Externalities Part I

Their Logic

A negative externality is a cost that one person’s actions impose on others without requiring their consent. A positive externality is a benefit that one person’s actions provide to others where the person producing the benefit cannot control who gets it, hence cannot charge for it. The existence of negative externalities is the usual economic argument for taxes, such as a carbon tax, imposed not to fund the government but to discourage activities that produce negative externalities. Positive externalities provide a similar argument for subsidies. The theory in either case is to make the private cost/benefit calculation of the individual taking an action correspond to the social calculation, making it in the interest of people to take actions that produce net benefits, avoid actions that produce net costs, with costs and benefits taking account of effects on everyone.

The problem with external costs is not that they are costs — external benefits are a problem too. The problem is that they result in individuals making the wrong decisions, decisions that are optimal for them but not for us. The size of the problem is not measured by the size of the externality but by the cost of the wrong decisions. If an externality, positive or negative, does not affect a decision, if the individual would have made the same decision if he paid the entire cost and collected the entire benefit, the existence of that externality changes who benefits or loses and by how much but it does not change the net benefit, the effect summed over everyone.

Consider a decision where the person making it receives all of the benefit but pays only 95% of the cost, with the remaining 5% falling on someone else. If benefit is less than 95% of cost he doesn’t do it and shouldn’t, since doing it harms both him and us. If benefit is more than 100% of cost he does it and should, since doing it benefits  both him and us. The existence of the externality, the fact that some of the cost is paid by other people, only makes us worse off if cost happens to be between 95% of benefit and 100% of benefit, in which case he does it and shouldn’t. If that happens he makes the wrong decision — but the decision is not very wrong, since benefit is only a little more than cost.

It follows that the size of the problem created by an externality depends on more than the size of the externality. If most of the relevant decisions will get made correctly, the benefit of correcting an externality, even a large externality, may be small.

Consider the relevance of this to the proposal for a carbon tax. If you know the size of the cost imposed by an additional ton of CO₂ — I argued in a previous post that we don’t, but for this one I will assume we do — that is enough to tell you how high your carbon tax should be, since a tax that exactly transfers the external cost to the person deciding whether to do something that produces CO₂ gives him exactly the right incentive.

Setting up and enforcing a carbon tax is itself costly, however. Someone has to calculate the cost of CO₂, measure how much is being produced by different people’s actions, collect the tax. There will be additional costs from people lobbying or litigating over how high the tax should be, trying to manipulate details of what is taxed and how it is measured, perhaps bribing inspectors or using political influence to lower the cost on themselves, raise the cost on their competitors. When something close to a carbon tax was passed by the house (but not the Senate) in 2009, the legislation was a compromise between what economists would have recommended and what politicians thought it in their interest to pass.

Part of the cost of a carbon tax is the cost of doing it wrong, using the excuse of a carbon tax to justify policies that are politically profitable but impose net costs. For a large real world example, consider biofuels. The policy was initially proposed as a way of reducing CO₂ output by replacing gasoline with alcohol produced from corn. More careful analysis found that it didn’t work, that the CO₂ produced in the process was at least as great as would have been produced by burning gasoline instead. We still have the program because, although it did not reduce CO₂ emissions, it did raise the price of corn, and farmers vote. The US, which is the world’s largest producer of maize (corn), currently converts more than a third of its output to alcohol. Think of it as our contribution to world hunger.

If follows that while the optimal size of the carbon tax, or any similar tax or subsidy, depends on the size of the externality, whether it is worth doing it at all depends on a more complicated calculation. Even a large externality might produce costs smaller than the cost of controlling it.

Or might not.

In my next piece I will drop the optimistic assumption of this one and extend the analysis to another issue.