In a new, long(ish) paper that I wrote for AIER, I ponder negative externalities – a term and concept easy to misunderstand, misuse, and abuse. The core take-away is that, as social creatures, we humans incessantly incur costs as the prices we willingly pay to enjoy the advantages of human society, but costs are not losses. Losses differ from costs categorically. Only when someone incurs a genuine loss – meaning, only when someone has taken from him or her something to which that person has a legitimate property interest – is there a negative externality. Here’s a link to my paper, and below are four slices:
By far, the market imperfection believed, at least by economists, to be most common is that of externalities. An externality, as defined by the Nobel-laureate economist George Stigler, “is an effect, whether beneficial or harmful, upon a person who was not a party to the decision.” Consult almost any economics textbook and you discover a similar definition of externality. Because harmful effects of this sort (“negative externalities”) generally get more attention than do beneficial effects (“positive externalities”), the discussion in this Explainer will be confined to negative externalities, although most of the points I make apply also to positive externalities.
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For all of its apparent cleverness, the Coase Theorem is actually mundane (as Coase himself understood). This theorem simply shows that, as long as individuals can bargain with each other, legal rights no less than goods and services will be acquired by those persons who value them most highly. Nor is the Theorem the most important part of Coase’s paper (as Coase also understood). That distinction belongs to Coase’s insistence that all externalities are bilateral or multilateral. Jones cannot impose a loss on Smith if Smith is not in a position to be harmed by Jones. If there were no cropland adjacent to the railroad tracks, trains running along the tracks would cause no crop damage. The existence of the externality results from actions taken by both parties. In our example, the externality is caused no less by the farmer’s actions to plant his crops where he does than by the railroad’s action to situate its tracks where it does and run trains along them. Just as it takes two to tango, it takes at least two to “externality.”
This reality has this implication: Because each party took steps to make the externality possible, each party can take steps to prevent the externality. The following question is thus raised: Which party should take that step? Answering a “should” question involves value judgments, but economics can lend a hand by pointing out that resources are saved if externalities are dealt with in the least costly way possible. It’s not a terribly controversial normative stance to argue that the party who can eliminate the externality at lowest cost “should” be the party on whom responsibility for doing so is placed.
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By “losses,” I mean the value that a party is denied when he or she is stripped of some property interest in which he or she has a legitimate legal entitlement. If a thief steals your car, you suffer genuine loss. If Jones builds a tall fence that blocks a view to which Smith has good reason to believe he is legally entitled, Smith suffers a loss. If a freak earthquake destroys my home in northern Virginia, I suffer a loss. Using conventional language we might say that the theft “cost” you $25,000, that Jones’s fence “cost” Smith his lovely view, and that the earthquake “cost” me my home. But to get a clearer understanding of externalities, the decrements from your welfare, from Smith’s welfare, and from my welfare are better called “losses” and not “costs,” for it’s important that losses and costs be kept distinct from each other.
Unlike losses, costs are what choosers voluntarily sacrifice in exchange for benefits. Both losses and costs, each standing alone, are decrements from individuals’ welfare. But only losses spring from a series of human interactions (or Acts of God) that decrease that welfare on net. When someone suffers a loss, that person is made worse off. In contrast, when someone incurs a cost, that person is made better off.
This odd-sounding conclusion about costs follows from the fact that costs, unlike losses, are the flip-side of choices. I choose to pay $20 for a pizza because I expect that the satisfaction that I will get from the pizza exceeds the satisfaction that I would get if I were to spend that $20 some other way. Because I can get satisfaction from the pizza only by incurring the cost of sacrificing $20 to obtain it, the process of incurring this cost makes me better off.
More precisely, my access to the opportunity to incur this cost makes me better off, for embedded in this opportunity is the prospect of my receiving a gain that is greater than the cost. This reality is not changed by the fact that the net increase in my welfare from taking advantage of this opportunity would be even greater were the restaurant owner to surprise me by giving me the pizza free of charge. The bottom line is that the $20 that I spend for the pizza is not a “loss,” and no one would describe it as such.
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Each worker in a modern commercial economy is very much like a mortgage holder or the McDonald’s franchisee. Each such worker voluntarily participates in this economy because of the benefits he or she reaps from doing so. But these benefits are possible only because producers must compete for consumers’ dollars—only because consumers are generally free to spend their incomes as they choose and are not regarded as contractually binding themselves, with their purchases, indefinitely to each producer that he or she patronizes.
These benefits are possible, in other words, because the law protects the physical uses and integrity of property and not properties’ market values. In brief, neither competition in general, nor free trade specifically, create losers who in justice must be compensated for whatever costs they bear as a result of participating in the market economy.
