Externality Accounting

Lynne Kiesling

David Friedman recently had an interesting externality exercise post:

If actions I might take would provide benefits for other people which I am not in a position to charge them for, I have too little incentive to take them. If my actions would imposes costs on other people which I am not required to reimburse them for, I have too much incentive to take them. So let government subsidize or mandate the production of positive externalities, tax or ban the production of negative externalities, thus making us all better off.

I offer the following challenge to readers. List all the positive and negative externalities from educating children. For a second challenge, pick some other public policy commonly defended on externality grounds, and try to list the externalities with the wrong sign–the ones that are an argument for subsidizing what we now tax, or taxing what we now subsidize.

He discusses examples from population and education; I naturally wonder if we can come up with energy and environment examples. Any ideas? How about the wind power subsidies we were discussing last week?

My starting point for such ideas is an idea that is implicit in his laying out the externality accounting problem: yes, living in society means that our actions and outcomes are frequently interdependent. But just because your action affects my welfare does not imply that every such interaction needs to be “internalized”. The “externality” can be sufficiently small that at the margin, if it were internalized, it wouldn’t change the outcome. In such a case, a government policy to internalize an externality is only redistributive. It doesn’t increase efficiency if it doesn’t change the outcome.

A concrete, simple example: my neighbor has a nice front garden. I derive value from her garden, but I don’t pay for the plants. If there’s a (Pareto-relevant) externality, the fact that I don’t pay induces her to plant less and have a smaller garden than she would otherwise. But consider the fact that she probably loves gardening and is the one who gets the most aggregate benefit from her garden, and I have a smaller benefit. If that is the case, it’s possible that at the margin, my marginal benefit from her garden is low enough that if I pay her for my value, it won’t change the size of her garden. In that case, the externality is not Pareto-relevant, if I pay her she won’t plant more plants, and my payment to her does not change the outcome, it just redistributes resources from me to her.

Just because an externality exists, that doesn’t mean it’s relevant. If it’s not relevant and we implement a policy to internalize it, that policy is redistributive.

How do we identify which externalities are relevant and which are irrelevant? That’s tricky. In the unreal world of fully defined property rights and zero transaction costs, relevant externalities are the ones that private parties go out of their way to internalize through side payments. But ill-defined property rights and positive transaction costs obscure that relationship. So in the real world, what do we do? I think we focus on identifying situations in which transaction costs are high enough to cause this problem, and recast the role of public policy as the reduction of transaction costs.


3 thoughts on “Externality Accounting

  1. Agreed. I think the majority of these problems can be solved by fully implenting property rights. If I have a chemical plant and I spill toxic waste into the river, but I own the river and lose money due to the toxicity, I will have incentive to clean the river or reduce the waste or dispose of it otherwise. If I earn less from the river than from the chemical plant, I may have little incentive – but that is the market choosing the value of each. If the river is within 200 miles of NYC, I might earn more by keeping it clean; if its in Alaska, I would have little incentive to clean it. This is the extreme case always used by economists to validate policies of internalizing the externalities yet property rights already put some incentives into place.

  2. The fundamental problem with externality accounting is obtaining an objective valuation of the externality. With regard to the externalities of power plant emissions, agreement on the valuation basis (control cost vs. damage cost) has been elusive for decades. The valuations, on either basis, have varied all over the map. California, always in the vanguard, at one time had three separate damage-cost-based valuations for power plant emissions externalities: one for emissions in the LA basin; another for emissions elsewhere in CA; and, a third for emissions outside CA from plants generating power for use in CA. One of these valuations may or may not have been objective; and, if objective, may have been reasonably accurate.

  3. “The “externality” can be sufficiently small that at the margin, if it were internalized, it wouldn’t change the outcome. In such a case, a government policy to internalize an externality is only redistributive. It doesn’t increase efficiency if it doesn’t change the outcome.” I think that when the costs or benefits for a certain action changes, there will be most likely one or more people who change their behaviour. There must be people who undertake actions for only a dollar worth of utility, and also ones who don’t do something because of a dollar worth of loss.

    That your driving habits (in particular) won’t be affected in any way by an increase in gas tax (externality: dependence on foreign oil from unstable countries, pollution), doesn’t mean that noone will drive less (or buy more fuel efficient cars).

    I would much rather see heavy taxes on behavior with high negative externalities than income taxes, taxes on honest work.

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