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The Mischief of “Pecuniary Externalities”

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In my latest column for AIER I reject the economists’ common claim that what they call “pecuniary externalities” are in fact externalities [2]. A slice:

But there’s a group of third-party effects that, merely by giving them a technical name, economists have fooled themselves into mistakenly thinking are relevant and deserving of special consideration. The technical name is “pecuniary externalities.”

This impressive-sounding term refers to the effects that Sarah’s buying, selling, or investment actions have on the market value of Silas’s property.

Everyone agrees that if Sarah negligently drives her car physically into Silas’s car and thereby inflicts on it $1,000 worth of damage, Sarah violates Silas’s property right in his car and should compensate him for the damage. But suppose, instead, that Sarah, by agreeing to put her car up for sale, causes the price for which Silas can sell his car to fall by $1,000. Although the negative effect in the second example of Sarah’s action on Silas’s welfare is identical to the negative effect of Sarah’s action in the first example, only in the first example does Sarah incur an obligation to take account of the consequences on Silas of her action.

Impressed by this difference separating example one from example two, economists call the consequence of the first of Sarah’s actions – her negligently causing physical damage to Silas’s property – a “technological externality,” while calling the consequence of the second of her actions a “pecuniary externality.”

Economists then proceed to wonder why the law requires compensation only for technological externalities but not for pecuniary externalities. After all, in both cases Sarah’s action harms Silas without his permission.

The answer economists give is this: The benefits to society from actions that cause technological externalities are generally lower than are the costs to persons who suffer technological externalities, while the benefits to society from actions that cause pecuniary externalities are generally higher than are the costs to persons who suffer pecuniary externalities. And so to ensure maximum possible economic growth – or, to increase the social welfare – the law punishes technological externalities but tolerates pecuniary ones.

Economists are here correct in their cost-benefit assessments. But they cause themselves and their audiences unnecessary confusion with this labeling. The reality is that, even though it does cause the market value of his car to fall, Sarah’s decision to sell her car imposes on Silas no externality of any sort.

The chief basis for this correct conclusion that no pecuniary externality exists is that, by putting her car up for sale, Sarah takes from Silas nothing to which Silas is entitled. Yes, Sarah’s decision to sell her car decreased the market value of Silas’s car. But Silas has no property claim to his car’s previous market value. Silas, being a reasonable person (as we must assume him to be), knows that the market value of his car can change in response to the economic decisions made by strangers. Stated differently, Silas expects, with some probability greater than zero, that the market value of his car will fall. Therefore, Sarah’s decision to sell her car was already “internalized” on Silas. He took account of this possibility in his earlier decisions regarding what kind of car to buy and how long to maintain his ownership of that vehicle.

But to show why “pecuniary externalities” is a mistaken concept, we need to do more than note that Silas’s expectations include the possibility that the market value of his car will fall because others might sell cars in competition with him. Another factor in play is that Silas would not want to be relieved of this expectation if such relief meant that everyone enjoyed relief of this expectation. To relieve everyone of the expectation of the possibility that the market value of their cars will fall would require that Silas himself no longer be free to offer his car for sale whenever doing so might cause a fall in the price of Sarah’s or Steve’s car.

Because Silas (it is reasonable to assume) wants the right to sell his car whenever he chooses and at whatever price he can fetch, he cannot legitimately assert ethical or legal standing to prevent Sarah from exercising the same right over her car. By giving this right to all persons, the law effectively recognizes that everyone under its jurisdiction agrees that all people have a right to sell their cars even if some car-selling actions harm some people at particular points in time by causing the market values of their cars to fall.

The law, therefore, doesn’t merely tolerate “pecuniary externalities” on the grounds that such toleration promotes economic growth. Rather, the law treats each person as ‘purchasing’ the right to sell his or her car by giving to all other persons the right to sell their cars. The law, in short – and unlike most economists – understands that “pecuniary externalities” are not externalities at all. They are mirages in economists’ minds.

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