Misusing ‘externality’ theories to bolster government power

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When the government regulatory process becomes the main entity for “solutions,” final results often are not going to reflect the best outcomes.

In a recent article, economist Timothy D. Terrell pointed out problems in modern economic theory that deal with what economists call externalities, or spillover costs, noting that in a world in which value is subjective, attempts to find objective ways to allay costs are elusive and generally end in failure. Of course, that doesn’t stop people from relying on the government for “solutions.”

Externalities are an important concept in urban planning, mainly because modern environmentalists often oppose new freeways and housing developments by claiming that they impose unaccounted-for costs on the general population. It’s important to debunk the misuse of legitimate theories to stifle the private and public projects that Americans need.

What are externalities?

In trying to explain economic reality, economists often use models that are based upon a neat and orderly world that doesn’t exist. Markets where economic exchange occurs are represented by linear supply and demand curves, all operating in what is called “perfect competition.” Within that state of being, all goods sold in such markets are homogenous, all market participants have perfect knowledge, no firm has a defining market share, and all costs, both internal and external, are borne by the producers and (by implication) consumers.

Furthermore, if markets produce heterogeneous goods (evidence of monopoly), some firms have more market share than others, and some external costs (and benefits) spill out onto people not directly involved in the production and exchange of those goods, then a “market failure” has occurred. The “solution” to such failure necessitates outside interference, most likely from government, to set appropriate boundaries and to ensure that costs are properly distributed.

Economists often use pollution, such as air pollution, as an example. Say that Jones operates a factory that has smoke coming from its stacks and the smoke drifts onto Smith’s nearby property, lowering Smith’s quality of life. Smith neither purchases nor is employed at Jones’ enterprise, so he doesn’t directly benefit from it, yet he clearly is harmed by the factory’s activities.

The “solution,” should Smith demand redress, would be something that would either compensate him for his loss or find a compromise in which Smith and others negatively affected by the wayward smoke can accept. Common law would use the courts to mediate the issue with outcomes ranging from no compensation at all (there was no “proof” of harm) to shutting down Jones’ factory altogether, as happened in Whalen v. Union Bag and Paper Co. (208 N.Y. 1).

Some economists, however, have believed that direct government regulation either by targeted taxation or specific rules can do a better job. The British economist A.C. Pigou called for taxes to be levied on polluters that would reflect the spillover costs without direct compensation for those harmed, the idea being that government represents the “community,” so paying a tax fulfills the same purpose as individual compensation.

There also are positive externalities. The Federal Reserve of St. Louis explains:

A positive externality exists when a benefit spills over to a third party. Government can discourage negative externalities by taxing goods and services that generate spillover costs. Government can encourage positive externalities by subsidizing goods and services that generate spillover benefits.

One example is that a neighbor creates a flower garden in her front yard that provides a beautiful setting for others to see. Her neighbors can enjoy the colorful display but neither contributed anything to its creation nor did they pay her for her efforts.

In the former case, theory holds that “too many” goods created in the atmosphere of a negative externality are produced, so by imposing corrective costs on producers, government can encourage the “optimal” amount of production. Likewise, as noted above, in the case of a positive externality, government can offer subsidies that will allow for more creation of this good, so the theory states. 

Can we create a world without externalities?

Because most of us live in close proximity to others, modern life is full of externalities, both negative and positive. A nearby field where we have watched deer browse becomes a lot full of new homes bringing more traffic and interrupting our bucolic vista. Urban air is less healthy to breathe than air in rural areas, and so on.

Dealing with these things is another matter, and in an imperfect world, not every externality can be “fixed,” at least not under a regime of scarcity in which some alleged benefits have less value than the costs needed to deal with externalities. When externalities become politicized, as has been the case over and over in the last half-century, it becomes almost impossible to weigh costs and benefits.

Unfortunately, in the past 60 years, Americans increasingly have turned to the regulatory system to deal with these issues. In his classic article on regulation, Bruce Yandle noted two important aspects of modern government regulation: (1) interest group politics tend to dominate the process, and (2) we have to remember that the self-interest of regulators themselves will factor into decision-making. Yandle first thought the regulatory failures he saw at the Federal Trade Commission were simply an issue of economic ignorance.

However, as Yandle soon discovered soon after arriving at the FTC, “(I)nstead of assuming that regulators really intended to minimize costs but somehow proceeded to make crazy mistakes, I began to assume that they were not trying to minimize costs at all – at least not the costs I had been concerned with. They were trying to minimize their costs, just as most sensible people do.” These costs are bureaucratic or political ones.

Externalities in the context of transportation 

As Free Cities Center director Steven Greenhut explained in his Pacific Research Institute book, “Putting Customers First,” research shows that all governments subsidize road travel by passenger mile by less than one cent a mile, yet subsidize transit by nearly 92 cents a mile. As he explains:

To get around these lopsided numbers, transit cheerleaders will argue that car transportation does not include a variety of “hidden” externalities relating to pollution, social equity and healthcare costs from accidents. There is some truth there (although rail and buses would impose similar costs if it were more widespread), but transit advocates wildly inflate those “externalities.” It’s really just an effort to divert attention from the realities of government finance. If one assesses driving with indeterminate costs related to climate change, then it’s a rigged formula that will always lead to the desired conclusion (more transit funding!).


The notion that government entities dispassionately examine a situation in which externalities exist and then apply the Wisdom of Solomon to solve the problems is a myth that dies hard, but it is a myth all the same. The underlying assumption is that since the government is the community, once the tax is paid, the problem is solved. However, the same problem still would exist; but the government now had more money in its coffers. Instead of limiting spillover costs, government mainly tilts the scales in favor of its own bureaucratic or political preferences (higher densities, fewer freeways, etc.).

None of this is to say that spillover costs are not real costs. The question is what can be done about them. In situations where private property rights permit negotiations, the individuals involved often can come to workable solutions. But when the government regulatory process becomes the main entity for “solutions,” final results often are not going to reflect the best outcomes. At the very least, policy makers ought not exaggerate the level of externalities for projects they don’t like and downplay them for the projects that they do like. They should analyze them accurately so that we can fairly determine how best to spend scarce resources.

William L. Anderson is an editor with the Mises Institute and Emeritus Professor of Economics, Frostburg State University, Frostburg, Md.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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