Thoughts on economics and liberty

A history of the concept of externalities – by Donald J. Boudreaux and Roger Meiners

Background: This summary by José Luis Gómez-Barroso

Donald J. Boudreaux and Roger Meiners’s 2019 work

This is part of my ongoing study of the concept of externalities. My annotations in blue.



The earliest developers of the concepts of external economies and diseconomies were Alfred Marshall, a major economist who wrote the leading text in economics from 1890 to 1920, and Arthur Cecil Pigou, one of his students, and the successor to his chair at Cambridge, who was a major figure in the profession in the first half of the 20th century.

Marshall, in his oft-cited 8th edition of his Principles of Economics, explained that external economies were factors relevant to a firm that were from the outside, such as better technology that could be adopted. Internal economies were factors under the control of those running a firm, for example, a clever manager figuring out how to run a firm better. “External economies,” Marshall wrote, are related to scale of production; they are “those dependent on the general development of the industry,” whereas “internal economies” are “those dependent on the resources of the individual houses of businesses engaged in it [a particular kind of production].” External economies grew as technology improved and large-scale production came to dominate industry. [Sanjeev: these are agglomeration/networking type effects] This was valuable knowledge “beyond the reach of anyone who could not afford to have well-paid agents in many distant places.” That is, small producers had access to valuable information that allowed them the possibility of more efficient, larger-scale production. This knowledge enhanced the “efficiency of capital and labour.”

Improved knowledge allows greater efficiencies in production, so supply can be expanded at lower per unit cost. However, there is a downside to such productivity. Marshall worried that large-scale efficiency could result in what is called a “natural monopoly”—when one firm can serve the market at lower cost than could two or more smaller firms. Natural monopolies require government intervention so as to maximize social welfare. However, Marshall opposed “collective ownership of the means of production” as it would “deaden the energies of mankind, and arrest economic progress.”

Marshall did not discuss pollution; however, he noted that “waste”— things thrown away in the production process—is reduced by large-scale producers who make more efficient use of inputs. “No doubt many of the most important advances of recent years have been due to the utilizing of what had been a waste product.” Fifty years later, the Marshallian view of external economies still held sway. In a leading microeconomic theory text, external economies were still discussed in terms of greater industrial efficiency resulting from technical improvements that force competitors to operate more cost-effectively.  Diseconomies are external effects that raise firms’ costs; pollution is not mentioned in this text.

While Marshall mentioned the notion of external impacts on production, the modern form of externality as a pervasive concept began with Pigou. We review his work at some length as his view is similar to how externality is now employed. Pigou acknowledged that private-property-based free markets often work well. However, “even Adam Smith had not realized fully the extent to which the System of Natural Liberty needs to be qualified and guarded by special laws, before it will promote the most productive employment of a country’s resources.” [Sanjeev: this is Pigou’s Fabian socialist manifesto speaking. Pigou was a very dangerous man.]

According to Pigou, the price system and legal and social institutions fail to cause all to act in ways that maximize social welfare. This failure justifies government intervention to correct the imperfections. Widespread market failures prevent a community’s resources from being distributed among different uses or occupations in the most effective way. The study [of this problem] … seeks to bring into clearer light some of the ways in which it now is, or eventually may become, feasible for governments to control the play of economic forces in such wise as to promote the economic welfare, and, through that, the total welfare of their citizens as a whole.

Pigou explains how economists should deal with this problem:

[W]e have next to distinguish precisely between the two varieties of marginal net product which I have named respectively social and private. The marginal social net product is the total net product of physical things or objective services due to the marginal increment of resources in any given use or place, no matter to whom any part of this product may accrue. It might happen, for example, as will be explained more fully in a later chapter, that costs are thrown upon people not directly concerned, through, say, uncompensated damage done to surrounding woods by sparks from railway engines. [Sanjeev: This is the example which Coase picked out in his paper] All such effects must be included – some of them will be positive, others negative elements – in reckoning up the social net product of the marginal increment of any volume of resources turned into any use or place.

Pigou explains further:

[I]f private and social net products everywhere coincide, the free play of self-interest, so far as it is not hampered by ignorance, will tend to bring about such a distribution of resources among different uses and places as will raise the national dividend and, with it, the sum of economic welfare to a maximum…. The essential point for our present purpose is that, when marginal private net products and marginal social net products coincide, any obstacles that obstruct the free play of self-interest will, in general, damage the national dividend [income]. [Sanjeev: It is a far stretch to claim that something not traded in the market will impact actual national income.] In real life, of course, marginal private and marginal social net products frequently do not coincide. [Sanjeev: and where is his evidence?]

Much of the market’s failure to produce maximum national income arises from “imperfect knowledge on the part of those in whose hands the power to direct the various branches of the stream [of resources] resides.” Pigou argues that private resource owners will not maximize social value:

In general industrialists are interested, not in the social, but only in the private, net product of their operations…. [Self-interest] will not tend to bring about equality in the values of the marginal social net products except when marginal private net product and marginal social net product are identical. When there is a divergence between these two sorts of marginal net products, self-interest will not, therefore, tend to make the national dividend a maximum; [Sanjeev: this is a huge stretch] and, consequently, certain specific acts of interference with normal economic processes may be expected, not to diminish, but to increase the dividend.

While Pigou does not call the divergence between social and private cost an externality, what he explains is the essence of the concept as now employed.

He saw the problem as being widespread. Pigou gave numerous examples of what we would call negative and positive externalities, all of which are explained to be a form of market failure that warrants consideration of state intervention to close the gap between private and social costs. For example, lighthouses provide benefits for ships that do not pay for their services. Public roads may provide higher real-estate values for adjoining landowners. Inventors produce valuable knowledge that can be exploited by others for their personal and social gain. While new production may add wealth, factory smoke may dim sunlight and inflict filth on buildings and laundries. Intoxicating beverages that we enjoy may also lead to the need for more prisons and policemen. In all such situations, social and private costs and benefits diverge and are not easy to resolve due to “technical difficulty of enforcing compensation for incidental disservices.”

There is much in the world not to like, both today and in Pigou’s time. He explained what he saw as the single worst social cost:

[T]he crowning illustration of this order of excess of private over social net product is afforded by the work done by women in factories, particularly during the periods immediately preceding and succeeding confinement; for there can be no doubt that this work often carries with it, besides the earnings of the women themselves, grave injury to the health of their children. The reality of this evil … . [Sanjeev: This is a good example of why Pigou was wrong. He forgets that the women voluntarily chose to work. Biologically, there’s no particular harm caused to the child. He’s imposing his personal ethics on society. This is not economics.]

One deals with such evil by legislation and regulation:

It is plain that divergences between private and social net product … cannot … be mitigated by a modification of the contractual relation between any two contracting parties, because the divergence arises out of a service or disservice rendered to persons other than the contracting parties. It is, however, possible for the State, if it so chooses, to remove the divergence in any field by ‘extraordinary encouragements’ or ‘extraordinary restraints’ upon investments in that field. The most obvious forms which these encouragements and restraints may assume are, of course, those of bounties and taxes.

His call for subsidies and taxes to reduce the gaps between social and private costs is a bedrock in modern externality analysis as we will see in later literature.

THE 1950S AND 1960S

Building on Pigou, the next generation of work on externalities included an influential 1954 article by Professor Tibor Scitovsky of Stanford. He explained that “external economies are a cause for divergence between private profit and social benefit and thus for the failure of perfect competition to lead to an optimum situation … .”

In discussing when externalities arise, Scitovsky identified “four types of direct interdependence”: 1) when one’s satisfaction is related to the satisfaction of another person; 2) when one’s satisfaction is affected by inconveniences, such as smoke from production; 3) when producers learn to offer goods and services at lower cost, so as to offer more satisfaction at lower cost; and 4) when the output of a producer depends on the activities of other firms.

Scitovsky explained that economists generally have little to say about the first kind of externality, the “interdependence of consumers’ satisfaction,” even though they know it is extremely important. Economists are not good at understanding interpersonal utility or satisfaction.

As an indication of how times change (many pollution levels were much higher in the 1950s than they are to today), Scitovsky thought that the second kind of externality, such as emissions from production, were “unimportant” as they could be handled by zoning rules (move producers to industrial areas) or regulations for public health and safety.

Similarly, the third kind of externality, which as noted by Marshall and Pigou is the one that occurs as more efficient methods of production cascade through to other production processes, was also regarded by Scitovsky as unimportant. [Sanjeev: It is quite absurd for Marshall to call technical advancement and innovation an externality] He regarded it as unimportant in a policy sense because patents for innovations allow innovators to capture gains and so encourages such productive activities. Innovators sell their output to buyers who benefit by using the new technology in their production. Other innovations result from research sponsored by the public, such as in agriculture, where the research results are made available to all.

The fourth kind of externality, interdependence among producers, seemed to Scitovsky to be “few” and so of little import. Such an externality can involve unpaid factors of production. Scitovsky recalled an earlier paper by James E. Meade, in which Meade gave the example of apple orchards benefiting from bees, which allowed beekeepers to benefit from apple blossoms, even though the two may not have contact with each other. If one or both of these parties fail to take adequate account of the effects of his actions on the output of the other party, there will be a sub-optimal production of apples and of honey. This divergence from optimality could justify a subsidy paid by apple growers to the beekeepers to encourage beekeepers to produce more honey. [Sanjeev: of course, this was nothing but the typical ivory tower talk of economicts: in reality, such interdependncy leads to normal market based contracts]

Similarly, the relationship among outputs as one firm’s knowledge or product spills over to others, as noted by Marshall, played a role in the literature on network externalities. The benefit one receives from a good, such as the telephone or the Internet, depends on how many other users there are. Without a network of other users who rely on products of others, phones or the Internet have little or no value. [Sanjeev: But that’s NOT an externality: it is the basic characteristic of such products. The market fully values it. There’s no role for any government.]

Economists have long distinguished “technical” from “pecuniary” externalities. This distinction originated with Jacob Viner. Within a firm, “technological internal economies would be savings in the labor, materials, or equipment requirements per unit of output resulting from improved organization or methods of production” whereas pecuniary internal economies “consist of advantages in buying, such as ‘quantity discounts’ … .” [Sanjeev: This is unnecessary jargon: the things described are normal market-based business activities]

While distinctions are made between technical and pecuniary economies, the form does not matter to the firm or the individual decision maker because both results represent financial benefits or losses. A gain is a gain, and a loss is a loss. Economists, however, continue to distinguish technical from pecuniary diseconomies, contending that the former matter to society while the latter do not. The reason is that technical externalities are believed to reduce social welfare while pecuniary externalities do not. [Sanjeev: how is innovation supposed to reduce social welfare?] Put differently, technical externalities result in physical production that is either too much or too little while pecuniary externalities merely redistribute wealth among economic actors without diminishing it.

Following Scitovsky, F.M. Bator of the Massachusetts Institute of Technology (MIT) published an influential article.Bator’s article likely forms the basis for the now-common notion of externality as demonstrated in the following discussion of the modern literature. Bator uses the notion of Paretian efficiency. If Pareto optimality is achieved in a society, no improvement in utility or efficiency is possible because no one can be made better off without making someone else worse off. Thus, society has achieved its “bliss point.”

Bator’s primary concern was with income redistribution via taxation to achieve social bliss, but his analysis applies to all economic matters. He notes that bliss is impossible due to “imperfect information, inertia and resistance to change, the infeasibility of costless lump-sum taxes, businessmen’s desire for a ‘quiet life,’ uncertainty and inconsistent expectations, the vagaries of aggregate demand, etc.”

Bator discusses multiple sources of market failure:

– Failure of existence due to lack of perfect marginal rates of substitution as related to input-output points or production needed to generate optimal prices);

– Failure by signal concerning proper levels of profit for each producer where having too much profit leads to over-allocation of resources in some areas and, on the converse side;

– Failure by incentive stemming from inadequate profits for some producers who should have higher levels to stimulate investment in their output;

– Failure by structure because in the absence of perfect information and pure competition, prices and output will deviate from optimality, as we observe in many markets where a few firms dominate; and

– Failure by enforcement due legal and organizational imperfections.

Bator explains that the Lange-Lerner model of socialist directions (scientific planning of an economy) faces many difficulties and that the literature on all these issues is complex and convoluted.

As explained by Marshall and Pigou, the existence of market imperfections requires that industries and individuals should be taxed and subsidized to bring society closer to bliss. Bator noted that economists who wrote soon after Marshall and Pigou, including Dennis Robertson, Piero Sraffa, Frank Knight, and Jacob Viner, demonstrated that the conclusion that such taxes and subsidies are necessary is mistaken. Changes in ownership arrangements can internalize many technological economies, while pecuniary external economies in competitive markets are simply the evidence and consequences of competition. Bator explains that this conclusion leaves as problems only those technological external economies (“externalities”) that cannot be handled by a change in ownership arrangements. Those markets, and this description applies generally, “will be efficient if, and only if, this private marginal cost ratio reflects the true marginal cost to society of an extra apple in terms of foregone honey[.]” This class of externalities, however, is huge. In them, market prices “diverge from true, social marginal cost.” Bator’s explanation of social marginal cost in case of external technological economies is what economists have worried about ever since.

To illustrate the point about social marginal costs and technical externalities, Bator gives examples of bridges and radio. Bridges face lumpiness in use not resolved by pricing. We have limited options in what we hear on the radio—including advertisements. Bator notes that many functioning markets are afflicted with externalities that justify consideration of state-imposed improvements. Externality, therefore, should mean “any situation where some Paretian costs and benefits remain external to decentralized cost-revenue calculation in terms of prices.” That is, we are not at bliss points due to “uncompensated services” and “incidental uncharged disservices” that are the essence of market failure.

Bator then argues that there are three, sometimes overlapping, categories of externalities:

First are ownership externalities. Even if markets work perfectly (“an Adam Smith dream world”), due to “circumstances of institutions, laws, customs, or feasibility, competitive markets would not be Pareto-efficient.” This problem exists in private venues, such as beekeepers’ interactions with orchardists, and in the public sector, such as in public-domain fishing waters.

Second are technical externalities. These arise from lumpiness or indivisibility in many goods, such as bridges. These would benefit from “a set of shadow-prices which, if centrally quoted, would efficiently ration among consumers the associated (fixed) total of goods.”

Third are public good externalities. A pure public good is one where consumption by one person does not affect consumption by another (e.g., the benefits I receive from national defense against North Korean missiles do not affect your ability to “consume” or to enjoy the same benefits). As the price mechanism cannot work for demanders and suppliers, administered prices are required. He cites lighthouses, schools, and open-air concerts among many examples, but not pollution.

About the time Bator’s article was published, Ronald Coase argued that the radio spectrum could be privatized to improve its efficiency. [Sanjeev: This is not new stuff, but back to basics. The competitive economy assumes private ownership, and unless that is first tried and it fails government ownership should not even be contemplated.] At that time, the Federal Communications Commission (FCC) granted licenses to use bits of the spectrum. It was asserted that regulation was the only way to prevent one spectrum user from disturbing the use of another spectrum user, otherwise, broadcasts would spill over into each other. Scientific control by the FCC was needed to prevent chaos, cut-throat competition, and allow for the orderly development of radio and then television. Private enterprise could not work. Coase testified before the FCC in 1959 and argued that the spectrum could be efficiently privatized. Apparently, commissioners were scandalized by this strange notion proposed by a professor with a British accent; one commissioner even asking him if the proposal was a “big joke.”

The broadcast spectrum fits Bator’s definition of technical limitations that require government intervention. However, Coase noted that, among other things, because the government controlled the licensing, valuable licenses were not handed out randomly; they went to favored interests allowing them to obtain “extraordinary” gains. Coase explained the then-revolutionary idea that spectrum can be made private property just as land is owned by private parties. The fact that there is a fixed quantity of land does not mean it must be in public hands to ensure its efficient use. “The advantage of establishing exclusive rights to use a resource when that use does not harm others (apart from the fact that they are excluded from using it) is easily understood.” Once private rights exist, parties may bargain over how the property is used, with the party who values a piece of property most highly being the one who ends up owning it.

In the FCC paper, Coase explained what has come to be called the Coase Theorem, although his more famous paper of the following year is more commonly cited as the source of this Theorem. Coase used an 1879 case, Sturges vs. Bridgman to illustrate. A confectioner used his property for years for business. A doctor later came to occupy adjoining property. There were no problems until eight years later when the doctor built a consulting room that abutted the confectioner’s premises. Noise and vibration from the confectioner’s machinery disturbed the doctor’s consulting room. The doctor sued and obtained an injunction against the machinery.

Coase did not address Bator’s concerns about market imperfections from lumpiness, dominant firms, and other external effects in either paper; rather Coase focused on the importance of property rights and the ability to exchange these rights. His more famous “Social Cost” paper is, for most readers, difficult to comprehend as a whole. However, it is cited to support many propositions and is said to be the most cited publication in law and economics.

In his papers, Coase did not use the terms externality or external costs, although many economists directly associate the Coase Theorem with those concepts. His non-use of the term externality was intentional. He explained:

But, as employed today, the term carries with it the connotation that when “externalities” are found, steps should be taken by the government to eliminate them. As already indicated, the only reason individuals and private organizations do not eliminate them is that the gain from doing so would be offset by what would be lost (including the costs of making the arrangements necessary to bring about this result). If with government intervention the losses also exceed the gains from eliminating the “externality,” it is obviously desirable that it should remain. To prevent being thought that I shared the common view, I never used the word “externality” in “The Problem of Social Cost” but spoke of “harmful effects” without specifying whether decision-makers took them into account or not.

Coase directly addressed Pigou’s welfare economics and its concern with the divergence of social and private costs. Coase used Pigou’s example of sparks from a railroad causing fires to adjoining farmland. Pigou saw the cost of fire as a social cost—that is, uncompensated damage that injured the social optimum. But as Coase explained, statutory law in Britain often exempted railroad from liability for fires caused by sparks from engines. Pigou was apparently ignorant of the law but, more importantly, viewed the matter as a cost imposed unilaterally by the railroad on adjacent property owners. The divergence between social and private cost could, given Pigou’s logic, be reduced if the railroad is forced to pay compensation and, thus, is forced to “internalize” the cost it imposes on landowners.

Coase’s celebrated insight is that it does not matter who has the liability so long as a property-rights assignment exists and the parties are able to bargain. Another key insight is that costs are reciprocal; each party’s action, or inaction, contributes to the problem. Therefore, if bargaining is possible, the parties can be expected to choose to minimize the costs of their interactions regardless of who is initially assigned the right.

Suppose, for example, the expected value of the damage from fires is greater than the cost of limiting sparks by investing in spark arresters. Hence, if the railroad has the right to emit fire-causing sparks, sparks will be emitted despite the fact that the damage caused by the sparks is greater than the cost of preventing the damage. After all, the cost of fire damage is borne by landowners and not by the railroad. Coase’s insight is that the ability to bargain is sufficient to internalize this cost. Landowners will offer to pay the railroad to prevent sparks from flying. The landowners will offer an amount greater than the railroad’s cost of preventing the sparks. If the railroad stubbornly refused the landowners’ offer, the cost of the resulting fire damage would be internalized on the railroad in the form of foregone payments from landowners. Seeking to avoid this cost, which is, by assumption here, higher than the cost of using spark arresters, the railroad’s self-interest will likely prompt it to accept the offered payments and install spark arresters.

The outcome would be no different if the landowners owned the right to be free of fire from railroad sparks. [Sanjeev: this is the default position of libertarians, with sparks being seen as an attack on their property] Then, the railroad would have to compensate landowners for fire damage caused by railroad sparks. Using its lower-cost option, the railroad would install spark arresters rather than pay to landowners the higher-cost damages for fires caused by sparks.

On a separate matter than the exposition of what is now called “the Coase Theorem,” Coase criticized Pigou for not bothering to investigate the law regarding railroad liability before decrying what he concluded was the obvious injustice of the rule. Pigou, like modern welfare economists, seems to presume that enlightened government leaders will get the rules right if economists point out to them defects in the rules that cause social waste. Parliament knew very well what it was doing when it passed the Railway (Fires) Act of 1905, which was amended various times, likely at the behest of affected parties. Coase’s point was that, like the rule or not due to its legislative origins, which may well reflect political special interests, it established a property right that parties were free to take into account as they organized their economic activity.

Coase knew that Pigou understood that government agencies might not always perform as well as their champions wished. But Coase dismissed Pigou’s warning of poorly performing government agencies as formulaic and unreflective of Pigou’s confidence in such agencies. For evidence, Coase cites Pigou’s optimism that improvements in democracy and in public administration, especially the advent of the independent regulatory commission, are sufficient to ensure that government (at least in the United Kingdom and the United States) will generally execute market-correcting tasks in the apolitical and scientific manner prescribed by economists such as Pigou. The bottom line, for Coase, of Pigou’s optimism about government’s capacity to correct market “imperfections” is that neither economists nor government officials take seriously enough the alternatives to regulatory intervention, including the alternative of what Coase described as “inaction.”

Besides a naïve view that politicians and other government officials will devise “optimal” solutions to “correct” the divergence of private from social cost, those who adopt this Pigouvian stance also fail to consider the social costs of government actions. The externality literature is overwhelmingly about private actors who allegedly need to be turned in other directions by corrective taxes, bans, limitations, or subsidies. For Coase, state-imposed rules also create costs that are unnecessary when judged by an inappropriate ideal that fails to account for the reality of transaction costs.

Coase uses the example of a red light installed at an intersection. Drivers stop at red lights even when no crossing traffic or pedestrians are visible because the cost running a red light, a combination of the risk of getting a traffic ticket and of getting into an automobile accident, is too high. State-imposed rules, such as traffic laws, are inefficient when judged by the same standard of perfection against which private rules are typically judged. The social costs imposed by such imperfect state controls are largely ignored. When welfare economists and others prescribe “fixes” to social cost problems, they should, at a minimum, investigate the practicality of the consequences, including consequences of the proposed remedies, rather than assume that social planners know best.

Government agencies routinely engage in cost-benefit analyses to assure us of the high value of rules that are imposed, but the analyses are often suspect. Estimates by excellent economists about costs of economic events and government programs can vary wildly. The 2010 BP oil spill in the Gulf of Mexico caused many people to change their vacation plans that resulted in litigation. One estimate of loss suffered by recreationalists due to changes in plans resulting from the oil spill was $661 million; another group estimated the same loss to be 26 times greater. Imaginary numbers (or wild assumptions employed in devising numbers) are routinely made to bolster alleged values.

Pigou and Bator were among the many economists who believed that corrective taxes could align social and private costs so as to reduce undesirable behavior and compensate supposed aggrieved parties. [Sanjeev: but in reality the taxes are not used for any compensation] That is, those suffering from smoke or railroad sparks would be compensated by the party that “caused” the externality. The notion of ownership, exchange, and liability apparently escaped attention. Presumably, if Pigou had understood that railroads had legislation in their favor, he would have objected and proposed reversing the rule. However, any imagined response by Pigou misses the point that the result, and costs, would be much the same regardless of the rule if bargaining is allowed.

Welfare economists often argue that actual compensation of externality “victims” is not needed because corrective taxes, accurately set, are sufficient to adjust the behavior of the party engaged in the disfavored act to improve social productivity. The tax revenues can go to the general treasury. This conclusion ignores the social costs created by government use of resources. As explained by Armen Alchian and William Meckling: “The problem is identical with the familiar problem of divergence between private and social costs. Once tax receipts reach the Treasury, they are owned by no one. To the individuals entrusted with their expenditure, the costs of using these funds are not equal to their value. They are not required as a condition of survival to see that value of output exceeds the value of inputs.” The non-optimal use of resources moved to political control compounds the problem by charging imperfect government officials with the task of correcting “imbalances” between social and private cost imbalances. Real resources are always at stake and are entrusted to the tender mercies of politicians for distribution.

To return to the evolution of economic thinking on externalities, next came two papers by James Buchanan. In the first paper, Buchanan begins by putting aside the notion that welfare economists can make meaningful policy prescriptions to solve the problems of market failure. He acknowledges that competitive markets do not satisfy the conditions for optimality. That is, bliss points – allocations of resources that cannot be improved upon – are constructs not related in any operational way to the real world. Economists cannot explain how to get society to nirvana; however, they talk as if such engineering is possible “to justify their own professional existence.” When Buchanan was writing in 1962, economists had devised the many prescriptions we hear today—”tax-subsidy schemes,” “multi-part pricing,” “collective stimulation of ideal market processes,” and other notions alleged to enhance economic efficiency.

Buchanan asked the question that if economists think their prescriptions are not, in fact, policy relevant, then why should they bother to advance such notions? To argue that the existing order is imperfect, and then to advance “solutions” that are recognized as unattainable is not as useful as focusing on what is likely to emerge in a majoritarian democracy. Each decision maker, including the politician and the polluter, balances social and private costs against social and private benefits as they understand the world. Cost margins in a world of private and political decision-makers are very different from those in the Pigovian world of universal benevolence.

Buchanan said to think of a world in which all activity is organized privately except for things involving genuine public goods, where consumption by one person does not affect use by another person. Assume further that taxes for public goods are based on marginal benefits, so each person must pay a tax proportional to his own marginal rate of substitution between the collective good and all other goods. Different people would pay different taxes as the marginal utilities of these public goods would vary across people. Such a world is filled with externalities as each citizen “buys” public goods based on her evaluation of it. She considers her marginal benefit in her decision making, which includes whatever value she might assign to benefits others receive.

That paper was quickly followed by another in which Buchanan and Craig Stubblebine worked through the mechanics (math and graphs) of the notion of externalities and social equilibrium. They note that discussions of Pareto-relevant externalities are common but vague. They dispose of pecuniary externalities, focusing on technical externalities where the actions of an actor—an individual or a firm—impacts others.115 The discussion in the paper is precise, concerning equilibrium conditions, but it adds little that is relevant to our discussion here.

Several years later, Buchanan added to the growing discussion in the 1960s about how externalities could be internalized, or resolved, by the use of corrective taxes and subsidies. He demonstrates that imposing corrective taxes to deal with, say, pollution emitted by a firm in a less than purely competitive industry will reduce consumer welfare. The trend in welfare economics to divine proper taxes and subsidies is not beneficial. “Even if we disregard all problems of measurement, making the marginal private cost as faced by the decision-taking unit equal to marginal social cost does not provide the Aladdin’s Lamp for the applied welfare theorist.” With this piece concluding his work in the 1960’s, Buchanan left little room, based on economic theory, for externalities to be seen as policy relevant.

The “Pigovian tradition” soon replied. William Baumol led the charge, contending that Coase, Buchanan, and others cast aspersions on Pigovian prescriptions “that might prove effective in practice.” While one-on-one bargaining cases need not be addressed as they are “relatively unimportant.” In large-number cases, such as air pollution or traffic congestion, “taxes upon the generator of the externality are all that is required.” The fact that the resulting allocation of resources is not optimal does not matter. Taxes and subsidies improve upon what exists even if they do not achieve bliss points. [Sanjeev: this seems simplistic – where do the taxes go?]

Baumol takes the classic example of the smoky factory that damages a neighbor’s laundry. Forget party-to-party bargaining, Baumol explains, the smoke is a public bad that should be taxed. [Sanjeev: that’s exactly the point that Demsetz had made: distinguish a public bad from the concept of externalities] When it is taxed, the smoke will be reduced and the laundry business will be in a better position, as will everyone else in society, due to the reduction in smoke. The laundry owner does not need to be compensated via the tax scheme; social benefits arise from the tax because the smoke is reduced to a reasonable level. If we want more output from a smoky factory, keep the tax low and there will be more factory output and laundries will not locate nearby, thereby producing a superior allocation of resources.

While Baumol knows the tax/subsidy scheme will work, he admits that discovering the exact correct level of, say, smoke emissions, is difficult. After all, “a very substantial proportion of the cost of pollution is psychic;” and differs across people, so the measurement problems are immense. A process of trial and error of different tax rates might need to be worked through to iterate toward the socially optimal level of output.

As optimal tax rates are unknowable in practice, Baumol recommends setting satisfactory levels of emissions. There needs to be a balance between emissions and production. He likens the matter to macroeconomic stabilization policy “where it is decided that an employment rate exceeding w percent and a rate of inflation exceeding v percent per year are simply unacceptable, and fiscal and monetary are then designed accordingly.” Such a policy avoids heavy administrative costs and does not use the police or the courts much. It is a system of direct controls “to achieve decreases in pollution … at minimum cost to society.” Policymakers should not be “paralyzed by councils of perfection” in an effort to achieve optimality, so we should have flexible rules that head us in the right direction.

Baumol set the stage for how much of environmental economics has progressed since that time. In his view, economists could play a role in crafting “solutions” to assorted problems, including pollution. On the other side, Coase spawned a literature that focuses on property law and other institutional arrangements, formal and informal, that serve to resolve disputes over the use of resources without the need for top-down edicts.

Harold Demsetz explained this divide. He notes that Marshall’s primary concern about external impacts on industry efficiency, important in Marshall’s time, is rarely discussed now. The externalities that matter now are those in which one party inflicts costs on another party. These cases can be divided into two categories: the first is where bargaining between the parties is possible; the second is where such bargaining in too costly.

The first of these two categories is illustrated by a tenant-landlord situation. The tenant has a short time horizon so little incentive to make long­term investments that the landlord would like. Pigou thought legislation could help correct this situation; he ignored the ability of landlords and tenants to solve problems through the contracts that they strike with each other. It is now generally understood that Coasean bargains will resolve such problems. Of greater relevance are situations in which bargaining is too costly. In such cases, bargaining will not resolve differences between the parties, thereby leaving a gap between private and social cost, and, hence, leaving open the possibility that taxes or subsidies are the best means for achieving optimal outcomes.

Demsetz explains that Pigou, Meade, and others presumed too much when they asserted that bargaining will not resolve problems. Beekeepers and lighthouses were common examples used to show the market was limited in application. But those examples have been shown not to be descriptive of reality. Private parties discerned how to strike mutually beneficial deals or to otherwise devise efficiency-enhancing institutional arrangements.

Transactions entail transaction costs. Economists often assert that the Coasean world is one of zero transaction costs—when parties will surely reach a bargain. But Coase never meant a world of zero-transaction costs to be the center of analytic or policy attention. Zero transaction cost is much like a frictionless world; it is practically irrelevant. What is instructive is to understand how parties achieve resolution of problems in the real world of positive transaction costs. Transaction costs are why firms exist and why bargains are struck all the time, everywhere. The fact that transaction costs are pervasive is taken by the advocates of regulatory intervention as justification for “an expanded government role in resource allocation.” Coase’s acceptance of transaction costs, and the focus on the study of these costs, is what can help us challenge the presumption that the mythical state interested in perfecting the world, under the wise direction of learned economists, is required to resolve problems.

To briefly summarize, Marshall and, especially, Pigou launched the notion of external costs as a concern for economic analysis. Marshall saw these costs mostly in terms of what might now be called industrial policy; Pigou saw them more in terms of social issues, such as the problem of women working in factories. In the 1950 and 1960s, externality analysis was formalized more into the manner it is known today. Buchanan and others found the notion to have little analytic merit; in contrast, Baumol and others saw it as a tool for advancing policies to rectify social problems.


This is a great summary. But I don’t think Bourdeaux has understood Demsetz’s main point re: transaction costs at all. The reference to Demsetz’s work is cursory and in sufficient. It is crucial to read Demsetz directly since he is basically saying that the externality problem DOESN’T EXIST. On the other hand, he does accept the “public bad” problem for which he does agree with taxes (although he doesn’t quite explain where the taxes go).



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Sanjeev Sabhlok

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