Problems posed by external costs are everywhere.
You encounter them every hour of your waking life, though you probably don’t recognize them, and you often contribute to them — from idling your car in a traffic jam to eating factory farmed meat. They are not are not a new phenomenon; the court records of the village of Foxton, near Cambridge, England (where I lived for many years) show more than five hundred years ago, in 1492, “John Everard, butcher, allowed his dunghill to drain into the common stream of this village, to the serious detriment of the tenants and residents; fined 4d; pain of 10s.” (4d is four pence, 10s is ten shillings, and “pain of” is the fine to be imposed if he does this again.)
And that such external costs interfere with the smooth functioning of the market is likewise not a new idea, or a controversial one. Cambridge economist Arthur Cecil Pigou (1877–1959) is often cited as the originator of the term. An undramatic academic but a man of strong principles, Pigou refused to join the army during the First World War on the grounds that he would not destroy life. The presiding genius of Cambridge economics for several decades, the formalization of the concept of external effects was his principal legacy. Pigou suggested that external effects be corrected by taxes or subsidies, which are now known in his honor as Pigouvian taxes or subsidies. If the private costs of an action are less than its total costs because of an external cost, then we should levy a charge that will raise the private cost by the amount of the external cost so the company then faces the correct cost. And if the external effect is a benefit rather than a cost, we should subsidize the action with an amount that reflects the value of the external benefit. Again, the company’s calculus is now in line with the overall social values.
Here’s a concrete example. I have to choose between generating electric power for my home from solar panels or a diesel generator. Taking into account the capital costs of acquiring the panels or the generator and the fuel costs associated with running the generator, power from the panels will cost me 12 cents per kilowatt-hour, and from the generator 10 cents. So, to me personally, the diesel generator is the less expensive. In Adam Smith’s world, my costs are society’s costs, because in his world all costs are internal. But in the real world today, there are external costs linked to my use of the generator, since diesel generates a wide range of pollutants as well as greenhouse gases that affect and change the climate. For simplicity, let’s assume these external costs are 8 cents per kilowatt-hour, increasing the total cost of running the generator to 18 cents. There are no such costs associated with the solar panels. This makes the generator, in total, the more expensive of the two options, but not to me: I only pay the private costs, 10 cents. So a good choice for me is not necessarily a good one from a social perspective, as minimizing my costs is not the same as minimizing the real, total costs. The Pigouvian approach would add the external costs to the private costs of the generator by a tax, raising the effective private cost to 18 cents and leading me to make the right choice.
Let’s think about the bargaining positions of the farmer and rancher. The rancher benefits from his cattle eating on the farmer’s land, and so he is willing to pay the farmer for the right to have them graze there. The farmer, on the other hand, loses from the cattle eating his crop and could either pay the rancher to keep his cattle off, or allow the animals on and accept compensation from the rancher for the damage to his crop. This suggests that several outcomes are possible: the rancher paying the farmer for grazing rights or the farmer paying the rancher to keep his cattle away from the farmer’s crops.
Which outcome occurs depends on who has what rights concerning the use of the land. Either the farmer has the right to exclude the rancher’s animals from his farmland or the rancher has grazing rights over the entire area, including rights over the farmland. If the farmer has the right to exclude the rancher’s animals then the rancher will have to pay him for access, and if not, the farmer will have to pay the rancher to keep the animals away. But in either case, the outcome is good from an economic perspective because the cost of the external effect is incorporated in the rancher’s calculations.
Coase’s ideas have rarely been tried in practice, largely because most external costs fall on more than just one person. Think of climate change, which affects over seven billion people. It would be impractical to bargain between all affected parties. The administrative complexity would be overwhelming. (Slightly ironically, the importance of administrative costs—the costs of organizing and taking action—was another one of Coase’s research themes.) However, Coase’s ideas have had a great indirect influence in shaping one of the most popular remedies for external costs: the cap and trade system…. The idea behind this approach is that external costs stem from inadequately defined property rights and can be corrected by a better assignment of rights. This insight has proven valuable for problems as diverse as overfishing and climate change.
External effects are more common in our crowded and interdependent world than they were in the wide-open frontier society several hundred years ago. They come with the territory of globalization and interconnection and a world population of seven billion (with another two billion expected to join us in the twenty-first century alone, an increase greater than the entire world population in 1900). And as we continue to connect more and the world’s population grows by billions, external effects will only become more important. It is crucial that we learn to put them in their place.
Excerpted from Endangered Economies: How the Neglect of Nature Threatens Our Prosperity by Geoffrey Heal, © 2017 Geoffrey Heal. Used by arrangement with the Publisher. All rights reserved. To learn more about the book, visit Columbia University Press.
About the researcher
Geoffrey Heal, Donald C. Waite III Professor of Social Enterprise at Columbia Business School, is noted for contributions to economic theory and resource and...Read more.