External Costs


Economists, even strongly pro-liberty/free-market economists like the Thomas Sowell and the late Milton Friedman recognize that external costs, where a cost of a transaction is incurred by people not directly part of the transaction, are not something the free market handles well.  External costs, where part of the cost of a transaction in a good is paid by those not party to the transaction, tend to produce more of the good than if the full cost was paid for by those transacting it.  Less commonly considered, external benefits, where part of the benefit is received by those not party to the transaction tends to produce less than if the full benefit were received by the parties to the transaction.  I don’t think I’ll get into external benefits this time.  External costs are more than sufficient for a blog post.

In the case of external costs consider the classic example.  If you own land through which a stream runs.  Someone upstream of you, let’s call him Ivan, decides to make widgets and sell them to you.  These widgets are something valuable to you.  The problem is, the process for making the widgets produces waste.  Ivan just dumps that waste in the stream and the contaminated water flows through your property.  You, of course, are not happy with this.  The contamination is a cost to you, reducing the value of that water to you.  Depending on how bad it is, it might be tolerable, but it’s still a cost imposed on you.

So long as Ivan is only selling his widgets to you, you can simply include the cost of the reduced water quality in what you’re willing to pay for them.  You’re willing to pay less for the widgets because you’re already “paying” through the damage to your water supply.  But suppose Ivan sells the widgets to someone else, let’s call this one Francois who doesn’t live anywhere near that river.  Francois is not already “paying” through the contaminated water so he’s willing to pay more for the widgets than you are.  Now maybe he’s willing to bid less for those widgets than he would otherwise in support of your plight and maybe he’s not.  If not, maybe Ivan will still sell them more cheaply to you to help compensate for your loss and maybe not.  Once that third party is involved, in a strictly market driven situation (no laws or regulations to force things), you getting compensation for the loss you suffered with the start of Ivan’s production and dumping relies on other people voluntarily deciding to act against their own self interest to compensate you for your loss.  And as more and more people become customers for Ivan’s widgets, the likelihood that they’ll all voluntarily adjust their bids to make sure you retain your own compensation for the loss to your water supply becomes vanishingly small.

You could get together with other folk downstream of Ivan and ride up to his house to express your displeasure in a way that will “suggest” that it would be in his own self interest to clean up his act. (Am I being too obscure here?  I mean you can threaten violence, and show that you’re both willing and capable of carrying through.) And if the contamination is severe and clear cut enough the vast majority might consider it justified.

Now, however, suppose you go into business making fishing lures.  You use lead for weights.  As a result of your own operation some lead gets into the water, about 5 micrograms per liter that’s about 1/3 of the actionable limit permitted by the EPA for drinking water.  Suppose, now, someone downstream objects to your contamination of the water.  Are they, in their turn, justified in coming and threatening violence to get you to reduce your already low effluence still further?  Or maybe you can just pay them to compensate for the “damage” you cause, the reduction in value of the water to them caused by your contamination.

Now add more people on the stream, some producing and adding some small amount of waste to the water, others using and seeing the value of the water reduced to them.  Some doing both–seeing the value of the water coming from upstream reduced by the waste those upstream producers are adding and their own waste reducing value to those below them.

It soon becomes simply impossible to determine who owes what to whom for value reduced, and value added.  Attempts at market solutions break down through the inability to sort out what the individual transactions would be.  In a market transaction if you don’t like the price offered you can simply not make the transaction.  Somebody charges too much or offers too little and you don’t buy or sell.  But in cases like the water, if you don’t accept the compensation that’s on offer for the cost imposed by water contamination and your neighbors do, the contamination keeps happening.

The usual fixes of a market to someone charging too much or too little break down in the case of external costs.  This is where an external party can, with advantage, step in to try to manage things.

This does not mean that the current approach with organizations like the EPA and their endlessly more complicated and more pervasive regulations are the best, or even a good, way to deal with the situation.  As Thomas Sowell is wont to point out, just because in some circumstances, government can do better than the market does not mean that it will.  While a strong case can be made that something needed to be done back when the EPA and various other government regulations went into effect, once they were begun the Iron Law of Bureaucracy went into place and they soon became an end in themselves, going from beneficial to actual harm.

Milton Friedman, on the same issue of pollution suggested an “effluent fee”, basically a tax on the emission of various levels of effluent.  This would ‘internalize” the external costs and allow the market to then find the optimal amount of emission.  Personally, I think he was optimistic in thinking that such fees would bear any resemblance to the actual external costs and think they would instead simply become another bottomless pit for government taxation, but they would probably be superior to the current approach.

So there are some things where government can handle them better than the market.  Unfortunately, current mechanisms manage to find ways to be actively worse than just letting the market operate.

Don’t have a pithy end to this because I don’t really have a solution.  We really need to scrap the current system and start over but the political forces in place pretty much mean that’s not going to happen.

9 thoughts on “External Costs”

  1. External costs is always the greatest argument against libertarianism. In the specifics, however, it often breaks down. For example, I have read that the environment was rapidly getting cleaner due to significant public pressure before the EPA was created. Much like the various gun prohibitions that are credited for reductions in crime that were already happening. Not saying that EC isn’t an issue, just that government is often not the answer.


    1. For example, I have read that the environment was rapidly getting cleaner due to significant public pressure before the EPA was created.

      I’ve read many things. Some of them are even true. I suspect here it’s a “yes and no”, a mixed bag. Some effect in some places, not so much in others. And even “mostly cleaned up” doesn’t really help if you’re the person downstream unhappy with even the “mostly” which diminishes the value you receive from your own property without the compensation you would accept in a free trade.


      1. A bit of snark regarding the “read stuff” but I take your point. I don’t have immediate access to all the information that I have read over the years but most of it wasn’t someone’s twitter feed, but rather a well researched book. That being said, the EPA hasn’t completely cleaned up the environment either, and to the extent that it has, that money has been taken from other potentially worthwhile projects.

        Another really good example is OSHA. Working conditions were getting better. OSHA was created and to a certain extent has ridden on the coattails of that pre-existing improvement. Meanwhile they have also caused problems while creating significant costs. There was a business (documented but again I don’t have the reference readily available) that had never had an accident on a particular machine. OSHA inspectors required the business to erect a barrier which then caused a pretty significant accident. The next inspector, investigating the accident, required the company to remove the barrier. Cost to the company, hundreds of thousands, cost to the individual, severe injuries, cost to OSHA, two well paid jobs, neither of which were affected by making expensive decisions for a company.

        That is just one more example and I could go on but I won’t. I am not suggesting that anecdotes should substitute for public policy research, but the fact that the anecdotes that would support scaling back regulation are generally dismissed while those suggesting a benefit are trumpeted. Meanwhile government spends trillions of taxpayer money on regulations of dubious benefit should be taken into consideration. There is precisely zero accountability for any of those bureaucracies and they never go away. That is my main objection to new laws and regulations: that there will never be any accountability or evaluation and the structure created will never be taken down.


        1. Shall I list a number of books that people find motivating and yet which are complete claptrap from beginning to end (I can start with von Daniken and Paul Erlich in two entirely different fields)? That’s why I don’t find vague “I read” to be compelling. There’s no way to consider what it actually says and weigh the strength of its case and any counter-arguments to it. I’m not saying it’s wrong. In fact, I strongly suspect its right since it’s in keeping with other things I’ve noted: (poverty was decreasing until Johnson declared “war” on it; cars were getting safer long before Federal safety regs were enacted, and so forth). It’s just that it’s hard to judge the case, and how well it applies to the argument at hand without the details.

          hasn’t completely

          One of the things Friedman points out is that “completely” is a complete myth (his book “Free to Choose”). The later Jerry Pournelle, in his “Survival with style” essays back in the 70’s pointed out that the cleanest stream in the state of California was the outflow of the Lake Tahoe Sewage Treatment Plant. This wasn’t a sad commentary on the condition of California’s streams as there were still “unspoiled” streams up in the mountains. But even those streams had the waste of the deer and bear that lived there, contamination from mineral deposits through which they flow, and so on.

          Back to Friedman’s argument. Air, water or whatever can always be cleaner. We might like it to be cleaner than it is but the question is how much cleaner and how much of other nice things we’d like to have are we willing to forego for that purpose. Indeed, going to argument’s Sowell is wont to make (several places, but Basic Economics and Applied Economics are examples) governments tend to make categorical rather than incremental decisions. They don’t consider the tradeoff that “cleaner” requires, but instead simply declare a level that must be achieved. Since the cost is paid by others, usually in the form of foregone opportunities, it can simply be ignored.

          And while public pressure can well have (and I believe did) influence that it’s still a matter of third parties making decisions for someone else. How much did that guy upstream clean up his act due to public pressure? Am I now happy with the stream flowing from his property to mine? And if it’s not completely clean (which it won’t be…see above), I’m still losing value, value is being taken from me, for which I receive no compensation.

          The way the current government programs are set up is no better and, indeed may be worse. Again a common thing Sowell is wont to say is that just because government can outperform the market in some specific cases does not mean that it will. Once you have a government bureaucracy making categorical decisions (the usual case) then Pournelle’s Iron Law of Bureaucracy comes into play (discussed elsewhere on this blog). The bureaucracy becomes an end in itself and the purpose for which it was formed a secondary matter at best.

          This is why I ended more on frustration than with any proposed fix. I really don’t know how to fix it. Perhaps something like Friedman’s proposed effluent fees with the revenue being used to compensate those affected by the effluent. However, how do you implement such a thing. I don’t know. And then, once implemented, there’s still the Iron Law.


  2. PS When I say “greatest argument against” I mean “best” as it is a legitimate concern, unlike the moronic “well then who would build roads” as though government predated roads.


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