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Are Pecuniary Externalities Externalities?

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WARNING: Wonky

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This weekend I’m in Tucson attending a Liberty Fund conference on law, legislation, and property rights – particularly as these relate to water.  My fellow conferees include a number of world-class thinkers, including Gerard Alexander, Terry Anderson, Peter Coclanis, Pierre Desrochers, Jay Dow, Jim Huffman, Gary Libecap, and Roger Meiners.  (I list only the more senior members of the group.)

During the second session this morning Terry Anderson expressed his unhappiness with the concept of what economists call “pecuniary externalities [2].”  Terry argues that this term and the concept to which it refers are hopelessly confused and confusing.  He is correct.

Economists commonly use the term “pecuniary externalities” to describe reductions in the price (and, hence, in the income) that Smith the Seller suffers when consumers, discovering better deals elsewhere, choose to buy less of Smiths’ product.  Pecuniary externalities are distinguished from “technological externalities,” which are the physical effects on Smith’s property caused by Jones without Smith’s permission.  (Of course, both sorts of “externalities” can be “positive” as well as “negative.”  My short descriptions here are of negative pecuniary and technological externalities.)

In a later post I will explain Terry Anderson’s proposed solution to the gross confusion caused by the concept “pecuniary externality.”  It is a solution that I endorse.  But for now – and being short on time – I want merely to register the observation that most, and perhaps all, of what are called “pecuniary externalities” are not externalities at all.

Any possible effects that a market participant does, or has good reason to, take account of in his or her choices and actions is not an externality even though these effects are caused by the actions and choices of other people without that market participant’s permission.  All such effects, being anticipated (or being anticipated by the ‘reasonable person’) are internalized on the market participant.*

Therefore, in a competitive market economy no seller – whether she be a merchant selling wares to consumers or a worker selling labor to employers – suffers a negative externality when consumers voluntarily shift their patronage away from her.  The reason is that this seller anticipated, or reasonably ought to have anticipated, the possibility that consumers will one day shift their patronage away from her.  (As Terry Anderson puts it, “No seller has a ‘right’ in a price.”  That is, no seller has a right to receive at least some minimum price or to sell some minimum quantity.)  Having thus internalized today the possibility that tomorrow’s demand for her product or her labor will be lower than it is today, if and when the actual reduction in consumer demand occurs, no external loss is imposed on this seller.  No ‘unbargained-for’ loss is imposed on this seller.

While the seller’s loss is real in the sense that she is made worse off by the actions of consumers – worse off, that is, compared to how she would have been had these consumers not shifted their demands away from her – it is a loss that has already been internalized on her.

While sellers often complain of being undeserving victims of wrong-doing – that is, of suffering negative pecuniary externalities when consumers voluntarily shift their demands away from them – sellers almost never proclaim themselves to be undeserving beneficiaries of unearned largess when consumers voluntarily shift their demands to them.

Put differently, if a loss of consumer patronage (and of the income that that loss entails) is a negative externality suffered by sellers, then the earlier gain of consumer patronage (and of the income that that gain made possible) is a positive externality enjoyed by sellers.  And, therefore, the earlier gain is the compensation for the later losses.

There’s no such thing as a pecuniary externality.  Or, at least, most of the price effects that are typically described as “pecuniary externalities” – including reductions in the value of capital equipment of or human capital caused by voluntary changes in consumers’ spending patterns – are not externalities at all.

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* I’m aware of the possible, and legitimate, question: “What if Jones anticipates, say, the government seizing Jones’s factory or anticipates an upstream producer polluting Jones’s drinking water?”  Such actions nevertheless are indeed often negative technological externalities, but I’ve no time now to write more.  I’ll do so in later posts.

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