I’m currently trying to write something on economics and what are called ‘externalities’. I’m not an economist, so am writing this in the hope of feedback telling me how I’m wrong, because it seems obvious I must be wrong.
Initial phrasing of the problem
‘Externalities’ seem to be usually thought of as those parts of an economic transaction which have harms, costs or benefits which affect people who external to that transaction. Externalities are usually described as positive (when someone can benefit without paying) for example clean air away from cities, or a neighbour’s bees fertilising one’s plants. A negative externality should (but often does not) include all forms of social and individual illth produced by economic activity (although illth production could come from the State, or other institutions). One immediate problem of this approach is that externalities as seen as coming from individual transactions rather than being systemic, so it localises and individualises the problem. For me, the major flaw of externality theory, is that it does not seem to be interested in preventing illth, it just wants to make some of the costs internal to the system, or even worse try to pretend illth is already costed and hence acceptable to the people who suffer from it.
In summary, my objections to the way the concept of externalities works, are:
- Definitions and treatment of externalities appear to aim at removing illth from consideration and confining it by making it local, and fixable through monetary payment (compensation or tax). They rarely seem to see illth production as a norm inherent to a system which ‘needs’ cheapness of operation for the highest possible profit, and so generally do not look for solutions at the system level. They also generally do not see the system as potentially self-damaging. Hence I will define a negative externality as a socially generated source of illth, whether intended or otherwise, expected or not. People, or groups, should be held responsible for the illth that they inflict on others, and we should not pretend the illth problem is solved when people and companies have to pay something for it.
- Research in the early 2000s by Nicholas Z. Muller, Robert Mendelsohn, and William Nordhaus showed that in some businesses (notably solid waste combustion, petroleum-fired electric power generation, sewage treatment, coal-fired electric power generation, stone mining and quarrying, marinas, and petroleum and coal products), the costs of externalities exceeded any value those businesses, added to the economy.
- Kapp argues modern business enterprise operates on the basis of shifting costs onto others as normal practice to make profits. [Kapp, Karl William (1971) Social costs, neo-classical economics and environmental planning. The Social Costs of Business Enterprise, 3rd edition. K. W. Kapp. Nottingham, Spokesman: 305–18 ]
- The standard model uses involves only three people, seller, purchaser and person suffering the illth. It effectively localizes illth (‘spillovers’, ‘neighbourhood effects’) rather than sees it as possibly affecting the functionality of whole systems. In other words writing on externalities generally ignores complexity, system and relationships – other than the price system.
- Much ‘free market’ economics seems to think that illth can always be reduced to monetary compensation and agreement. Economists don’t have to look at the type of illth involved. Consequently, if people are monetarily compensated, then illth is not a problem and, for practical purposes, has disappeared as it is treated as having no other effects on people or the system.
- Problems with government charges for illth are discussed below under Pigou, many of these difficulties apply to private negotiations as well.
- It is not clear how you can always put a monetary cost on illth and suffering, or come to a valid agreement on those ‘costs’; especially if the illth is allowed to continue.
- Illth is often produced by powerful people, and economics ignores the power and riches relations generally present, and the ways those relations could affect, or distort, any agreements likely to be reached on the monetary cost of illth.
- Economics often seems to presume that ‘the invisible hand’ with its claimed beneficial emergent order will get rid of the problem, or make everything else so much better it no longer matters. This is simply optimism not a basis for governance or for disregarding harm.
- Often it seems the theory is attempting to protect companies from any responsibility.
- The energy and attention costs of cleaning up long term illth is ignored. Apparently it will just go away, as it it were ‘waste.’
- Free market arguments tend to propose that penalties and regulation always, without exception, make everything worse, but that the market always works out fine for everyone, irrespective of their position in the power relations. This almost certainly fantasy.
There also seems to be a large amount of dispute about what the main hero economists thought on this issue.
History: Pigou, Hayek and Coase
Pigou and his objectors
Historically the idea begins with Pigou, although he does not appear to use the term ‘externality’. Pigou’s basic economic principle was:
the economic welfare of a community of given size is likely to be greater (1) the larger is the volume of the national dividend, and (2) the larger is the absolute share of that dividend that accrues to the poor.
Pigou Economics of Welfare 4th edition p 5-6
Not a currently fashionable position
In a chapter on the divergence between marginal social net product and marginal private net product (Chapter IX), he writes:
It thus becomes important to inquire in what conditions the values of the social net product and the private net product of any given (rth) increment of investment in an industry are liable to diverge from one another in either direction.
174
This is a problem not only when private riches overwhelm social wealth, but when the effects or costs of private investment comes “as a positive or negative item, to other people.” He examples Irish farmers who pay for improvements to farms owned by others.
He suggests that a problem arises because the costs of illth are not borne by those producing it, so they are not discouraged from its production. He argues that an appropriate tax, or price, on illth, equivalent to the harm inflicted on others, would lower the profitability of illth production. For example, makers of alcohol should be “debited with the extra costs in policemen and prisons which it indirectly makes necessary” (p 186).
This charge, assumes the harm can be priced, the damage can be fixed, or that cost discourages illth production, which would probably depend upon the profits being made. This would seem to be best as a matter of experiment, not of dogma.
As we might expect, neoliberal [1] [2] [3] economists think taxing illth production, is government interference in the market and hence bad.
- It is alleged the government cannot know what the best price is, and hence it will be wrong and produce terrible disasters. The EU Carbon trading scheme can be used as an example of a system which did not work very well at the beginning – largely because it was too generous to business to avoid trouble for the EU, however, some levels of air pollution have now decreased (https://wordpress.com/post/cmandchaos.wordpress.com/11300 and https://www.theguardian.com/environment/2024/mar/13/air-pollution-levels-have-improved-in-europe-over-20-years-say-researchers). However, this criticism of tax solutions ignores the possibility of experiment, or of gradually increasing charge for the illth with no exemptions.
- Instabilities, and changes in government, may destroy any such prices, tax or trading schemes, especially (although this seems rarely mentioned) due to the influence of powerful and wealthy industries who want to continue illth production. This problem has been experienced in Australia with the carbon price being repealed by pro-corporate government..
- Lack of a global carbon price or tax, might incentivize companies to go where pollution is cheapest, which is a particular problem if the pollution diffuses, as with CO2.
- It is difficult to estimate the cost of damage done by illth. It is difficult to measure emissions from individual factories and across an industry.
- Another argument suggests that If people want non-polluting energy then, if non-polluting energy is cheaper people will purchase it. This ignores established powers in the market, and their ability to corrupt the information in the price system, or to corrupt people’s response to that information.
- Pollution can be said to be an engineering problem, not an economic problem, while at the same time suggesting engineering is driven by economics. Spontaneous new technology is the solution.
- One writer states that a tax/charge is unfair because it only punishes the polluter, and ignores the impact of the polluted, who are causing the polluter damage “by being there and causing a tax to be imposed on the other business.” [cf 3]. Possibly this rather odd idea may come from Coase, who assumes that externalities are reciprocal [check], and that there must be two specific parties interacting for an externality to exist. Hopefully the term ‘reciprocal’ was not meant to indicate the parties are equally responsible (deleting power relations) or that there can only ever be two parties at a time, or that a party cannot harm itself.
[Barnett, A. H.; Yandle, Bruce (24 June 2009). “The end of the externality revolution”. Social Philosophy and Policy. 26 (2): 130–50. doi:10.1017/S0265052509090190. S2CID 154357550.]
In all, the problem with the idea of tax or charge for illth appears to be that economists popular with governments and companies tend to see any governmental planning as the road to serfdom, because it suggests that the market may not always find the best way forward by itself. However, we may wonder how much better private transactions will be in estimating monetary substitutions for the harm of illth, all the time. Again, an expected increase in the charge may help provide incentive to reduce the illth.
Hayek
Hayek by his support for dictatorships in Chile, Argentina and Portugal and his response to criticism on this issue, appears to have thought that governments who murdered, tortured and’ disappeared’ their citizens, as long as they dictatorships did not, or might not, interfere with the market or with business profits, were far less tyrannous than governments who tried to plan for the betterment of everyone. Following this lead many Hayekians propose that free markets may have nothing to do with welfare. In which case, of course we can ask what is their point? Power? Unequal riches? Lack of general welfare? etc. and is that the kind of market they want. It is not clear what Hayek would have thought about climate change, but his apparent concern for protecting companies rather than people’s ‘rights’ (which he always dismissed) and safety, suggest he would leave it to the corporate market, and its power relations.
I follow Shahar here. Some people use Hayek, to argue that politically based responses to externalities are guaranteed to fail. for example::
- [Carden, Art. 2013. “Economic Calculation in the Environmentalist Commonwealth.” Quarterly Journal of Austrian Economics 16: 3-16.;
- Cordato, Roy E. 1997. “Market-Based Environmentalism and the Free Market: They’re Not the Same.” Independent Review 1: 371-86.;
- McGee, Robert W., and Walter E. Block. 1994. “Pollution Trading Permits as a Form of Market Socialism and the Search for a Real Market Solution to Environmental Pollution.” Fordham Environmental Law Journal 6: 51-77.]
While other Hayekians argue that Hayek would have supported aggressive environmental protections on the same grounds that he defended liberty, property, and markets in economic arenas:
- [DiZerega, Gus. 1992. “Social Ecology, Deep Ecology, and Liberalism.” Critical Review 6: 305-70.,
- 1996a. “Towards an Ecocentric Political Economy.” Trumpeter 13.
- 1996b. “Deep Ecology and Liberalism: The Greener Implications of Evolutionary Liberal Theory.” Review of Politics 58: 699-734;
- Gamble, Andrew. 2006. “Hayek on Knowledge, Economics, and Society.” In The Cambridge Companion to Hayek, edited by Edward Feser, 111-31. New York: Cambridge University Press;
- O’Neill, John. 2012. “Austrian Economics and the Limits of Markets.” Cambridge Journal of Economics 36: 1073-90.]
In treated useable resources Hayek was blatantly optimistic. He noticed that “fertility of the soil, can only be expected to endure permanently if we take care to preserve them.” (2008, Pure theory of Capital: 72). This preservation is said to be part of the problem of maintaining and reproducing capital so as to permanently elevate prosperity (??102). As Shahar shows, for Hayek, this does not really mean conservation, but replacing “each resource that is being used up with a new one that will make at least an equal contribution to future income.” There is no need to keep the “total stock of natural resources… intact,” as used up land can be abandoned and this is not reprehensible or wasteful, because it is in the nature of monetary capital to be used (Constitution of liberty 1960: 323 [collected works 496]). However, while land can function as capital, it is not just capital or money and using it up does not always have no effects. Hayek states:
most consumption of irreplaceable resources rests on an act of faith. We are generally confident that, by the time the resource is exhausted, something new will have been discovered which will either satisfy the same need or at least compensate us for what we no longer have, so that we are, on the whole, as well off as before. We are constantly using up resources on the basis of the mere probability that our knowledge of available resources will increase indefinitely.
(constitution 1960, 319)
We might say that the pathology of capitalism is based on sentiments like this. However, as some resources have been replaced in the past with different ones, this does not mean we can assume that all resources can always be so replaced. Judging by the awkward phrasing Hayek realises there is a potential problem, but wants to embrace a magic pudding economy.
As well as potentially encouraging harm, Hayek also warns about protections against harm:
Industrial development would have been greatly retarded if sixty or eighty years ago the warning of the conservationists about the threatening exhaustion of the supply of coal had been heeded; and the internal combustion engine would never have revolutionized transport if its use had been limited to the then known supplies of oil (during the first few decades of the era of the automobile and the airplane the known resources of oil at the current rate of use would have been exhausted in ten years). Though it is important that on all these matters the opinion of the experts about the physical facts should be heard, the result in most instances would have been very detrimental if they had had the power to enforce their views on policy
(constitution 320)
Experts get in the way of capitalist know-how? Hayek also threatens us with the tragedy of the commons:
no individual exploiter will have an interest in conserving [commons], since what he does not take will be taken by others (1960, 319).
But, for once, he relies on the well managed commons principle. Commons may work out, if people “agree to be compelled, provided this compulsion is also applied to others” (Law, Legislation, and Liberty, vol. III: The Political Order of a Free People. Chicago: University of Chicago Press. 1981: 44)
Hayek also argues that while people should have regulations that force them to use the market (probably as the price system is the only information system he trusts, and failure and misery should be allowed to occur, if you are not rich), the market should not be told what to do, as actors would have:
“no chance to use their own knowledge or follow their own predilections. The action performed according to such commands serves exclusively the purposes of him who has issued it” (1960, 132)
having direction or paying charges is not the obstruction of use of knowledge. This is just hyperbole to stop capitalists being constrained, to demonstrate faith in markets.
A free market approach is said by some to mean that people would see the dangers, rebuild cities on higher land, use fish farms, invent profitable heat tolerant crops and so on. This assumes there are not unintended consequences of fish farms, that there is land inland which is not already being used, and that heat tolerant crops do not prove vulnerable in some other unexpected way. However, the main objection to the proposal is that nothing like this is happening in market societies, and that cannot just be blamed on governments. And if we need ideal free markets, then we might as well give up, as they will never happen, due to plutocrats buying governments to support their advantages.
Free marketeers are relying on top down planning from corporations who only are concerned about profit and appearance. We may need to rely more on local movements.
- Steve Rayner, “How to Eat an Elephant: A Bottom-Up Approach to Climate Policy,” Climate Policy 10, no. 6 (2010): 615–21, https://doi.org/10.3763/cpol.2010.0138.
- Steve Rayner, “Uncomfortable Knowledge: The Social Construction of Ignorance in Science and Environmental Policy Discourses,” Economy and Society 41, no. 1 (2012): 107–125.
Coase
Ronald Coase [“The Problem of Social Cost Journal of Law and Economics, Vol. 3, No. 1, pp. 1–44], objected to Pigouvian taxes, by alleging that all externality costs, could be resolved by strong property rights and market bargaining, and hence made ‘internalities’ in the market.
- The first obvious objection to this kind of procedure is that the atmosphere, rivers, oceans and migratory animals are not generally private property, and can range across countries. It would also be unpleasant to be charged for breathing. Hence it is hard to negotiate over the main forms of climate illth due to its dispersion.
- If the polluter owns what is being polluted or the owner does not care, then it becomes impossible to reduce pollution.
- Property and borders are also rendered complicated by the fact that multiple organisations all over the world are polluting, and those companies who can avoid Coasian bargaining can benefit from pollution. Examples of this occur in Carbon Accounting whereby the burning of, say, Australian originating fossil fuels, does not count against Australia’s emissions totals – even if it profited from that transaction.
- Another objection is that the more powerful the illth maker may be with respect to the harmed, the more they will be able to refuse participating in a genuine transaction. This happens commonly when people have been poisoned by work, and it takes what is usually a massively unequally funded court case to get anywhere, and people may be dead before they are compensated, as with Australian asbestos cases.
- Or someone may be able to come up and say. “I’m founding a polluting business, down the street that will possibly drive away your customers. It would be sad if your business got broken, you know what I mean, I want [blah] a month to stop.” The transaction is essentially a bribe, or protection.
- It may also be impossible for me to pay the cost of not polluting to the polluting company if they do stop polluting.
- There is no guarantee market participants will know the value of not-polluting either. That does not make whatever agreement we come to the best possible agreement.
- In some cases the full costs of the pollution may be paid by unknown people, or people who have not been born yet, for example those people born into our future, a world of completely out of control climate change.
- In most cases we might think that the purpose of taxes and charges, is to stop the pollution, rather than to have people to decide on what compensation they want for the pollution, or how much money or cost a polluter wants to stop polluting.
- There is no reason to assume that a monetary cost can always be imposed upon the illth, or the trouble of bargaining, agreed to.
- If the illth is diffuse then, the actual short term cost might be so small that no one can be bothered to sue the company for restoration. Hence the illth continues to grow.
Some have argued that Coase is arguing that after transaction costs are taken into account, then there is no problem, even if the illth has not gone away. Dahlman adds, in “The Problem of Externality” (1979), that once we recognise levels of uncertainty then we cannot easily claim the Externality wasn’t internalized by somebody or other. Note this says nothing about the illth, even though it attempts to make it vanish, it just says that no one is financially responsible, ever.
A writer for the ‘free market’ Cato Institute writes without any apparent irony after giving an example of Coasian trading in action: “well‐defined and tradable property rights abolish externalities, even if the pollution remains.” We will apparently get the least monetarily costly arrangement, even if it leaves the illth alone. It appears for these economists that there is no real world other than the price system. James Buchanan apparently adopts the position, that if the polluted don’t notice the pollution, then its not harming them. The obvious consequence from that position is not to lower the pollution but the amount of information about its harms.
- Externality,” by James M. Buchanan and Wm. Craig Stubblebine. Economica 29(116): 371–384 (1962).
Buchanan also argues that comparison of the current word with a world in which illth of the type under discussion is not present is a fantasy.
To argue that an existing order is ‘imperfect’ in comparison with an alternative order of affairs that turns out, upon careful inspection, to be unattainable may not be different from arguing that the existing order is ‘perfect… [There is] nothing in the collective choice process that will tend to produce the ‘ideal’ solution, as determined by the welfare economist.”
Politics, Policy, and the Pigovian Margins,” by James M. Buchanan. Economica 29(113): 17–28 (1962).
Yes but it is also a fantasy to assume that illth can always be ignored.
Saying that the market cannot solve, or has not, solved these problems can be dismissed as thinking the government could do better – which is presumably obviously untrue [Externality: Origins and Classifications,” by Donald J. Boudreaux and Roger Meiners. Natural Resources Journal 59(1): 1–33 (2019)]. It can hardly do much worse.
Another Free market writer states:
What is called “pollution” is the use of a non-owned resource without compensation. In some situations, there are no private owners, as with the air. If there were, they could demand compensation for permission to use the resources, as with ordinary purchases. The consequences would be “internalized” on the responsible person, and pollution might be avoided or reduced
This argument functions as a way of protecting companies who destroy commons, or ‘public goods,’
In a similar mode, Candela writes that when ‘externalities’ occur “[i]t simply implies the failure of the conditions of the market process to exist, not the existence of market failure” (see Candela and Geloso 2020). But this is happening in a market, and no market is perfect, so its just a way of saying that when markets fail, there are no real markets, which is a sleight of hand to excuse harmful business activity in real existing markets.
Expectations
Some say that externalities must be unexpected, because people will always (if sensible) factor expected costs or harms into their lives.
“Externalities exist only when another party’s actions create unexpected spillover effects,” “Insofar as no one’s legitimate expectations are upset,.. no externality occurs.” The bargains have been made and the receivers of negative externalities indirectly compensated. “The problem, if one asserts there is a problem, is the structure of property rights” [Externality: Origins and Classifications,” by Donald J. Boudreaux and Roger Meiners. Natural Resources Journal 59(1): 1–33 (2019)]
If you move near a motorway then you have no right to demand compensation for the pollution you suffer, as that pollution (possibly) gave you a cheaper house price, or you figured that other benefits of the area compensated you for the financial ‘cost’ of breathing polluted air. There is therefore no need to reduce illth produced by the motorway’s use. In this system it appears that no one should be able to claim that climate change is unexpected so companies should bear no cost for the climate change that they have generated. If I am reading this correctly, then this theory seems to be another way of protecting polluters from their responsibilities.
Another fundamental part of the issue, is there can be uncertainty or incomplete information about who is responsible for damages or contract restrictions. Coase apparently implies that complete information must exist for his solution to work, along with rationality. However, uncertainty and incompleteness are normal in complex systems, so to imply that perfect and complete information is needed for something to work, is one indirect way of saying it will not work.
Technologies of corporatism
One question that might be worth asking is: “Is it market failure, or market success that increases illth?” Increasing illth increases profitability in the short term.
Is the presence of corporations as a technology which structures a group so that investors only have a limited liability for the harms they are profiting from, part of the cause of illth?
Liability and the Known Unknown”. Duke Law Journal. 68: 275–332. doi:10.2139/ssrn.3121519. ISSN 1556-5068. S2CID 44186028 – via SSRN. Hansmann, Henry; Kraakman, Reinier (May 1991). “Toward Unlimited Shareholder Liability for Corporate Torts”. The Yale Law Journal. 100 (7): 1879. doi:10.2307/796812. ISSN 0044-0094. JSTOR 796812.]
If fossil fuels do not get more expensive to produce, the fossil fuel companies do not issue propaganda, or buy or threaten governments, and renewables do not get more profitable, then the illth of GHG will continue if left to the market.
The theory of externalities seems largely designed to avoid the problem of illth production or to avoid reducing it.
The failure of market economics to apparently get the problem, means that the only plausible remedies seem legal and governmental ones.
- A government charge for illth production, that gradually and regularly increases, until the illth production is no longer profitable. The monies raised from the charge to be used for illth remediation.
- Defining economically produced illth as illegal, with a period to allow adjustment to this proclamation. Followed by other sources of illth, with people having the right to bring government subsidized cases against illth production and to fund remediation.
Climate, technology and chaos Blog 