Thinking about Externalities

Because the concept of externalities came up in a recent Forum post I thought it might be useful to explore it. What I learned turned out to be fascinating.

To an economist, “an externality is a cost or benefit for a third party who did not agree to it” (Wikipedia). Most of us can easily think of examples; air pollution and public education come to mind.

But things get weird when you begin to ask how (or even if) externalities can be dealt with. Should a polluter, for example, be required to pay for the damage his pollution causes? And if so, how much, to whom, and by what mechanism? Alternatively, should an educator receive extended compensation for the benefits to society his industry produces over many years?

These questions arise from our economic assumptions about value. If our conception of value were to change or evaporate we would ask different questions, or none at all. It is here, on the nature of economic value, that the theory of externalities utterly collapses.

We like to think that value can be stored in things. An ounce of gold, for example, holds the value of some number of dollars, or a dollar holds the value of some number of different items it can buy. But value of this sort is transitory. The price of gold and the purchasing power of a dollar change every day, if only slightly.

It is for this reason that economists talk about value as arising in transaction or through exchange. There is no objective measurement of value that applies in any other context, no general concept of value except the one that materializes in the moment of trading one thing for another.

Under these circumstances it may seem inevitable that externalities will occur. But it is not so.

One may be tempted to propose that both parties to any transaction must account for every cost and benefit likely to arise in consequence of the exchange, yet it is impossible to imagine how such a rule could be enforced. As a contractual matter, the costs/benefits for a third party are not under the control of the transacting parties and it is therefore impossible for whatever value they represent to be exchanged. Also (for the same reason), it is impossible for those third party costs/benefits to be measured in any practical way.

In other words, it is impossible for there to be an exchange of all things for every other thing, involving all persons, including those who are unaware of the transaction. It is in this sense that externalities never really occur.

This is a hard challenge to our intuition that, say, pollution is harmful and education is helpful to society in ways not anticipated in the exchanges from which they emerge. We want those unanticipated costs/benefits to be realized in some way, but there is no economic analysis by which that realization can be achieved.

An interesting corollary is that you can’t use the theory of externalities to say that markets have only limited social value. Since the theory itself is meaningless, so is the critique.

14 thoughts on “Thinking about Externalities

  1. How to charge for externalities from private enterprise is fairly cut and dried: the private company pays to rectify damage. CAFO’s should pay the cost of cleanup of their waste ponds. Power and energy companies are responsible for their pollution cleanups. Purdue Pharma had to pay for its role in creating a drug addiction crisis. As did tobacco companies.

    In all private enterprise external costs profit is affected. If the costs of externalities can be passed on to government, that is American taxpayers, then the price point can be lower and more competitive and this also affects profit. This is why such legal battles are so protracted.

    Public education is already paid for by taxpayers, so who is the aggrieved party?

    Liked by 1 person

    1. RE: “How to charge for externalities from private enterprise is fairly cut and dried..”

      So you say, but based on what?

      RE: “Public education is already paid for by taxpayers, so who is the aggrieved party?”

      As stated, the teacher who doesn’t get compensated for his “value to society.”


          1. And it can’t be both?

            Take the economic burden of polluted neighborhoods and injured people and reverse it by making the external costs the responsibility of the polluter.

            This frees up monies for the victims since their housing values may increase, they can go back to work instead of being sick and healthcare costs can come down.

            Justice in the sense that the polluter has to run a cleaner business at its own expense rather than a more profitable one at the public’s. Not to mention, of course, the human value of healthier citizens adding to the economic value of the nation.

            Simply put, you cannot avoid the expense of a proper leach field, septic tank and related maintenance by running a drain into your neighbors pond.

            Liked by 1 person

  2. External costs are a problem only if unresolved. External benefits? I’m not so sure.

    In the simplest form, Peter makes batteries for sale to Paul, but in the course of doing so, unavoidable acid runoff damages Tom’s property. Peter and Paul are the participants in the transaction. Tom bears a cost for which he is uncompensated. Easily resolved, either Peter and/or Paul compensate Tom or he sues Peter.

    But what if instead of a measurable and direct damage to Tom, the battery production produces widespread, but trivial, damages to thousands of people living downwind? None of them has enough damage to merit a lawsuit, but all bear a cost of the production of those batteries?

    How is that external cost resolved? You could fine the polluter, but giving government money doesn’t remove the stink from the batteries from those affected. Nothing has been resolved unless the fine is high enough to make Peter go out of the battery business.

    But then we don’t have the batteries and the utility they provide. And that is a cost as well.


    1. I don’t think it is an all or nothing issue.

      Instead of fining Peter for polluting, let’s set parameters that he has to adhere to to lower his environmental damage. The air and water were clean before he started making batteries and they are not now.

      You say there is measurable, but trivial, damage. Properties may be inhabitable but unsalable. That is huge in a country whose citizens generally depend upon property as a major family and generational wealth building asset.

      The old camping adage of leaving the area as clean, or cleaner, than you found it would be a principle to apply.

      For that matter, global environmental impact by major industries is a huge price to pay as we are now learning.

      Liked by 1 person

    2. RE: “External costs are a problem only if unresolved.”

      Exactly. The question then becomes, What motivates the resolution and how can it be structured?

      Since value arises only in transaction, and the third party was never part of the original, contracted exchange, the value of the damage must be determined by other means. That is, by means not based on first principles of economics.

      RE: “External benefits? I’m not so sure.”

      Externalities can be either positive or negative, the way the term is used. But applying the same logic to both shows that the concept of externalities itself doesn’t hold up.

      One way to see this in practical terms is to contemplate the “value” of positive externalities, such as the benefits of an education or of peace due to military spending. Such things are literally “priceless.” How, then, is it possible to determine the price or cost of negative externalities?


      1. It is not necessarily easy, but measuring external costs is at least possible.

        If the value of lot A is X and the value of identical lot B next to the hog farm settling pond is X-Y, Y is the external cost of treating hog wastes.

        But the value of education is harder. We have some great teachers whose efforts are wasted on dull minds and bad parenting, and yet Einstein had crappy teachers.


        1. During the investigations into for profit schools versus traditional or state higher education there was discussion about reparations for students who could not get the high paying jobs promised by recruiters. Student debt relief is still a target.

          The externality here would be the combined debt burden along with low incomes that can, and do, affect the economic contribution by the graduates.

          As it turns out, taxpayers are often stuck with the bill to rectify the damage.

          In other words, the school recruited unqualified students with unrealistic promises of bright, prosperous futures. This increased their profits immensely. The externality is the cost of another low income future that we help cover to a degree through food subsidies, Medicaid, etc. That is calculable. What may be harder to ascertain is the loss of a wage earner in other more realistic skills.

          Industrial pollution is probably an easier calculation.

          Liked by 1 person

          1. Are you claiming government career education is the model to emulate?

            While I was practicing in Norfolk, I interviewed potential dental assistants who had completed a government paid course as a requirement for keeping their welfare. It was not uncommon for them to have a certificate as a paralegal, medical assistant and beautician as well.

            One had nails a good 4 inches long she had no intention of cutting, saying I had to make “accommodations.”

            They had racked up a good hundred thousand in educational costs and had no intention of ever getting a job in those fields.

            So, if you want an external cost, there you go.


        2. RE: “It is not necessarily easy, but measuring external costs is at least possible.”

          That’s true. I can easily calculate a value for my car, but until I sell or trade it the calculation is just a personal fantasy.

          I don’t dispute that actions have consequences, only that there is little reason to call consequences something else. Specifically, I refute that the theory of externalities as economists understand it can be used to make justice or social justice arguments.


  3. “One had nails a good 4 inches long she had no intention of cutting, saying I had to make “accommodations.”

    You met some idiots, obviously.

    I am talking about private for profit schools (Trump U?) that scam the vulnerable. Recruiting totally unqualified student with phony data about hiring their graduates. Keeping the loan money even if they don’t graduate or get a better job than retail clerk.

    But we are delving into another topic.

    Liked by 1 person

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