At the core, market exchange is about well informed buyers and sellers freely exchanging to their mutual advantage. But what happens when the transaction price doesn’t capture all the cost or benefits of the transaction … that is, someone external to the transaction bears part of the cost and/or reaps part of the benefit? When this external impact occurs, economists refer to it as an externality. There are both negative and positive externalities. Today we look at negative externalities.
The most typical externality example is pollution. If I build a factory that puts smelly odors into the air, my neighbors will have to live with that odor. That odor decreases my neighbors’ quality of life and reduces their property values. Yet my neighbors get none of the income from factory. Therefore, both my customers and I are in engaging in exchange that places a cost on my neighbors.
There are a number of ways to address these problems. First, government creates zoning laws that segregate pollution emitting enterprises from residential and retail areas. That way my pollution will only affect those who have bought property in an area with the full knowledge that pollution is likely to be present. They calculate the cost of this pollution into the price they pay for their land. This clearly is a limit on the market. I can’t buy any piece of land and just do with it what I please. But zoning helps minimize the likelihood that neighbors will engage in activities that exact costs on their neighbors.
Another way to address an externality is through taxation. Many believe that carbon dioxide is having a damaging effect on the environment. In that sense, it is society-wide externality. The cost to ourselves and to future generations isn’t captured in the costs of the fuel sources we use. By adding a significant tax to activities relative to the amount of CO2 they produce, the costs of these activities are more fully factored into market exchanges.
Another way pollution is addressed is through cap and trade. Here the total allowable amount of a specific particulate over the course of a year is set. Then permits to emit a set amount of the particulate are sold at auction. For businesses that find it very costly to reduce emissions, these licenses will be highly valued, thus driving the auction price up. For businesses that find it easier to reduce emissions, it will be less expensive to convert to other technologies, thus reducing the overall pollution. But overtime, as the cost of licenses becomes more constraining more businesses will find it in their financial interest to make significant investments in pollution reduction. The last holdouts will eventually find themselves paying prohibitive fees to stay in operation.
With both taxation and cap and trade, businesses and markets develop their own solutions. Another approach is to either outright ban certain activities or to mandate technologies to be used in particular activities. A softer approach is to give subsidies to people who will employ specific technologies. In this way, government is not only making sure externalities are captured in the price of transactions but dictating what transactions will be permissible.
So externalities are often created and must be addressed. But notice that there are perils with each of the suggested solutions above. An overarching one is unequal application of these laws. Some powerful industries or company’s make a case for why they should receive special treatment. If politicians bow to this approach that means competitors of these now favored entities must enter the lobbying arena in order to get similar deals or to block their competitors’ deals. This suddenly makes politicians very important recipients of campaign dollars and other support from these competing interests.
What many fail to appreciate is that many large corporations welcome regulation of their industry. Regulation creates a barrier to any firms who might want to enter the market and compete. The burden of regulation is usually disproportionately cumbersome for smaller firms. The net result can be melding of powerful political and business interests all in the name of protecting the public and capturing externalities.
Both taxation and cap and trade have inherent information problems. Using taxes to counter externalities allows business to be informed of how much things will cost but how do you know which tax amount will get you the right result. Cap and trade makes the level of pollution known but how do you know how much impact a cap is going to have on costs and the ability of businesses to plan?
Another factor is that regulation sometimes has the reverse affect of what is intended. Several years ago I read about a guy in North Carolina who had hundreds of acres of tall timber forest land. Each year he would cut 1% to 2% of the trees and then replant. Then a species of owl was placed on the endangered species list. An environmental regulation was proposed that no harvesting of trees could take place within a given distance from wherever a habitat for one of these owls was discovered. Doing the calculations showed that it would take only a few owls before his entire property would not be available for harvest. He, and many other land owners, were preparing to harvest their entire acreage before owls would arrive or be found, thus wiping out habitats for the owls. What eventually happened is that the regulation was abandoned and a volunteer owl preservation program was initiated that became very successful.
There is no question that externalities are a problem but solutions to the externalities also have their problems. There are usually trade-offs between options and there are differences of opinion about which trade-off should be valued over another. The idea that no interference in the markets on these matters is always the most just approach is highly doubtful. But which policy to apply on which occasions is rarely self-evident.
As I noted at the start, there are also positive externalities … instances where people external to a transaction receive benefit from the transaction. They are sometimes called spillovers. We will turn to these next.
(Paul Krugman has a piece about externalities and climate change in the New York Times today. I don’t necessarily agree with Krugman’s assessment at every point but it gives you an idea of how economists process the issues.)