29th October 2023
What Donald J. Boudreaux and Roger Meiners think about externalities
Continuing from here.
Now for their own views on externalities.
WHERE WE ARE NOW
By the 1970s, the notion of externalities had become entrenched and became particularly popular in the area of environmental economics. The notion now, at root, is normative, as Professor Carl Dahlman of the University of Wisconsin explains; it concerns assertions of market failure.
The argument can be summarized as follows. Market failure implies that there exists a reallocation of resources, such as a change in the structure of market activities that will enrich society. In more-formal economic terms, market failure exists whenever the existing resource allocation is declared to be Pareto-inefficient. As noted above, Pareto-efficient allocation of resources exists when no person can be made better off without making at least one other person worse off. Any Pareto-inefficient allocation of resources, therefore, implies the possibility of changing resource allocation in a way that improves the well-being of at least one person without making anyone else worse off. Whenever a Pareto-inefficient allocation of resources persists, then the market is said to fail because the current arrangement leaves potential social gains on the table.
Any failing market necessarily contains the opportunity for profit; that is, the possibility of converting unexploited “social gains” into exploited private gains. Whoever works successfully to improve the allocation of resources (say an “entrepreneur”) can profit from efforts: the person or persons who gain from the improved allocation will be willing to pay the entrepreneur for the results of his effort. The amount paid will be large enough to allow the entrepreneur not only to cover his costs (which might include compensating people who are harmed by his resource-reallocation efforts) but also to reap profit for his successful effort to improve the structure of resource allocation.
Of course, the entrepreneur will undertake such efforts only if his expected cost of doing so falls short of his expected gain. This qualification is as it should be. Suppose, if we ignore whatever costs the entrepreneur must bear to change the pattern of resource allocation, the gain to society of changing the resource-allocation pattern is $100. If the cost to the entrepreneur is greater than $100, then efforts to change resource-allocation pattern are not worthwhile. If the entrepreneur who successfully changes the allocation pattern discovers that it costs $101 to do so, not only does he suffer a loss, society does too. It is wasteful from society’s perspective to use $101 worth of resources to generate $100 of benefit. Put differently, if the cost of improving the resource-allocation pattern is greater than the benefit from doing so, the unimproved pattern is optimal. The unimproved structure of resource allocation, it turns out, was Pareto efficient. The existing pattern did not reflect market failure.
This logic prompts three different sorts of responses; responses from analysts we will call Stiglerians, Hayekians, and Stiglitzians. When Stiglerians are confronted by an Observer (one who makes observations about the state of the economy) with allegations of a market failure, Stiglerians reject the allegations. They argue that whatever exists is optimal, otherwise some profit-seeking party would have already acted to improve the situation. The Stiglerians assert, therefore, that the current situation only appears to the Observer to be suboptimal because the Observer fails to see and to account for some of the costs that must be incurred to rearrange the resource-allocation pattern. Because such costs cannot legitimately be ignored when assessing the propriety of rearranging the resource-allocation pattern—and because any worthwhile change will be brought about by economic agents—any assertion of market failure is a myth.
When Hayekians are confronted by an Observer with assertions of some market failure, they acknowledge that the market may be failing. But Hayekians have confidence that the profit motive prompts people to discover ways to earn a profit by improving the pattern of resource allocation. Profit-seeking entrepreneurs can be relied upon to improve the matter soon enough. Like Stiglerians, Hayekians reject the notion that government officials, economists or not, are better than entrepreneurs and other economic actors at assessing the costs and benefits of resource allocation. Yet unlike Stiglerians, Hayekians believe that human error is real. Time is required to discover suboptimal patterns of resource allocation and to accomplish improvements.
Although the details of their analyses differ, Stiglerians and Hayekians reach identical policy conclusions when confronted with claims that some putative market failure must be corrected by the state. That policy conclusion is almost always that alleged market failure does not benefit from state action. The claim is dismissed as being false by Stiglerians, or as one that fails to appreciate the superiority of the entrepreneurial market process over the political process in discovering and correcting market failures by Hayekians.
When Stiglitzians are confronted by an Observer with allegations of some market failure they are generally sympathetic. Stiglitzians have no great confidence in the ability of private parties to correctly assess the state of the market or to competently act in pursuit of profit to improve resource allocation. They have confidence in the ability of government officials, especially economists, to assess the state of the market and to competently design and carry out effective interventions that generate improved resource allocation. Stiglitzians’ policy conclusions are very different from that of Stiglerians and Hayekians.
By exploring the strengths and weaknesses of these three dispositions we demonstrate that these positions, and others that might exist or be imagined, are just that: dispositions. None can be proven analytically to be correct or even to be better than the others. Where any person comes down—as a Stiglerian, a Hayekian, or a Stiglitzian—is determined by that person’s judgment, or even by his or her priors, about the competence of people acting privately compared to that of people acting politically.
Despite the differences that separate Stiglerians from Hayekians, and both of these tribes from Stiglitzians, all three accept the reality of externalities. Stiglerians insist that almost all externalities are what Buchanan and Stubblebine labeled “Pareto-irrelevant externalities”—that is, externalities that, while real, are not worth the cost of internalizing. Hayekians agree with Stiglerians that many externalities about which politicians, professors and pundits complain, are Pareto-irrelevant, but Hayekians disagree with Stiglerians’ insistence that all externalities are such. Hayekians concede the reality of Pareto-relevant externalities, but argue that these will reliably and cost-effectively be corrected, sooner or later, by private market forces. Stiglitzians, of course, agree with the Hayekians that Pareto-relevant externalities exist in the real world, but disagree that many alleged externalities are Pareto-irrelevant. Stiglitzians insist also, contrary to Hayekians, that few, if any, Pareto-relevant externalities can be corrected adequately by market forces. Unlike the Hayekians, Stiglitzians believe that government officials can correct Pareto-relevant externalities in cost-effective ways.
[THE EXPECTATIONS ANALYSIS OF EXTERNALITIES]
We agree more with the Hayekians than with either the Stiglerians or the Stiglitzians. However, we part company with all three in our understanding of the nature of externalities and offer a different conception of externalities, one based upon expectations. We argue that nearly all discussions of externalities proceed from a flawed understanding of third-party effects, whether they are negative or positive. As we will discuss, we conclude that externalities are far less common than is commonly asserted. [Sanjeev: I differ entirely on the second part, i.e. there can be NO PROBLEM OF SOCIAL BENEFIT]
A standard description of an externality is to say that it is an unbargained-for “third-party” effect. That is, it is a “spillover” effect that arises whenever an actor fails to take account of the cost or the benefit that an instance of her action has on a third party.
Our objection is to the typical Pigouvian manner of reckoning social costs. The common assertion of externalities fails to take adequate account of expectations. Assertions of externalities—of “market failure”—pay insufficient attention to the fact that real-world economic actors form reasonable expectations about the likelihood that they or their properties will encounter spillover effects from other people’s actions. When people expect certain consequences, either physically or to their own properties’ market values, from other people’s actions, they adjust their own actions to minimize the costs they bear, or to maximize the benefits they receive, from the expected actions of others. These expectations and the adjustments they spark “internalize” the consequences of spillover effects that appear as externalities in standard market-failure analyses. The internalized reasonable expectations of spillover effects are reflected in, and incorporated into, property rights and the value placed on them. Once incorporated, these expectations render many spillover effects that appear on casual observation to be externalities to be, in fact, part of the structure of property rights.
A common example: someone who buys land located near a busy airport should reasonably expect to regularly hear noise from airplanes. That person’s property right to her land does not include the right to be free of airport noise. In the language of the common law, the person “comes to the nuisance.” The price that she pays for this land is discounted to reflect the absence of this particular “stick” in the bundle of rights received when she purchased the land. This price discount reflects the internalization of this landowner of airport spillover effects. [Sanjeev: in reality, there is usually NO SUCH DISCOUNT, instead LAND NEAR AIRPORTS IS OFTEN MORE EXPENSIVE, since being close to an airport dramatically increases the demand for short term accommodation such as hotels – but the general point being made is correct]
DEFINING CLASSES OF EXTERNALITIES
Given that expectations constantly adjust to the changing state of the world, property rights, and the prices attached to them, constantly adjust in an ongoing process of internalization. In a world in which people can and do change activities to reflect their evolving expectations, externalities exist only when spillover effects are unexpected. The following examples help to demonstrate this principle.
(1a) Smith owns a piece of land. Jones offers Smith $10,000 for an easement allowing Jones to lawfully drive his truck to and fro across Smith’s unpaved land for the next ten years. Smith accepts. Jones then drives across Smith’s land according to the agreement. Although Jones’s truck leaves tire marks on Smith’s land, which is unsightly to Smith, there is no externality.
Why isn’t Jones’ crossing Smith’s land an externality? One answer is: because Jones bought the right to drive his truck across Smith’s land. While true, this answer doesn’t reveal the essence of the situation. This essence is that Smith should expect Jones to drive across his land and that driving will likely leave unsightly tire marks.
The moment Smith sold the easement to Jones, Smith expected Jones would drive across his land and to leave tire marks that trucks typically make. The price Smith received for the easement reflects his expectations of such negative spillovers. Smith internalized Jones’ infliction of physical damage to Smith’s land when he reasonably came to expect such damage. There is, therefore, no externality despite one person (Jones) physically damaging property belonging to another person (Smith).
(1b) Changing the example slightly yields a different outcome. If Jones owns no easement over Smith’s land but drives his truck across the land and leaves unsightly tire marks, then Smith may suffer a negative externality. [Sanjeev: The term negative exteranlity might not quite be approropriate for this case but one can live with it]
More to the point, his expectation of not having his property invaded and damaged by another has been violated. A court would be expected to grant Smith’s request to enjoin Jones’s damaging actions, as well as hold Jones liable for damages inflicted on Smith.
(2a) Johnson’s suburban residence is ten miles from downtown, where she works. She drives to and from her office on open-access roads. Her route, were she to drive it at 3:00 am, would take 15 minutes, but during rush hour the drive typically takes an hour. The standard economist’s assessment of this situation is that it is rife with negative externalities. The economist reasons that, when deciding whether or not to drive on particular roads each driver considers only the costs and benefits that she experiences by driving. Drivers do not account for the costs their driving imposes on other drivers. But there is no externality.
Each day as she sets out to drive during rush hour, Johnson is aware of the likely traffic conditions. Although she’s unhappy with those conditions, she chooses to drive on the traffic-jammed roads. She expects to encounter heavy traffic during rush hour. She internalizes the effects of the actions of the many other drivers who share the roads with her. Moreover, her internalization of traffic congestion causes Johnson to alter her behavior. Where she chooses to live might be closer to her place of work than it would be if she didn’t expect to encounter congestion.
The price of her abode reflects expectations of congestion. Ceteris paribus, the prices of homes any given distance from a city center is usually lower the greater the expected amount of traffic from that location. Suppose that Johnson would have paid $200,000 for a home ten miles from the city if she expected little traffic during rush hour. If she expects heavy traffic, however, the value of that home to her falls. The market value of the home also falls because most people share Johnson’s expectations of heavy traffic. So Johnson purchases the home for, say, $180,000 rather than the $200,000 that she would have paid in the absence of traffic congestion. The lower price of her home compensates her for the congestion she expects to endure during the commute.
(2b) Suppose instead that Johnson bought a home that, although it is ten miles from where she works, is just off of a privately owned, restricted-access highway on which tolls are charged at market rates. The tolls are scientifically designed to ensure that traffic volume are always socially “optimal.” Given that traffic congestion on an identical open-access road imposes unnecessarily high costs on drivers—that is, given that the cost to each driver of the congestion is assumed to be inefficiently high—the cost to Johnson of paying tolls to drive on the uncongested restricted-access highway is lower than is the cost to Johnson of enduring the congestion that regularly slows her commute on an identical open-access highway. In this example, Johnson’s daily commute is not inefficiently slow. The cost to her of using the tolled, restricted-access highway is lower than is the cost to her of using the open-access highway, justifying to her the $200,000 price she paid for her home just off the restricted-access highway.
Unexpectedly, a year after Johnson bought this home, the government uses eminent domain to seize the restricted-access highway and convert it into a public open-access highway. Johnson’s commute suddenly becomes much longer. We might say that the government’s conversion of the highway from restricted- to open-access imposes an externality on Johnson. Not only does she find herself confronting a longer commute than she reasonably expected when she bought the home, but the market value of her home will fall to reflect the increased inefficiency of the commute. Because the government’s action was unexpected, Johnson could not reasonably have adjusted to that action to shield herself from these losses. As in example (1b) above, a party here suffers an unexpected loss, or cost, because another party acted in a way not reasonably expected.
(3a) Williams has worked since she was 18 years old in a factory making furniture. Williams loses her job at age 50 because consumers’ preference for lower-priced furniture imports causes her employer to go bankrupt. Williams suffers a loss. [Sanjeev: this kind of “externality” is ruled out from first principles]
Economists classify Williams’s loss as a “negative pecuniary externality.” That is, she incurs a real loss but its value is more than offset by pecuniary gains to consumers from the lower prices paid for furniture. That is, negative pecuniary externalities are offset by positive pecuniary externalities of at least the same value. Because there is no net social loss with pecuniary externalities, economists conclude that corrective action by government is neither necessary nor appropriate.
That is, with pecuniary externalities there is no market failure. The failure of consumers, when buying furniture, to account for the consequences of their decisions on Williams and other domestic furniture producers is not a failure of consumers to take adequate account of the marginal social costs of their decisions. With pecuniary externalities, there is no divergence between the marginal private cost and the marginal social cost of a decision. Although consumers do not account for the cost that purchases of imports imposes on workers in domestic furniture factories, the consumer does account for gains from lower prices. Because the gains to consumers from competition-driven economic change can be shown to be at least as large as the losses the changes cause producers, there is no net social cost of competition-driven economic change.
We agree with the standard economic analysis that in this example there is neither economic inefficiency nor any need for corrective intervention by government. But we disagree with those who contend the furniture worker suffers an externality. In a market economy, particularly one in which employment contracts are at-will, no worker reasonably expects that she will keep her job for as long as she wants it. Put differently, Williams expects, or should expect, that she might lose her job for any number of regularly occurring reasons, including changes in market conditions.
Williams reasonably expected the prospect of job loss and, therefore, internalized the prospect. She adjusted to it or reasonably should have adjusted to it. For example, she and other furniture workers likely earned wages higher than for work at similar jobs in industries less likely to be subject to increased import competition. When the job loss occurs, Williams suffers no externality; because there are no spillover effects from other people’s actions that are not already internalized. She suffers nothing that “ought” to be compensated or that other people ought to be taxed for or prevented from imposing on her.
(3b) Williams at age 18 is unusually forward-looking and unusually economically risk-averse. She seeks the most secure employment possible. She avoids employment in “tradable-goods” industries (ones likely to suffer competition from imports). She instead seeks employment in an occupation unlikely to be destroyed by imports. Williams moves to Nevada and begins work as a prostitute. After twenty years of working legally as a prostitute, the State of Nevada unexpectedly outlaws prostitution statewide. Williams might be said to suffer an externality. Having no good reason to expect that her occupation would be outlawed, Williams loses the opportunity to earn a living in that particular occupation, but, more to our point, she had no opportunity to adjust her actions to protect against this unexpected change.
Each of these examples features a person who experiences negative consequences, spillover effects, as a result of the actions of others. Yet in examples (1a), (2a), and (3a) the person expects or should expect to experience these consequences. These expectations lead each to adjust his or her actions to compensate for the expected negative effects. These expectations and the adjustments they spark internalize the spillover effects on the individuals. In contrast, in examples (1b), (2b), and (3b), none of the individuals expects, or has reason to expect, the negative spillovers. The individuals had no opportunity to adjust actions to such negative spillover effects. The spillover effects in these cases can sensibly be called “externalities.”
Example (1a) describes an obvious case of a spillover effect not being an externality on the person suffering that effect. Landowner Smith gave Jones permission to take the actions that generate some negative effect on Smith. The absence of an externality in (2a) is less obvious. Nevertheless, no externality exists in (2a) because commuter and homeowner Johnson, expecting long commutes, takes other drivers’ actions into account and changes her behavior accordingly. Given the existing property-rights structure of the roads (open-access), Johnson has no property or other legal interest that is damaged, obstructed, or taken from her by other drivers. In (3a), Williams has no legal right to continued employment at any particular job and, thus, when she loses her job making furniture, has no legal interest is upended.
Matters differ in each of the “b” parts of the examples. In (1b) Smith suffers a violation of a legal right long recognized and enforced at common law. The violations in (2b) and (3b) are less straightforward but real. The expectations of Johnson in (2b) and Williams in (3b) were grounded in the existing structure of law and legislation. There was no reason to expect to change. While unlike in (1b) neither of the individuals in (2b) and (3b) suffer an infringement of a right recognized at common law, each of the individuals in (2b) and (3b) suffer as a result of a legal change that no reasonable person had cause to expect.
In sum, in a world in which people adjust activities to reflect their expectations, externalities exist only when spillover effects are unexpected. When expected, spillover effects are incorporated into the structure of property rights. Transactions such as the purchase and sale of property and creation of contracts and protection of those interests from tortious interference result in market prices for those rights that reflect expected spillover effects. In the example of Jones buying an easement across Smith’s land, Smith knows his enjoyment of his property will be affected. If after six years, Smith sells his land to Wilson, the property right that Wilson acquires does not allow him to unilaterally prevent Jones from crossing the land according to the terms of the easement. When the easement was created, the nature of the property changed.
In the example of Johnson driving on open-access roads, she has no reasonable expectation of enjoying exclusive use of the roads. Even if Johnson, when suing to reduce the number of drivers, proves that when she began to use the roads they were not as clogged with traffic, the court would deny her claim to possess a right to less traffic on those roads. Johnson should have expected the possibility that open-access roads could become clogged with traffic. If, in contrast, she had built and operated the roads privately, reserving to herself the right to decide who uses the roads and on what terms, matters would differ. Drivers who use the roads, without Johnson’s permission, even if she was not using the road, violate her property right.
In the case of Williams who works in a furniture factory, her agreement to work at-will means that she should reasonably expect the possibility that one day she will lose her job. She has no property right in her job. If Williams’s employer contractually agreed never to fire her for as long as the employer remained in business, then Williams would have, by contract, certain property rights in her job.
A WORLD FILLED WITH SPILLOVERS
Prices, wages, and other market values adjust to reflect expectations of spillover effects. Although obvious when stated, this conclusion is more substantive than it first appears. Most discussions of externalities begin mid-stream. Landowners are assumed to exist and are assumed to use their lands in certain ways. Factories are assumed to exist and are assumed to produce certain outputs using certain production methods. Drivers are assumed to exist driving wherever they happen to drive. Residential areas are assumed to exist in locations particular distances from factories. The analyst then identifies spillovers across parties. [Sanjeev: We can agree with this. Taking this forward, we observe that positive externalities are embedded into the prices as well; in any event, a social planner needs to consider all effects, not just negative ones]
In a common example, a factory pollutes the air used by a nearby laundry to clean the clothes of its customers, thereby inflicting a spillover on the laundry. A Pigouvian or Stiglitzian draws a graph showing that the marginal private cost confronted by the factory owner is less than the marginal social cost of the factory’s production activities. The Pigouvian concludes that the factory produces too much output that results in too much pollution. Therefore, corrective taxes or regulations are necessary. The Coasean agrees with the Pigouvian that a spillover exists, but disagrees on the solution. The Coasean notes that if rights to air quality exist, the parties can bargain or litigate to enforce the rights. The “optimal” result will arise because the party who values the property right the highest will buy it from or not sell it to the other party.
Factories and laundries do not simply pop into existence. Each sets up at a particular time and place [Sanjeev: the sequencing issue], with a set of expectations about what it may and may not do. The decision by the party coming to the scene after the first party arrived determines the second party’s expectations about the state of the world. If the laundry arrived on the scene after the factory, decisions by the laundry owner must incorporate legitimate expectations of the operation of the factory, including whatever spillover effects are likely to affect it. The price the laundry owner paid for the site reflects these expectations as do the supplies the laundry owner buys to operate his laundry. Given that the laundry owner chose to set up shop when and where he did, and given the expectations that he had in doing so, or should have had given the rights structure, it is difficult to see in such examples effects that are called “externalities” demanding governmental action.
The physical spillover effects the factory has on the laundry are indisputable but are not externalities. The laundry owner’s expectation of the effects must be presumed to be internalized in his decisions. Put differently, these spillover effects are part of the definition of the both the laundry-owners’ property rights and of the factory’s owner’s property rights: to wit, the factory owns the right to emit pollutants of this sort into the air, while the laundry owner owns no right to be free of such pollutants from this factory.
Externalities exist only when another party’s actions create unexpected spillover effects. Put differently, for there to be no externality, all that is necessary is that the party encountering spillover effects expects or reasonably should expect to encounter them. This expectation prompts the party to adjust to the expected effects. To the extent that adjustments to the spillover effects do not occur because the benefits of adjusting do not justify the costs of doing so, the market value of affected properties adjusts to reflect the spillover effects.
When a spillover is expected, it is internalized on the parties to the effects, which eliminates the externality. Internalizing the externality does not require the party who might conventionally be identified as ‘causing’ the spillover effect to take account of the effect either consciously or by responding appropriately to prices, taxes, or subsidies that include the value of the effect on the ‘victim’ of the spillover. For example, for there to be no externality, it is not necessary, although it would be sufficient, for a railroad to take account of the effects that sparks from its locomotives have on the owners of lands adjoining the railroad’s tracks. If the landowners expect their lands will be damaged from the sparks of locomotives, the landowners internalize these costs. The landowners adjust in various ways, say by moving their crops further from the tracks or by growing crops less likely to burn easily. Further, the market value of the land incorporates the landowners’ success or failure at avoiding the ill-effects of the sparks.
When a pattern of effects is expected, the details of those expectations define the specific contours and contents of property rights. If owners of land adjoining railroad tracks expect routine damage to the land from locomotive sparks, the landowner does not own the right to be free of railroad sparks. That right is not one of the sticks in the landowners’ bundle of rights. That stick is owned by the railroad.
PROPERTY RIGHTS, NOT SOCIAL ENGINEERING
Unlike in the literature on externalities, nothing said here suggests that the absence of spillovers implies a Pareto-optimal allocation of resources. The problem is not externalities or spillover effects whether anticipated or not. The problem, if one asserts there is a problem, is in the structure of property rights. It is necessary to have a set of institutions that allows parties to make deals under a set of enforceable and protected rights.
This approach describes traditional common-law courts. In Sturgis v. Bridgeman, the court was not called upon to make an economic assessment regarding which of the two parties is the least-cost avoider. The court was asked to determine which party had the property right to the noise and vibration environment of the building: the confectioner or the physician. When courts make such determinations they ask which party acted consistently within prevailing expectations or rights structure.
The process of determining, in any legal case, which party is the least-cost avoider is not rational calculation by the court but evolves from human behavior leading up to the dispute that gave rise to the case. The determinative factor, in short, is prevailing custom.161 The courts have long looked to community expectations, broadly defined, to discover as best as they can which party acted in a way most consistent with expectations. That party is the one declared to have “the right.” Property rights are a bundle of expectations about how others (including the state) will act in different circumstances. Expectations may originally give rise to de facto property rights which, if courts rule in ways consistent with these expectations when disputes arise, become de jure property rights. Hence. insofar as no one’s legitimate expectations are upset, no externality occurs.
The prevailing pattern of expectations—and, hence, the particular arrangement of property rights in which expectations are embedded—is not necessarily economically optimal with respect to a particular situation. However, having clear property rules in place allows parties to adjust their behavior to the legal structure. The point is that no externality occurs when spillover effects are expected, or reasonably should be expected. In some instances, altering existing property rights might improve economic efficiency even if doing so violates prevailing expectations.
The challenge is not for external observers, such as wise economists, to design and implement government policies that “internalize externalities” given transitory circumstances. There are few instances when someone experiences a consequence that he did not expect or had no good reason to expect, and, hence, to which he has not already adjusted his actions in a Pareto-optimal way. The challenge is to allow the evolution of a system of property rights that encourages productive social cooperation. Framing the problem as one centered on external effects deflects attention from the core issue and gives rise to the notion that planners can respond to issues and help construct statutory or administrative rules to enhance economic efficiency as seen by the planners. To believe that approach can succeed requires omniscience by such observers who generate policies divorced from politics. Both assumptions are absurd.
We have reviewed the origins of the concept of externality. It began with the noted economist Alfred Marshall more than a century ago. His concern centered on the effects of the spread of information that would spur economic development. Some information was internal to a firm, some was external information that could help spur productivity. His protégé and successor at Cambridge, A.C. Pigou, wrote extensively about problems associated with private production and consumption decisions. Society would not maximize its well-being if private actors were not restrained by legislation designed to ameliorate wrongs, such as women working in factories, which was of particular concern. Pigou’s distinction between social cost and private cost launched the discussion that proceeds apace about the need for governmental action to right economic wrongs.
Some economists, especially in the 1950s, expanding the work on externalities, showed that by pulling just the right levers, higher levels of wealth and welfare, all the way up to “bliss points,” could be achieved. Professors Scitovsky, Meade, and Bator formalized the model of externality, showing how a change in rules, perhaps by imposing taxes on undesirable activities or by ordering investment in underutilized areas, could raise social welfare. Nobel laureate James Buchanan dismissed such hopes through formal economic logic, showing that the justification for state action to rectify private-sector problems applied only to a limited set of instances and, in any case, ignored the consequences of turning such matters over to the tender mercies of legislatures or the bureaucracies they create and monitor.
Until about 1970 the focus was on more efficient economic planning. For years, development economists contended that backwards countries could be pulled into modernization and wealth by assorted planning tools such as investment in select infrastructure, import substitution policies, and more. However, concern
about environmental matters soon came to dominate the application of externality. For a half-century now, economists have trotted out numerous schemes to reduce externalities, that is, close the imagined gap between imagined social optimality and private outcomes.
Professor Baumol swatted aside Buchanan’s analysis and likened environmental externalities to underemployment or excess inflation—call in the experts and they would change monetary and fiscal policy to balance inflation and employment to make the economy great again. Following Baumol, many would-be policymakers volunteer to pull the levers of power to fix the environment. Despite economists such as Buchanan dismembering the theoretical bases for asserting that bliss points can be achieved by policy actions that attack alleged externalities, many environmental economists plow ahead, sure that their wisdom, drawn upon by well-meaning politicians, will succeed in planning a better environment and economy.
We join Ronald Coase in believing that when property rights are clearly established and enforceable, and when parties are free to bargain to rearrange who owns and may use property in a productive manner that does not inflict unacceptable harm on others, we have the greatest likelihood of sustainable economic growth and private protection of property. In terms of economic logic, externalities are rare species. More common are claims that things we do not happen to like are externalities that should be changed by legislative or administrative edict.