Externalities & Their Solutions

Not a prescription, but an acknowledgment

A factory on a lake produces bread, massive quantities of bread. That production process expells a certain pollutant into the lake, which is home to over 100 residents. The residents all have families and love this lake, so what should be done about this pollutant?

For some, this may be a simple answer: the residents were their first, the bread factory should fix the polluting problem, relocate, or be subject to a tax on their bread production. But this problem isn’t so simple. First, the basics. The lake pollution is an externality, a negative production externality to be specific. An externality is simply an unintended consequence of any process. Here, the factory is producing bread, but through that process, expells a harmful agent into the lake which negatively affects the residents in the area.

Because the effect is negative and the externality occurs due to the production process, this is a negative production externality. But externalities can be positive as well, for example, the production of low-fat milk creates a surplus quantity of milk fat, which can be used to produce cheeses.

Externalities are not limited to production, they can occur due to consumptive habits as well. These would be when the consumption of a given good positively or negatively affects those around the good’s consumer. A negative consumption externality could be secondhand smoke, a positive one may be purchasing a meal at a fundraising drive for some charitable cause.

Externalities, however, are not quite this simple in practice. The question naturally becomes, where does the line of subsequent impact get drawn? If a smoker’s secondhand smoke caused a bystander to catch a cold from all the coughing, does the blame for each subsequent individual to catch this bystander’s cold fall at the feet of the smoker or the person with the cold? In practice, both consumption and production incite multiple domino effects, causing the range of their effect to expand far beyond anything we can quantify.

Our bread factory is polluting a lake, but what if it were polluting a river? How far downstream does the impact of the pollution go? How many dominos is the factory responsible for? Would the factory be liable for damages if the pollution negatively affects residents who then grow fewer crops, causing the price of x to rise, hurting families who can no longer afford x? Is the factory still responsible if these farmers could have easily moved their production to a different plot? And how far do we take the effect within families; kids, grandkids, or great-grandkids? Externalities are practically unquantifiable. This isn’t a problem of intelligence or computational power, it’s a domino effect wrapped in a moral quandary. And that moral quandary is made more difficult when the direction of effect is considered.

The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A?

- Ronald Coase

Again, our bread factory is polluting a lake. The residents would not be harmed by this pollution if they moved or had simply not resided on this particular lake in the first place. Worse yet, if a central body stepped in to stop this pollution, these residents would still be harmed. To pollute less, the factory would need to produce less bread, these residents consume that bread. Less pollution necessarily means less bread is available and the bread is more expensive because of it.

But the effect isn’t isolated to these residents, that factory produced bread for the whole nation. Now everybody needs to pay more for bread, and perhaps there are families who can’t consume any bread because of it. Does this does this impact fall at the feet of the lake’s residents?

Effect is a two-way street, it does not just flow in one direction. It was Ronald Coase who said, “The question is commonly thought of as one in which A inflicts harm on B and what has to be decided is: how should we restrain A? But this is wrong. We are dealing with a problem of a reciprocal nature. To avoid the harm to B would inflict harm on A. The real question that has to be decided is: should A be allowed to harm B or should B be allowed to harm A?” This was in his paper, ‘The Problem of Social Cost’, where he outlines the need for a partnership between market forces and common law to address the externality problem.

If the direction of effect cuts both ways, then parties ought to negotiate on the externality as though it were a product itself. Essentially, create a market for the externality. This already happens in the case of certain positive production externalities (milk fat and cheese), but it ought to occur in the negative and consumptive case as well. In an unrestricted context where there exists minimal transaction costs and full information, parties will negotiate to what economists call a market clearing level. That is, an equilibrium state of production.

Some issues, though, should be immediately obvious. Markets today are not usually unrestricted, transaction costs exist, perfect information is impossible and, as I’ve noted previously, equilibrium isn’t a reachable state, it’s the light at the end of the market process tunnel. But these are not the death knell for Coase’s theorem.

Taken on the whole, these complications with Coase’s reasoning actually strengthen the original insight. Transaction costs are everywhere and everything, they’re the reason firms exist in the first place. Ultimately, that today’s markets aren’t unrestricted and that perfect information is a practical impossibility are themselves transaction costs.

Transaction costs essentially represent a challenge to acquisition. Before the advent of the internet, purchasing a bicycle was far more difficult than it is now. Today, a consumer can research multiple bikes to select the best one, locate shops near them that have that bike in stock and compare prices to find the least expensive one. Each of those steps are a transaction cost that has been minimized by the internet.

Just as transaction costs in the purchasing process for bicycles haven’t been eliminated but made easier, transaction costs in the market for externalities must be as minimal as feasibly possible. Markets operate in uncertainty by definition, information is never certain and the future is impossible to know. The most challenging transaction cost to overcome, then, is ownership. In the case of the polluting bread factory, who owns the pollution? If the residents own the pollution, the factory would need to effectively purchase levels of production from the residents that correspond to the amount of pollution they are willing to accept at the price they are willing to accept it.

This sounds intuitive but it cuts both ways. If the factory owns the pollution, the residents would need to purchase the factory down to a level of production that corresponds to the level of pollution the factory is willing to accept. In either case, the theoretical level of production that is ultimately agreed to will be the same regardless of who owns the externality.

Remember, the harm flows in both directions. Both the factory and the residents are harmed in any case. Less pollution results in profit losses for the factory and more expensive bread for the residents. Higher pollution levels result in a worse lake for the residents and property value decreases for everybody, including the factory. Not to mention the damage to brand image and the potential for protests for the factory. And again, consider the two proximate causes; the factory pollutes the lake, there would be no damage if no residents hadn’t lived on the lake.

However, this outcome equivalence is only true in the case of perfect information and little to no transaction costs. In order to freely negotiate levels of externality in reality, the government must properly assign property rights to the party with the greatest level of intrinsic transaction costs. This is because, in a contractual negotiation of this type, the party with the least transaction costs has an advantage.

It can be argued that either the factory or the residents hold a transaction cost advantage in this example. Perhaps the factory holds more information about the production process than the residents, giving it an advantage at the negotiation table. If this is the largest effect, the residents ought to own the pollution. But the residents may have public opinion on their side, or they may hold an advantage through collective bargaining power if residents also work at the factory.

Further, think of ownership as a responsibility for the externality in question. In a situation where the lake is essential to a farming process for these residents. Putting responsibility for the pollution in the hands of the factory would then leave the residents indifferent to the outcome, as they could simply sell the land for market price whether the lake is polluted or not. Assuming less pollution is socially optimal, placing the responsibility of the externality in the hands of the factory would actually lead to comparatively more pollution.

In this case, placing ownership and responsibility for the pollution in the hands of the residents would be most beneficial, as the residents now have an incentive to either negotiate pollution to be lesser or move cultivation to a new location. In either case, this results in comparatively more farming or less pollution.

When it comes to externalities, there is no obvious solution. In fact, the actual solution to the problem may be completely counterintuitive. It’s far too simplistic to suggest a tax levied against an externality-creating firm will solve the problem when the direction of harm is a two-way street. It is impossible to effectively plan solutions to these sorts of problems. The issue, then, is deciding what exactly is to be done. In a world with no transaction costs, simply allowing a market for externalities to develop would work wonderfully, but that’s not the world we live in. In the real world, with real transaction costs, parties in a given negotiation will hold advantages that may skew the end results in their favor.

The role of government, then, is to assign ownership of the externality in question to the disadvantaged party or the party with the most skin in the game. Though, as I’ve noted in the farming on the lake example, deciphering which party is which may be an impossible task as well. What many get wrong about Coase’s ‘The Problem of Social Cost’ is that it was not an answer sheet to the social cost problem, rather, Coase pointed out just how impossible the real challenge is — knowing what ought to be done about it.

In practice, the best answer to the unknown is the market process. No individual economist can give a correct answer for what ought to be done about an externality, and no government body can know for certain which party ought to hold ownership and responsibility for the externality in question. The best solution we can offer is one of dynamic and frequent decisions and negotiations. A system through which externalities are frequently and routinely negotiated, that is supported by a common law system that is just as frequently reviewing property rights and externality ownership cases, is the only practical way to eventually discover the “right answer”.

The true equilibrium level of an externality will forever be unknown. Not only is it impossible to calculate due to the domino-style impact any decision has, but the theoretical steady state point is a moving target. What is optimal today is not optimal tomorrow, and so on. The only hope is to construct a process where levels of externalities are frequently negotiated and ownership patterns are frequently retried in common law. This process would result in a dynamic landscape for externalities and their ownership, allowing for potential emergent solutions, which could never have been predicted, to emerge.

The problem with externalities is the complexity of their effect. This is made worse by the impossibility of calculating any equilibrium level of a given production externality. Coase’s analysis wasn’t a prescription, it was an acknowledgment that the problem we face isn’t a question of how much ought to be done, but what ought to be done, if done at all. Rather than suggest the government stay out of externalities, which many take the Coase Theorem to mean, the government’s role is a key one. The government must discover which party is to own responsibility for an externality — a nearly impossible task for one person to complete.

Because of the nature of these problems, nobody can know what ought to be done, we can only hope to try time and time again, eventually progressing toward that elusive equilibrium level of production through those numerous attempts at assigning ownership. This is an acknowledgment of the complexity of these situations in it of itself. There can be no prescribed answer because there is no answer. Instead, we must turn to a dynamic process, which itself tends toward an equilibrium it will never reach.