- Capital Gains
- What Do You Do About Externalities?
What Do You Do About Externalities?
Tax Like Pigou, Litigate Like Coase, Ban Them, or Just Ignore Them?
From an economic perspective, other people are generally quite alright; we tend to specialize in tasks for which we have a comparative advantage, which allows all of us to enjoy a higher standard of living (thanks to the miracle of the division of labor). But "Hell is other people" is more right than Sartre probably realized: these “other people” also insist on doing things that produce negative externalities they're oblivious or indifferent to—anything from chewing loudly to exhaling secondhand smoke to accidentally dumping toxic waste into drinking water or polluting the Internet with reams of redundant AI-generated content.
Externalities enormously complicate economic models because they exist when a problem is below the threshold of caring for the perpetrator, but above it for the person dealing with the problem (i.e. they imply a messy world with unclearly-delineated property rights and hard-to-measure, but certainly nonzero, costs of either coming to an agreement or even noticing that there's a problem).
The simplest toolkit for dealing with externalities is to either a) tolerate them or b) ban them. Tolerance is the default, at least at the level of regulators, because the state's capacity to spot an externality, identify the perpetrator, and punish them is limited. That’s why the list of things that used to be legal but are no longer tolerated gets longer and longer as countries get richer. It’s hard to ban smoking in restaurants, eating durian on trains, and an ad hoc and impressionistic set of rules for driving when states are weak, but trivial when they're strong.1 On the other hand, a higher standard of living also raises the cost of service-sector jobs, one of which is law enforcement: poor countries can have a surprisingly robust police state because the cost of police is so low—especially if the government's source of income is some natural resource that produce lots of GDP with little headcount.
The ban-or-allow dichotomy is simplistic, though. There are some externalities that are bad, but not so bad that they ought to be actively illegal. There's another way to discourage them: the economist Arthur Pigou, who introduced the term "externality," proposed a simple approach: estimate the cost, and tax it. Do alcohol and cigarettes impose costs, not just on the people who consume them, but on others around them and on publicly-subsidized healthcare systems? Add up the costs, divide by the volume of consumption, and you know how much to tax them.
What this tries to do is essentially to create a market in externalities. You can "consume" the downsides of these products, but only if the producer pays accordingly (or you do, if they choose to pass the cost onto you—and they will if they can). A simplistic look at Finland's policy of income-based speeding tickets makes it sound somewhat non-Pigouvian: higher-income people have a higher opportunity cost, so from a simple GDP-maximization perspective you might insist that they drive faster. But it turns out to be Pigouvian after all! If they're always speeding, they're at risk of dying, which is going to reduce the net present value of their future productivity. The Finns have accidentally created an extremely elitist policy that literally places a higher value on the lives of high earners, as expressed by their Pigouvian tax on endangering high earners' lives through reckless driving.
One issue with Pigouvian taxes is that many of the externality-ridden products we consume—cigarettes, alcohol, oil, reckless driving, gambling—are extremely inelastic. Part of the point of the tax is to offset the social cost of consumption, but if consumption isn’t reduced by making the product pricier, then the wrong party bears the cost. Unfortunately, it's hard to set a tax for these products that's high enough to seriously reduce consumption, but not so high that it creates a black market. In fact, for many of them the inelasticity is a component of the social cost! The health impact of smoking is dose-dependent (if you slice the data just right, for example, the higher socioeconomic status of cigar smokers offsets the health effects of cigar smoking such that they have the same life expectancy as everyone else). It's the heavy smokers who impose a high cost, but if they're addicted enough to go through two packs a day, a higher tax on cigarettes probably just reduces other kinds of spending, even though it will induce some fraction of them to cut back or quit.
Is there a more elegant approach? The economist Ronald Coase offers one. In Coase's model, we need to think of externalities more personally: to you, neighbors playing loud music at 2am is a problem, but to the right neighbor, this is a benefit. Perhaps you think of graffiti as vandalism, and someone else thinks of it as art. The goal in externality-management, in this model, is to arrange the world so externalities are imposed on people who care the least.
How do you do this? Rethink the idea of property rights: when you buy something, like a house, you're really buying a bundle of different rights—the ability to live there, but not necessarily the right to operate a nightclub in your living room; access to the kitchen, but not the unlimited right to brew as much crystal meth as you feel like; a backyard, but not a backyard in which you can practice your homemade rocketry hobby. All of these restrictions are liabilities for you but assets for your neighbors: they're getting a quiet, low-drug, rocket-free environment. And once these rights exist, they can be priced.
Coase got a lot of mileage out of English Common Law, which was essentially one long process of identifying and pricing externalities. Coase considers a case where a candy manufacturer starts operating next door to a dentist. The vibrations from the candy-making equipment make dental work a slower and bloodier process. But the confectioner can't afford to only operate during the night shift, or to make everything by hand. Coase's solution is to treat the right to determine acceptable vibration levels as a property right, let each side submit a bid, and sell it to the high bidder.
This is helpful in two ways:
The value-maximizing question for society is whether the cost of installing vibration-dampening equipment is lower than the benefit of the dentist continuing to operate in that location. By pricing the externality, we can measure which mitigation tools work.
The dentist and factory don't absolutely need to be in the locations they happen to be in, and perhaps the cost of their proximity indicates that one or the other should switch places with a business that either doesn't cause that specific problem or doesn't care about it. (Perhaps you'll buy the dentist's office and convert it into a nightclub, now that your living room is off-limits.)
The downside is that every little dispute has to get litigated. Both sides tend to operate on the assumption that they're being reasonable, so each side either sees the externality as a rude surprise or sees that their behavior imposes an externality in the same way. The classic “applied Coase” is paying a fellow plane passenger $20 not to recline their seat into your knees, but in that instance, both the person doing the reclining and the person getting reclined-upon feel that the other party is being weirdly unreasonable.
Coase works in a world where the judicial system is swift and efficient (in both the everyday sense and the economic sense). But that's not the world we live in. Ad hoc Coasian bargains—doing someone a favor or paying them money so they stop doing something that annoys you—is also awkward. In practice, the solution to the reclining seat problem is that the airline sells seats of varying legroom for varying prices; it's not a peer-to-peer transaction, but you do a more-or-less Coasian bargain with Delta or United when you pay them extra to a) spare your knees, and b) avoid having an awkward conversation with a stranger.
But even if Coase isn't practical in most cases, he's a great intuition pump. Asking what arrangement we would have if we had time to carefully argue our point and accurately value every element of the property rights bundle can be very illuminating. There are many problems people will pay a bit to get rid of, and making it as simple as possible for them to do so makes everyone better-off.
And, going back to the airline example, it ends up being Coasian in practice: airline economics are dominated by high fixed costs and the necessity of recouping them by selling every seat possible (without cutting prices so much that it trains customers to hold out for less). This means that every passenger is, in some sense, cross-subsidizing the others: business travelers pay more per seat, but get the convenience of a regular schedule; a high volume of leisure travelers ensures that a dense schedule can still lead to full planes. Since anyone can buy an A321 and many routes can be competed on, the airlines themselves tend not to capture the upside from this cross-subsidy; instead, it's reflected in lower prices for the cheapest tickets.
As we increasingly live in a world where every transaction you're offered is the result of an enormous data science effort designed to find the best way to extract money from you based on data on all the rest of your spending, we'll increasingly live in an indirectly Coasian world. In that model, the secret to reducing externalities is to put them under the control of ruthless for-profit companies that can't build durable monopolies. They end up designing a system whose outcomes are equivalent to what Coase proposes, but whose process embodies the low transaction costs that Coase viewed as indispensable.
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Read More in The Diff
The Diff talks about externalities a lot, sometimes in passing and sometimes as a central focus. Some examples:
Monday’s piece on Argentina notes that their new President-elect has talked about internalizing externalities (in this case, the externalities of bad government).
Adding Up Emissions ($) considers the challenge of measuring and accounting for externalities in complex supply chains where more than one participant can be said to “cause” them (did the oil emissions happen because oil left the ground, or because it went into a car’s gas tank and got burned?).
One surprising case of externalities having a big impact: the rise of air conditioning arguably contributed to the consolidation of finance into a few big cities ($).
Some externalities show up, not in the physical world, but in terms of how they shape incentives. The question of whether or not we should ban some legacy software technologies on the grounds that they’re economically equivalent to a tontine, i.e. a financial instrument that a group invests in with the survivor of the group collecting the total sum is ultimately about the externalities imposed by different choices in technology stacks.
1. There is a correlation versus causation question here: Singapore used to be a poor country with unusually strict laws, and is now a rich one. On the other hand, North Korea was a poor country with even stricter rules about what behavior is and isn't acceptable in public, and this has not been a great driver of growth. It's not monocausal. But one useful model is that, as countries get richer, people's ability to impose externalities on one another goes up, too. If nobody has a car, poorly-enforced traffic laws don't make a huge difference; the speed limit is set by the density of bikes and pedestrians in the street, not by traffic laws. But as the country gets richer, more people start driving, and many of them drive badly. At a higher level of wealth than that, they start demanding better traffic laws. Our World in Data shows this nicely; look at Asian Tiger economies, and you'll tend to see rising GDP and rising traffic accidents throughout the early 90s, a drop in both in the late 90s, followed by a rise in GDP and a decline in traffic fatalities.
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