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.