Economics Concept: Externality – When Prices Lie!
In a free-market economy, preferences (regarding the quantity offered and the quantity demanded of any good or service) determine prices. As we discussed in “The History of Economics in Three Lessons,” exchange occurs in only one of two ways: “political exchange” (whereby coercion is used to effect the exchange) OR “economic exchange” (whereby both parties to the exchange willingly make the trade). A free-market determined price is that at which a willing buyer and willing seller make a deal. Voluntary exchange is considered mutually beneficial to both parties involved, because buyers or sellers would not trade if either thought it detrimental to themselves.
However, are there conditions under which free-market prices are not accurate? Are there exceptions to this rule? Can a voluntary transaction cause additional effects on third parties? Yes, there can exist situation whereby a voluntary exchange may reduce societal welfare, if external costs or benefits exist. In economics, the concept is referred to as an “externality”—a cost or benefit that affects a party who did not choose to incur that cost or benefit.
Under plausible conditions, economics suggests that the existence of externalities will result in outcomes that are not socially optimal. Those who incur the “external” costs do so involuntarily (a “negative externality”), whereas those who enjoy the “external” benefits do not pay the actual cost (a “positive externality”).
In the case of positive externality, a less than optimal amount will be produced because the producer has no way of monetizing the benefit provided to third parties. In the case of negative externality, more than is optimal will be produced because the producer does not bear the external cost absorbed by third parties.
Economics suggests several means of potentially improving overall utility (optimized allocation of scarce resources) when externalities are involved. The market-driven approach to correcting externalities is to add back third-party costs (such as requiring a polluter to clean up the pollution or pay the cost of cleaning up the pollution) and benefits (such as property taxes to pay for schools) to the producers. But in some cases, this may not be feasible if the true monetary values of external cost and benefits cannot be determined.
Externalities commonly occur in situations where property rights have not been assigned or are uncertain. For example, no one owns the oceans and they are not the private property of anyone; fisherman may overfish without fear of cost or consequences. Peruvian economist, Hernando De Soto, has widely argued that successful market economies need a widespread allocation of property rights, to enable economies to fully develop.
The traditional policy response to externalities has been for governments to subsidize those activities that exhibit positive externalities (give money) and tax those that have negative externalities (take money). However, as we have seen with many centrally-planned calculations, it is almost impossible to estimate the level of taxes or subsidies that produce accurate net prices. Likewise, we know that total utility (societal well-being) is not measurable, because individual preferences are not measurable (except as expressed in prices, so we are back to square one where prices are inaccurate when externalities exist).
Economist Murray Rothbard said it best: “It is only through preference demonstrated in action that we can gauge what actors really value, and that to try to deduce values from mathematical formulas, without the evidence of action, is a hopeless cause.” The best that can be done is to see if a policy (tax or subsidy) makes at least one person better off and none worse off (try finding that solution!).
Perhaps the problem of Externalities is not as bad or as common as many economist assume. In real life, we find that social pressure plays a role in handling potential externalities (no one likes someone who pollutes, over-fishes or fails to maintain their lawn).
Frederick Hayek contended that those who value liberty should prefer social pressure against “deviant” behavior to outright bans or government intervention. Also, in real life, negotiating between the parties affected allows them to use the “particular circumstances of time and place,” with which they alone are familiar, to arrive at an equitable solution. Regulators generally cannot take such specific knowledge into account in their drafting of edicts; however, there are many case studies illustrating the resourcefulness of voluntary exchange in accounting for potential externalities (Economist Steven Cheung has studied real-life markets and has found that the parties involved had accounted for the externalities quite well—contracting with each other to raise production to optimal levels).
Walter Block, now at Loyola University, has continued work on externalities in the tradition of Rothbard. Block has challenged the traditional distinction between public goods—which must be produced collectively, because of the positive externalities they create—and private goods—the production of which may be left to the market. Block points out that this sort of analysis is flawed in that almost any good could be said to provide some benefits or costs to third parties.
The free market private ownership of resources and property rights are not a panacea; however, using externalities to justify government intervention and regulation is often a situation where “the cure is worse than the disease.” Keep this in mind as it is important to The Future of your Wealth!