Externalities

Positive externalities are benefits that are infeasible to charge to provide; negative externalities are costs that are infeasible to charge to not provide. Selfishness leads markets to produce whatever people want; to get rich, you have to sell what the public is eager to buy. Externalities undermine the social benefits of individual selfishness.

Economists measure externalities the same way they measure everything else: according to human beings’ willingness to pay.Externalities are frequently used to justify the government’s ownership of industries with positive externalities and prohibition of products with negative externalities. Economically speaking, however, this is overkill.

Especially when faced with environmental externalities, economists have almost universally objected to government regulations that mandate specific technologies (especially “best-available technology”) or business practices. These approaches make environmental cleanup much more expensive than it has to be because the cost of reducing pollution varies widely from firm to firm and from industry to industry. A more efficient solution is to issue tradable “pollution permits” that add up to the target level of emissions. Sources able to cheaply curtail their negative externalities would drastically cut back, selling their permits to less flexible polluters.

The most accepted examples of activities with large externalities are probably air pollution, violent and property crimes, and national defense.

Other common candidates include health care, education, and the environment, but claims that these are externalities are much less tenable.If the price of aluminum cans fails to spark recycling, that suggests that the cost of recycling—including human effort—is less than the benefit.

Externalities are often blamed for “market failure,” but they are also a source of government failure.


Even from a strictly economic point of view, however, some externalities are not worth correcting. One reason is that many activities have positive and negative externalities that roughly cancel out.

Another economic rationale for government inaction is as follows: sometimes an externality is large at low levels of production but rapidly fades out as the quantity increases. Economies of scales.

Faced with externalities, modern analysts almost immediately inquire about transactions costs.

Coase’s approach is probably the main reason economists are skeptical of antismoking legislation. While it is costly for smokers and nonsmokers to directly negotiate with each other, the owners of bars, restaurants, and workplaces can cheaply balance their conflicting interests.