mean that we might produce too much of a thing that generates negative externalities because we don’t bear all the costs and not enough of another thing that generates positive externalities because we don’t capture the benefits. When we produce coffee that creates costs in excess of its benefits, we’re wasting resources.

What can we do about it?

The easy answer says “find and ban the source of a negative externality” or “find and require the source of a positive externality.” We see this in, for example, mandatory pollution control equipment on cars and trucks to control negative spillovers and mandatory schooling or vaccination to create positive spillovers. The problem is that command‐​and‐​control assumes there’s One Right Way to control pollution when, in fact, it’s hardly clear that regulators will know the least‐​costly way to address the externality. Again, we’re wasting resources when we produce coffee that creates costs in excess of its benefits. Our experience with government regulation and systems like socialism suggests there’s a good chance that command‐​and‐​control will make the inefficiencies worse, not better.

A better answer appears in most introductory economics textbooks. There’s an external cost in the form of pollution and a contribution to climate change emanating from those next gallons of diesel fuel that Shell and Chevron are considering producing. According to A.C. Pigou, a tax equal to that external cost will force Shell and Chevron to take those costs into consideration where they wouldn’t have before. With a tax that modifies the price just a little bit, the invisible hand leads us to the right outcome.

While it’s better than command‐​and‐​control, it’s still incomplete. As Ronald Coase pointed out in his 1960 article “The Problem of Social Cost,” externalities come from incompletely‐​defined property rights. What’s more, it’s not clear who causes the problem. After all, if someone fells trees that will eventually become cups at your local coffee shop and there is no one around to be disturbed by the noise, he has definitely made a sound—but he has created no externality. Just as it takes two people to tango, it takes two people for there to be an externality. If there’s no problem until you add the second person, who’s to say it’s the lumberjack causing the problem, and not the person hearing the lumberjack’s noise?

One problem concerns deciding who has rights to what and then letting the market go to work. In their textbook The Economic Way of Thinking, Paul Heyne, Peter Boettke, and David Prychitko discuss how externalities can be addressed via negotiation, adjudication, and legislation. Negotiation happens when property rights are clearly‐​specified and well‐​enforced. Think back to the logger and imagine a retiree has a cabin near where he is working. Once we know who owns the noise rights, people can bargain to a solution. If the logger has the right to use the chainsaw, then the retiree can pay him to stop. If the retiree has the right to peace and quiet, then the logger can buy a noise easement from the retiree.

Coase develops an interesting implication: the initial assignment of rights doesn’t matter for the allocation of resources if transaction costs (the costs of negotiating, executing, and enforcing exchanges) are low enough. Suppose the retiree values peace and quiet at $1,000. The logger values the right to use the chainsaw at $10,000. If the logger has the right, then he runs his chainsaw. If the retiree has the right, then the logger can buy a noise easement for anything between $1,000 and $10,000. She’s better off because you receive a payment that she values more highly than the peace and quiet. The logger is better off because he pays less than the $10,000 at which he values the noise rights. Negotiation gets the rights into the right hands.

It’s not always clear who has what rights. Enter adjudication, which is how people (likely aided by courts and lawyers) learn who has which rights. A lot of people think that the idea of first‐​user appropriation is a reasonable way of deciding who has which rights. Think back to when you were little and had a dispute over a toy: “who had it first?” was often the decisive question. Thinking again about the logger and the retiree, it seems reasonable to ask who was there first. If the retiree was there first, then the logger has to pay for the noise rights. If the logger was there first, the retiree doesn’t have a claim. Again, if transaction costs are low enough, the rights will end up in the right hands no matter where they start.

Sometimes, a conflict is difficult to resolve through adjudication. Legislation might be called for. In this case, the government simply decides who has the right. Sometimes, governments simply reallocate rights by legislation (taking land via eminent domain, for example). If these reallocations are credible, they need not affect economic efficiency though they will affect the distribution of wealth and might offend our sense of justice.

Externalities emerge because of poorly‐​defined rights and high transaction costs (see, for example, Michael Munger on the public goods problem as a technological problem). One problem with Pigou’s solution, as John V.C. Nye points out, is that the measured size of the spillover for purposes of informing a corrective tax (or subsidy) is irrelevant to the efficiency of the outcome if the kind of Coasian bargains discussed above are happening. The measured size of the noise externality in the logging example doesn’t tell us whether or not we are near to or far from the optimal amount of logging. With respect to auto exhaust, for example, he points out that we need to account for existing taxes, regulations, and possible monopoly power—Gulf Oil, for example, owns a lease that allows it the exclusive right to sell gas along the Massachusetts Turnpike. 1 Presumably, one of the costs of monopoly power is that monopolists under‐​produce goods—but if gasoline produces negative externalities, then a competitive market will produce too much. If Gulf’s market power allows it to raise prices and lower output—my few gas purchases on the Massachusetts Turnpike have been pricey, and there are certainly fewer opportunities to buy gas than along (say) I-20 between Birmingham and Atlanta—then their market power at least partially mitigates the spillover costs from burning gas. As Nye puts it (p. 32):

Even in a world of positive transactions costs, some Coasian transfers may take place that partly mitigate the harm of the externality. Unless the Pigovian tax collector can fully account for all those transfers, any estimate of an appropriate tax based solely on the size of the externality will clearly overstate the optimally efficient tax level.

People come up with all sorts of “Coasian transfers” that obviate the “obvious” need for government intervention. Advertising supports radio and television broadcasts. The sandwich shop Jimmy John’s advertises “free smells.” They are willing to provide the pleasant smell of baking bread in order to increase brand awareness and attract customers. Beekeeping was alleged to be in suboptimal supply because bees pollinate fruit trees, but Steven N.S. Cheung’s empirical investigation showed how beekeepers and orchard‐​owners contract to internalize spillover benefits. 2

People also form proprietary communities that establish rules governing externality‐​generating activities. 3 Homeowners’ Associations might have rules about whether or not people can paint their houses garish colors. Colleges and universities might require students to be vaccinated. Disney World has rules. And so on.

Markets do a better job with externalities than we might at first believe. Coase, in 1974, wrote an article on “The Lighthouse in Economics” that explained how lighthouse services were provided privately, and this insight was extended (and objections to Coase’s thesis were addressed) by Rosolino Candela and Vincent Geloso in a 2018 study of the lightship, which disappeared not because of insurmountable externalities but because government squashed it.

If we’re going to address externalities, we need to account for all the externalities, positive and negative. One person’s foul odor might be another’s pleasant seasonal scent (the faint smell of smoke in the Fall, for example). The same action might produce offsetting externalities. Mowing your grass is a perfect example. Power mowers are noisy, and they pollute. However, mowing your yard makes it less of a breeding ground for pests and less of a fire hazard.

Finally, we have to make sure the cure we’re proposing isn’t worse than the disease. I’m reminded of an old episode of The Simpsons in which invasive Bolivian tree lizards ended up in Springfield. Principal Skinner recanted his criticism of the lizards and called them “a godsend” because they ate pigeons. Lisa asked if this wasn’t short‐​sighted. Principal Skinner suggested that they could “unleash wave after wave of Chinese needle snakes” in the event that the lizard population became unmanageable. Lisa replied: “but…aren’t the snakes even worse?” Principal Skinner replies that they’ve “lined up a fabulous type of gorilla that thrives on snake meat.” When Lisa protests that they would then be “stuck with gorillas,” Principal Skinner points to “the beautiful part: when winter time rolls around, the gorillas simply freeze to death”—leaving the town buried under rotting gorilla carcasses.

Externalities are everywhere. Part of living in a civilized society is developing the ability to live with a thousand little annoyances because frankly, you’re probably producing a thousand little annoyances for everyone else and we wouldn’t get anything done if we tried to resolve to a standard of abstract justice every little slight real or imagined. Some spillovers are big enough and important enough that they’re worth paying more attention to and perhaps even addressing with public policy. Just because an externality exists doesn’t mean the market has “failed” enough for command‐​and‐​control regulation or even corrective taxation to be appropriate. Markets—and the institutions of civil society—have proven themselves pretty robust aids to voluntary cooperation and voluntary solutions.

References And Further Reading

Candela, Rosolino and Vincent Geloso. 2018. The Lightship in Economics. Public Choice 176(3):479–506.

Caplan, Bryan. 2008. Externalities. Concise Encyclopedia of Economics: https://​www​.econ​lib​.org/​l​i​b​r​a​r​y​/​E​n​c​/​E​x​t​e​r​n​a​l​i​t​i​e​s​.html, last accessed Mon 01 Jul 19.

Cheung, Steven N.S. 1973. The Fable of the Bees: An Economic Investigation. Journal of Law and Economics 16:11–33.

Coase, Ronald H. 1960. The Problem of Social Cost. Journal of Law and Economics 3:1–44.

Coase, Ronald H. 1974. The Lighthouse in Economics. Journal of Law and Economics 17(2):357–376.

Friedman, David D. 1990. Price Theory: An Intermediate Text. Nashville: South‐​Western Publishing Co.

Friedman, David. 1996. Hidden Order: The Economics of Everyday Life. New York: HarperBusiness.

Harford, Tim. 2007. The Undercover Economist. New York: Random House.

Munger, Michael. 2008. Orange Blossom Special: Externalities and the Coase Theorem. Library of Economics and Liberty. Online: https://​www​.econ​lib​.org/​l​i​b​r​a​r​y​/​C​o​l​u​m​n​s​/​y​2​0​0​8​/​M​u​n​g​e​r​b​e​e​s​.html. Last Accessed 13 Jul 19.

Nye, John V.C. 2008. The Pigou Problem. Regulation 31(2):32–37.

Rothbard, Murray N. 1982. Law, Property Rights, and Air Pollution. Cato Journal 2(1):55–99.

  1. I don’t know the details of the leases or the arrangement, but if Gulf does have market power, then they can supply less gas than a perfectly‐​competitive gasoline market would.
  2. Michael Munger discusses his experience with this phenomenon here.
  3. David D. Friedman discusses these in his intermediate price theory textbook, available online for $0.