Negative Externalities

A concept much beloved of economists is externalities. When an activity has an impact (negative or positive) on people who are not involved in it, that is known as an externality. Aabir is learning drumming. He practices for hours at home. The noise is a negative externality for the neighbors. Ayaan is an avid gardener. His front garden has awesome flowers. That is a positive externality for the neighborhood.

The concept of externalities was first systematically developed by British economist Arthur C. Pigou in his 1920 book “The Economics of Welfare.” Many economists, but not all, consider the presence of externalities to be a “market failure” and recommend government intervention to correct that failure. Is government intervention a good idea? Are there other ways of addressing the problem?

I will not waste any more time on the subject because I am unlikely to improve on an excellent essay (Feb 5, 2025) titled “What, Exactly, are Negative Externalities?” by Don Boudreaux at the American Institute for Economic Research. An excerpt:

A classic example of a negative externality is a railroad that builds a line next to farmland and, when it runs its trains, throws sparks onto the farmland, occasionally burning the farmer’s crops. The farmer suffers damage that he did not bargain for. If the railroad doesn’t pay for this damage, it does not cover all of its operating costs, which include doing damage to crops. Because incurring costs restrains the actions that generate the costs, not having to pay all of its costs leads the railroad to run too many trains. And when the railroad runs too many trains, the farmer winds up supplying too few crops.

To induce the railroad to produce the optimal amount of railroad services, it must somehow be obliged to pay not just for some of its costs of doing business – to pay not just wages to compensate its workers, and prices to compensate its suppliers of fuel – but to pay for all of its costs, including whatever damage it causes to farmers and other parties who suffer incidental losses as a result of the railroad’s operation.

A.C. Pigou and Ronald Coase

The government can “correct” this market imperfection by imposing on the railroad a tax equal to the value of the crops damaged by its trains. This tax – called by economists a “Pigouvian tax” (after the British economist A.C. Pigou⁴) – “internalizes” on the railroad the cost that it once imposed on the farmer. A cost that was previously external to the railroad’s decision-making processes is now internal to it given that the railroad must pay the tax. With this cost “internalized” on the railroad, it will now produce the economically optimal amount of railroad services, and allow the farmer to supply the optimal amount of crops.

As Ronald Coase pointed out in one of the most influential economics papers ever written, such a tax isn’t the only, and likely not even the best, means of internalizing this externality.⁵ If the railroad and farmer can bargain with each other, all that needs to be done is for the property right to be clarified. With a clear understanding of prevailing property rights, the farmer and railroad will bargain with each other to reach an agreement that brings about the optimal amount of both railroad services and crop supply.

According to the famous “Coase Theorem,” if bargaining is possible it does not matter economically what the property-rights assignment is, only that it exists and is known and unequivocal. A simple example makes the Coase Theorem clear.

End excerpt. I love Don’s excellent analysis. It’s clear and elegantly stated. Also, it makes you think. For instance, he distinguishes between costs and losses.

It’s important to get the language straight. The value of the damaged crops, in this case, are not “losses.” They are costs, and costs differ from losses categorically. This distinction might at first come across as one without a difference, but it is real and relevant. Before returning to the farmer and railroad, let’s explore this difference.

By “losses,” I mean the value that a party is denied when he or she is stripped of some property interest in which he or she has a legitimate legal entitlement. If a thief steals your car, you suffer genuine loss. If Jones builds a tall fence that blocks a view to which Smith has good reason to believe he is legally entitled, Smith suffers a loss. If a freak earthquake destroys my home in northern Virginia, I suffer a loss. Using conventional language we might say that the theft “cost” you $25,000, that Jones’s fence “cost” Smith his lovely view, and that the earthquake “cost” me my home. But to get a clearer understanding of externalities, the decrements from your welfare, from Smith’s welfare, and from my welfare are better called “losses” and not “costs,” for it’s important that losses and costs be kept distinct from each other.

Prof Boudreaux’s essay is a must read if one is interested in learning a bit of economics. It’s a long but delightful and instructive. Go read it all.

Author: Atanu Dey

Economist. View all posts by Atanu Dey