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Category — Economics (real world)

The Externality Debate: Remember Subjectivity in Economic Science

“Greenhouses set up next to carbon-dioxide emitting factories give food producers easy access to the gas their plants love…. Everyone on the planet eats food, so perhaps a tax should be imposed on every global citizen to remunerate the creators of carbon dioxide.”

I doubt this suggestion will find much support; I don’t even believe in it! But the reason that I don’t believe in it has nothing to do with my feelings over the goodness or badness of the externalities in question. Instead it stems from a recognition that we just don’t know what the relevant externalities are.

One of the greatest contributions of the Marginal Revolution from 1871-74 was a focus on subjectivity as the fount of value. From thence forth no economist could say that value was inherent in a good or the result of its costs of production, as had been the case for thousands of years.

Now, value was properly reckoned as the personal and wholly subjective assessment by an individual of the usefulness that a good would serve in fulfilling a need specific to him.

Yet despite the persuasiveness of the arguments put forth over the last 140 years, there are still fields within economics where an objective conception of value is used. Nowhere is this error more apparent than in the common treatment of externalities.

Externality Analysis

An externality is the result of one person’s activity affecting an innocent bystander. The externality is positive in that it creates value for the innocent bystander, and negative if a cost is imposed on him.

In general, economists argue that markets allocate goods well when costs and benefits are internalized. When you get the benefits from buying a good or pay for the costs of producing it an efficient level of consumption and production will occur.

Externalities are problematic, supposedly, as they remove the possibility that the person benefiting from the good will solely be the person paying for it. Alternatively, there could be a problem where the person producing something will not be required to pay for all the costs if some costs are imposed on others via a negative externality. All this is subsumed under the term, “market failure.”

Economists are very quick not to pass value judgments on peoples’ choices for the simple reason that even though they may look faulty to us, we are not in a position to know the actual tradeoffs, options or knowledge available to the individual making the choice.

Lower cigarette prices make a smoker better off from an economic viewpoint because we are unsure of what the smoker’s criteria are for his action although we probably all agree that the activity is not a wise health choice. If the smoker is pursuing his habit, it is only because he perceives the benefits to outweigh the costs, at least as he perceives them. (And reducing the costs through lower cigarette prices must, therefore, make him better off.)

Externalities are a little bit of a paradox in light of this. Externalities are commonly categorized as negative or positive depending on whether the economist perceives them to be helpful or harmful. Education is commonly cited as being positive, as an educated population gives beneficial side effects to third parties in the economy – more job opportunities are created through their ideas, for example. Smoky factories are a negative externality because they impose a cost on others through the health damage caused by their pollution.

Maybe the examples are not as clear cut as may be supposed. Perhaps that smoky factory brings harm through pollution, but does well through job creation. Of course, if you work in one of those jobs you are compensated for the benefit through your wage, but even innocent third parties might benefit. I think many (though admittedly not all) people would prefer to live in a town with employment opportunities than no future. The bad the factory does to the town through smoke is perhaps offset by the good provided by a brighter future for its inhabitants.

The key in the preceding example is admitting that we just don’t know what the extent of the externalities are. Some people unconcerned with pollution may welcome the job creation. Those with jobs might not care about that benefit, and instead focus on the negative nature of the pollution. The fact is that at the end of the day we are not in a position to pass a judgment on one or the other. We just don’t know what the relevant externality is, or even whether it is positive or negative.

Climate Change Debate

This is not just armchair theorizing without real world implications. The problem creeps up continually.

In the global warming debate, for example, the phrase “climate problem” assumes clear, net negative externalities. Anthropogenic (man-made) global warming will raise sea temperatures and flood low-lying areas. The people who live in these low-lying areas didn’t do anything to cause the climate to change, but they will bear the costs of having their livelihoods removed.

One man from the low-lying South Pacific island of Kiribati just sought asylum in New Zealand to escape this painful future. In fact, there were reports of the entire nation of Kiribati negotiating to buy land in New Zealand so as to keep their nation alive even when the sea floods its islands. Should we really expect this small country to pay for its relocation when it had almost no part in the increase in sea levels?

The commonly accepted doctrine of externalities would answer that question in the negative. There is a negative externality imposed on the residents of Kiribati which should be rectified by having the person who caused the externality pay. This commonly means the citizens of developed countries who are at least by some measures the creators of climate change wreaking havoc with the world’s sea level.

Positive Externalities Too …

Yet evidence for positive externalities from climate change also exists. This report (pdf here) argues that increased levels of carbon dioxide emissions are creating a positive effect on agricultural output.

This should not be surprising, but here’s something that probably will be. The world’s second largest agricultural exporter after the United States is the tiny nation of the Netherlands. This doesn’t come by accident. The Dutch work hard to get every ounce of product out of the land that God gave them and that they created themselves. Greenhouses set up next to carbon dioxide emitting factories give food producers easy access to the gas their plants love – farmers pump this gas into the greenhouses to spur on plant growth and output.

Yet what the Dutch farmers would have to pay is what the world is getting for free from carbon dioxide emissions. Maybe instead of being a negative externality there is actually a positive aspect to these emissions, and as per standard microeconomic theory those who benefit should pay those who create the positive externality. Everyone on the planet eats food, so perhaps a tax should be imposed on every global citizen to remunerate the creators of carbon dioxide.

I doubt this suggestion will find much support; I don’t even believe in it! But the reason that I don’t believe in it has nothing to do with my feelings over the goodness or badness of the externalities in question. Instead it stems from a recognition that we just don’t know what the relevant externalities are.

Conclusion

Economics was put on solid footing by a simple lesson in subjectivity learnt over 140 years ago. A simple refresher course would serve most people well, and remove the pretence of knowledge that some people have regarding the actions of others and their and side effects.

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David Howden is Chair of the Department of Business and Economics, and professor of economics at St. Louis University—Madrid. Professor Howden is also academic vice president of the Ludwig von Mises Institute of Canada, and winner of the Mises Institute’s Douglas E. French Prize.

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Related Posts at MasterResource

The Positive Social Benefits of Carbon Dioxide (October 24, 2013)

“The Greening of Planet Earth” (June 25, 2013)

55 Positive Externalities: Hail to Atmospheric CO2 Enrichment (March 10, 2011)

November 8, 2013   7 Comments

Real World Economics (key to understanding real-world energy)

“If you want to be an economist, it would be wise to study the economy.” [1]

It was a simple but profound statement made in an everyday email exchange. The writer was Peter Boettke, the author of an important new book, Living Economics: Yesterday, Today, and Tomorrow (reviewed below), which makes a case for realistic, applicable, fascinating economics in place of so much of the hyper-theoretical, classroom variety.

Real-world economics elucidates the world of business, politics, and decision-making in general. Such analysis and application brings in real-world energy, the subject of MasterResource and much of my books.

A prolific scholar, Dr. Boettke is BB&T Professor for the Study of Capitalism, Mercatus Center, and University Professor of Economics and Philosophy, Department of Economics, all at George Mason University. He was profiled for his good teaching work in the Wall Street Journal piece, Spreading Hayek, Spurning Keynes.

Boettke is considered a leader of Generation 6 of the Austrian School of Economics. [2] Yes, the iconic Milton Friedman said there was only good economics and bad economics, and not schools of thought. But Austrianism is surely a useful way of characterizing real-world economics premised on sound assumptions and logical reasoning.

Hail to Boettke’s new book! What follows is a review, “Economics By and For Human Beings,” by big-picture-thinker Jeffrey Tucker. Tucker, formerly of the Mises Institute, is now executive editor at Laissez-Faire Books. [Read more →]

May 18, 2012   No Comments