Market Failure 2: Externalities (Coase and Effect)

The traditional approach has tended to obscure the nature of the choice that has to be made. The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A?

Ronald Coase, The Problem of Social Cost

An externality is a cost (or benefit) of a market activity that does not accrue to the parties to the transaction. They are external to the transaction, hence the name. These can be negative like pollution, or positive like the herd immunity of vaccinations.

Externalities are a problem for markets because they introduce a bias into the price signal. Prices are supposed to account for all the costs and benefits generated by the production and consumption of a good, but in the case of externalities, some of those costs are left out. This leads markets to under-produce goods with positive externalities and over-produce goods with negative externalities.

The first economist to identify externalities and suggest how to deal with them was Arthur Cecil Pigou, in 1920. His proposed solution was to use taxes on products with negative externalities, and subsidies for ones with positive externalities. If the government can estimate the magnitudes of the external costs and benefits, it can improve the market’s function by bringing the market’s price closer to where it should be. In honour of his contributions, we refer to this kind of intervention a Pigouvian Tax (or subsidy).

A couple of quick notes on doing Pigou right:

1. Magnitudes matter. The purpose of the exercise is to fix a bias in the pricing system, so the goal is to set the tax / subsidy at a specific price. Estimating that price can be a tricky exercise, but you should at least try to be confident the price you settle on is closer to the real value than $0 would be, since that’s the price you could impose by doing nothing.
2. The market may not react exactly the way you expect; assuming you’ve paid attention to point 1, this is a feature, not a bug. The advantage of Pigouvian interventions over more direct regulation (like bans, mandates and similar) is that the market’s discovery process is working for you. Some producers will respond to a tax by changing their production methods, some will end up contracting due to reduced consumer demand, and others will decide that eating the extra cost is cheaper than doing anything different. The market figures all this stuff out so you don’t have to.
3. It doesn’t really matter where in the production chain the tax or subsidy is placed. As I’ve discussed before, taxes and subsidies are passed through the system. Just tax or subsidise whichever part of the process is administratively easiest.
4. For reasons of distributional equity, many people advocate using revenue from Pigouvian taxes to compensate those hurt by the externality (or tax those who benefit from an externality to pay for a Pigouvian subsidy), but this isn’t actually necessary from an efficiency standpoint. All that matters is that the market price is corrected; beyond that the market will work fine, no matter what happens to the money.

So this may all seem pretty simple so far, right? Well let me disabuse you of that by introducing the other big name in externalities – Ronald Coase.

Coase is one of the genuine legends of economics and he wrote one of the most important, and misunderstood, articles in economics: The Problem of Social Cost. For those who have heard of Coase at all, they may have heard of the “Coase Theorem,” which is sometimes rendered as “private bargaining can deal with externalities,” occasionally with a caveat about transaction costs. But this misses the complexity and importance of Coase’s contributions to externalities.

What Coase offered was a different approach to thinking about externalities, though one that is not necessarily opposed to Pigou’s. Coase used a simple example to show how complex externalities can be:

Consider a rancher and a farmer who are neighbours. The farmer grows crops, and the rancher raises cattle. Left to their own devices the cattle will trample and/or eat the crops, to the detriment of the farmer. The Pigouvian solution would be to tax the cattle, and while that works, there are several other options that would work just as well:

1. Make the rancher liable for damages. The rancher would have to compensate the farmer for any damage, leaving them to either simply pay out when they need to or come up with some cheaper solution like fencing their cattle in or moving them somewhere else.
2. Don’t make the rancher liable for damages (bear with me here). If the farmer bears the losses from cattle damage they can fence their crops in to prevent damage, or if that’s too expensive pay the rancher to go elsewhere or reduce their herd.

The important point is that from an efficiency standpoint it actually doesn’t matter who pays for the damage, as long as the government makes it clear who has to pay. The rancher and farmer can figure out between themselves what happens from there. Clearly each side benefits more from one assignment of rights than the other, but from a social efficiency standpoint it doesn’t matter – the lowest cost outcome will prevail regardless. This leads to the standard economists’ formulation of the “Coase Theorem.”

In the absence of transaction costs, private bargaining will be efficient no matter how responsibility for an externality is assigned.

Doubtless many of you are already formulating objections, but let me cut you off before you go there. Coase was well aware of how important transaction costs are in the real world; the complexity of the real world was one of the recurrent themes in Coase’s work throughout his life. His point was that how rights should be allocated will depend on those real-life complications (and distributional concerns), not the demands of allocative efficiency. Coase showed us that an externality problem can be thought of as a market that has failed to emerge and that sometimes the government’s best option is to facilitate the creation of a market to solve the problem (you may be familiar with this option under the name Cap and Trade). And sometimes private bargaining will do the job and all the government needs to do is mediate the dispute. And sometimes you need a Pigouvian solution after all.

The primary factor that determines whether private bargaining will be sufficient is how local the externality is. If all the affected parties are near each other, or better yet are already doing business with each other, then private bargaining may well be sufficient. For more diffuse externalities, more direct intervention may be necessary.

The other side of Coase’s insight is that classifying something as an externality is equivalent to saying that someone’s rights are being violated in some way. This means that you can define externalities based on who has the right to do what. This helps answer some uncomfortable edge cases that can render Pigou problematic.  For example: should forms of expression that the majority finds offensive (like flag burning or blasphemy against the majority religion) be taxed? It takes a bit of hand-waving to dodge this question with a Pigouvian framework, but Coase makes it much easier – offence is only a negative externality if people have a legally-defensible right to not be offended.

As an aside, this is why I am uncomfortable when people use the argument that unhealthy things should be taxed because unhealthy people cost the government more money. By saying that a person’s lifestyle imposes a negative externality on the government, you are implying that the government has a property right in our bodies, and is entitled to compensation if you misuse its property. I much prefer the reverse model, where the government subsidises healthy actions (if doing so would save the government money) as that assigns rights of bodily autonomy to people rather than to the government.

Tune in next week where we’ll be discussing imperfect competition.