Externalities

Inside, outside
Leave me alone
Inside, outside
Nowhere is home
--The Who

Externalities (a.k.a. external economies or external costs) involve situations where the outcomes of A's activities impact B. These impacts on B, sometimes termed 'spillovers,' are usually regarded as indirect, perhaps even unintentional, outcomes of A's actions.

Spillovers that are beneficial to B are called positive externalities. For example, innovation that creates new products and industries can generate large positive externalities.

Spillovers that are costly to B are called negative externalities. For example, air pollution spewing from a factory smokestack can generate negative externalities for those living in nearby communities.

A complaint often levied against free market designs is that they ignore the problem of negative externalities. Polluting producers, it is posited, are motivated to think narrowly and act myopically in their own self-interest. While their situation improves, those producers harm others.

Early interventions to address this perceived market deficiency involved taxes and regulation intended to penalize or reduce the negative externalities. However, monitoring costs (read: bureaucracy) of these approaches are high, and may even offset the benefits incurred from reduced externalities. Moreover, these interventions bypass the voice of consumers, who in free markets demonstrate thru their buying actions what they truly value. Absent free trade where buyers and sellers can express their preferences thru voluntary exchange, estimating the costs of externalities by fiat is merely guesswork and subject to significant error (Rothbard, 1956).

Coase (1960) theorized that as long as property rights are clearly defined and transaction costs are low, then A and B can privately negotiate a solution that 'internalizes' the externality. Thus, if people living in nearby communities have a property right to 'clean air,' then the factory will have to negotiate with them in order to rightfully discharge waste thru the people's property.

There seems a compelling argument to be made that, rather than a failure of free market designs, cases of negative externalities can be seen as failure of government, whose purpose in a free market system is to enforce individual property rights against subtle forms of invasion. In the case of smoke control, the proper free market remedy is not the creation of a State bureau to prescribe smoke control regs. Rather, the appropriate remedy is judicial action to punish pollution damage to the person and property of others (Rothbard, 1962).

An additional advantage to the 'property rights' solution to negative externalities is that both A and B are motivated to determine ways to reduce the costs, which benefits social welfare over time.

Of course, market pressure alone may limit externalities. Those seeking organic foods, for example, vote with their wallets for produce that does not encourage negative externalities associated with chemical additives. Producers who do not follow the market's signal are penalized with declining trade.

References

Coase, R.H. 1960. The problem of social cost. Journal of Law and Economics, 3: 1-44.

Rothbard, M.N. 1956. Toward a reconstruction of utility and welfare economics. In M. Sennholz (ed.), On freedom and free enterprise: Essays in honor of Ludwig von Mises. Princeton, N.J.: D. Van Nostrand.

Rothbard, M.N. 1962. Man, economy, & state. Princeton, NJ: D. Van Nostrand.