The most obvious example is taxation for purposes of income redistribution. Whatever the merits or demerits of a policy of redistribution, the essence of any such policy is that some people (the net recipients of tax revenues) live partially at the expense of other people (the net payers of tax revenues). Consistent application of the economic logic that powers textbook explanations of externalities leads to the conclusion that government-engineered income redistribution causes too many people to seek such redistribution (chiefly, by exerting less effort than they otherwise would to increase their own earnings), while at the same time causing high-income earners to exert too little effort at earning taxable income.
Absent redistribution, each person would be paid as income an amount closer to the value of what he or she contributes to the market economy — meaning, the market causes each person to internalize the costs and benefits of whatever amount of effort they choose to devote to earning income. But redistribution obstructs this market result; it artificially dims both the personal penalty for not working and the personal reward for working.
Another example of the externalization of internalities is protectionism. Producers’ earnings in competitive markets reflect roughly the value of that product to consumers. When consumers spend their own incomes in whatever peaceful ways they choose, they personally pay the costs and reap the benefits of their choices. Producers that better please consumers are rewarded with higher profits — higher profits voluntarily paid to them by consumers. Markets, in other words, internalize on producers the value of their efforts to please consumers.
Protectionist tariffs and non-tariff barriers, by contrast, externalize this internality. By shrinking consumers’ range of choices, protectionism artificially increases consumer demand for the outputs of protected producers. Protected producers thus earn higher profits without creating more value for consumers. A consequence that belonged inside the producer-consumer relationship has been transferred outside it.
Protected firms free-ride on a portion of their fellow citizens’ incomes — the funds these citizens would otherwise have spent on imports. As a result of protectionism, producers exert less effort than otherwise to please consumers. Far from correcting a market failure, protectionism distorts markets. Protectionism externalizes an internality.
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