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26 November 2015 12:18 (South Africa)
Opinionista Ivo Vegter

'Externalities', the catch-all justification for regulation

  • Ivo Vegter
The problem with so-called “externalities” – most commonly applied to pollution – is an old one. It is no closer to being solved, but keeps getting raised as a fall-back justification for ever-more bureaucratic regulation and government intervention.

Whenever a cost or risk is imposed on people who are not party to the production and consumption of a good or service, the ugly concept of “externalities” raises its head. It is used as a justification for all sorts of government intervention that, it is claimed, will correct market failure.

I say “ugly”, because it is an inconsistent and imprecise formulation of a convoluted and often intractable problem.

Externalities occur when someone other than the voluntary parties to a transaction gains a benefit, incurs a cost, or shares a risk, without their consent, as a consequence of that transaction.

An example of a positive externality is immunisation. When one parent immunises their child, it benefits not only that child. Many others gain the benefit of being less exposed to a much-feared disease. They do not, however, pay for this benefit. Forcing them to do so when they did not consent to the immunisation in the first place would be a clear violation of their moral rights.

Another example is when a tenant improves a property. This may contractually be the province of the landlord, but many tenants do make improvements at their own time and expense, for any number of reasons. Without having obtained prior consent from the landlord, however, they have no claim on the landlord for having caused them a positive externality. A government regulation that coerces landlords to compensate tenants for such unsolicited improvements would violate the rights of the landlord.

An example of a negative externality is pollution. When a factory pollutes a water course, rendering it unusable or harmful for a downstream farmer, that action imposes a cost on the farmer that is not included in the price of whatever the factory produces. Because the buyer of its product doesn’t pay for it, they are not making a rational economic decision, since the price does not include all relevant information. Had they known the additional cost imposed on the third party, and had they been required to pay this cost, they may not have bought the product.

In economic terms, the argument goes, goods with negative externalities suffer from over-production, because their full cost is not priced in, while goods with positive externalities are under-produced, because the full benefit is not priced in. Each case appears to merit government intervention to correct the over- or under-production, and bring the market closer to a state of perfect competition with perfect information.

This is intuitively attractive, but practically it becomes a minefield.

One simple kind of externality is easily dealt with, without requiring any new regulation. When someone can show material damages caused by someone else in the furtherance of the latter’s business, it is a trivial matter to approach the courts for relief. All the elements for a civil compensation award are present: evidence of the amount of harm caused to the plaintiff by the actions of an identifiable respondent.

In effect, the failure in this case is not a market failure, but a failure on the part of the respondent to seek the consent of the plaintiff for an action that materially affects the plaintiff’s interests. Asking a court to intercede in this case is merely a matter of protecting the plaintiff’s rights, and ensuring proper market operation. It is based in the assertion and enforcement of property rights.

It is true that many companies actively seek to “externalise” costs. A classic example is dumping on public or private land, rather than paying for proper waste disposal. Again, however, these actions are adequately covered by private property rights, which give an owner grounds for action against the offender, should the misdeed be proven in court.

Ironically, many cases of externalising costs or risks occur with the active complicity of government. Take the case of the Gautrain, in which a so-called “public-private partnership” between the Gauteng Provincial Government and the Bombela Consortium includes terms that guarantee the private company’s loans, and even guarantee them a sufficient level of ridership. If the risks turn out to be ill-advised, because not enough people take the train, the taxpayers of Gauteng carry the can by paying the shareholders of Bombela a “patronage guarantee” amounting to hundreds of millions of rand.

Assessing externalities becomes very complicated very quickly, however. What of someone who builds a house on a newly-acquired lot adjacent to another landowner’s property? This act can materially reduce the pleasure that landowner can take in his unobstructed view, uninterrupted silence, or unimpeded access to water resources or even clean air. At what point does the externality imposed by the new builder on the existing landowner become sufficient to justify state intervention to correct it?

Or take smog in a city. If one person drives to work, the harm caused by that person to other residents of the city is negligible. There are no more grounds for acting against that motorist than there are to act against him for spoiling a view while he stands to admire it, breaking the silence when he sings, or reducing the supply of bread when he purchases a loaf for his lunch. When a million people drive to work, however, the harm caused by smog becomes real and measurable.

A similar argument goes for traffic congestion. One person makes an immeasurable, insignificant and non-actionable difference. Are they responsible for the actions of everyone else, who turn many individual actions into a collective traffic nightmare? What about pollution in a river caused by the combined effluvia of a city upstream from others who live along the river? How would you fairly assign blame, determine damages, and determine the beneficiaries of compensation?

If the actions of a single person are not culpable, how can they be held liable for the concurrent actions of others?

A similar problem occurs conversely: when the actions of one person cause insignificant or unquantifiable harm, but that harm is caused to enough others raise public concern.

In some of these cases, groups can seek recompense through class action lawsuits or public-interest litigation. The law can offer justice in cases where many plaintiffs are harmed in some small way by the actions of an identifiable individual or group. However, the legal burdens of proving both cause and quantum are relatively high.

Even when the legal hurdles are cleared, the question of just awards and settlements in class actions can become fraught with ethical problems. If those hurdles cannot be cleared, because the harm is hard to quantify, the perpetrators hard to positively link to the cause, or the damages suffered are unequal, how much more difficult is it to impose prejudicial regulations that do not even try to identify victims, prove causation, or compensate those who supposedly suffered harm?

When externalities are not “priced in” by the market, this is usually because the damage is low, or the cause is hard to prove. The cost of pricing in the unintended harm to others exceeds any benefit they might gain.

One also has to consider the benefits endowed by the person or company that causes the negative externality. The fact that we live more than twice as long as our forebears a century or two ago, and have access to electric light, refrigerated food, brick-and-mortar houses, time-saving domestic appliances, life-saving medical technology and convenient motorised personal transport are all great benefits. Much of that benefit accrues above and beyond the mere price of the goods and services in question, such as in the case of telephones or computer networks, where the more people who use them, the more benefit every individual owner derives.

The industrial revolution has had many positive externalities, but it is the same process that gave us air and water pollution that imposed significant costs on us and took many decades to combat. It is as hard to price the positive externalities as it is to quantify the negative externalities, so for the most part, we’ve tacitly agreed to take the good with the bad, and be glad that we enjoy a better quality of life than our great-grandparents did.

Let’s return to the smog example. Externality theory suggests that merely by making motorists pay for the smog their cars emit, the problem would be fairly addressed. This assumes that any individual motorist can be held responsible for the cumulative impact of the actions of all other motorists, which is morally questionable. It also assumes that the victims of that smog would actually see any of that compensation, which rarely occurs in reality. It assumes that the cost of implementing such a scheme does not exceed the revenue it generates. And it assumes that motorists would change their behaviour as a consequence of paying a nominal smog penalty. None of these assumptions hold. If they did, the rising fuel price alone would have solved smog problems.

It is impossible to tell whether an alternative future in which regulation has not mandated cleaner fuels, but in which the free market offered cleaner fuels to environmentally-conscious consumers, would have led to a different outcome to the one we have today. The experience of preservative-free foods, organic farming and natural remedies are instructive: people often do choose to do what they believe to be better for them and society, and companies voluntarily respond to the free choice of their customers. All that’s needed in law is protection of property rights and provisions against fraud.

However, if these matters become heavily regulated, we run into further problems. If all claimed externalities are to be paid for, then what about positive externalities? Should I pay the owner of a neat and tidy house for the pleasure of living next door? Should the owner of an unkempt house pay me?

If this is so, every homeowner ought to pay an externality fee to their neighbours for causing visual and noise “pollution”, and drawing on common resources like groundwater. Every person who makes a fire in his house to keep him warm in winter would have to pay those people (and only those people) affected by the smoke. Every person who contributes to a footpath in a forest has to pay everyone else who wishes to enjoy the forest unspoilt by the presence of others. The examples become legion, and increasingly absurd, but consistency about the concept of externalities requires that we take them into account. On what grounds can we say one example is patently absurd, but another is a matter of urgent justice?

The upshot of the lack of clarity offered by the concept of externalities is this: it is a last resort for those who are not able to prove their case in court.

Climate change is one such case. While there is a great deal of speculation going on, there is also a great deal of uncertainty and disagreement about the likely causes, effects and remedies. Merely slapping a tax on, say, carbon emissions, imposes costs on everyone, while even those who believe human carbon emissions are the primary cause of climate change agree that limiting them won’t make much difference anyway.

An economic analysis of various possible responses to climate change conducted by the Copenhagen Consensus project found that adaptation offers a far more attractive cost-benefit proposition than mitigation, and mitigation is a far worse way to spend limited resources than on any number of other urgent problems the world faces, such as malnutrition or sanitation.

This inability to properly quantify the extent of the harm caused by carbon emissions, or conversely, the benefit caused by limiting them, leads environmental activists to demand arbitrary limits, quotas, penalties or taxes as the price of unspecified externalities.

More generally, the notion of “externalities” is so ambiguous, so inconsistent, and so fraught with contradictions, that it is useless as an analytical concept. It merely raises the cost of production, without offering any real benefits. That makes everyone poorer, and nobody richer.

If you can show that someone caused you quantifiable harm by violating your rights, you’re perfectly entitled to both compensation and action to prevent future violation, under the existing laws of market economies. Those laws don’t remedy market failure; they establish markets by asserting and protecting property rights. No appeal to externalities is necessary.

An appeal to externalities, however, is an admission that you’re unable to prove who caused the harm, how they caused the harm, what harm was caused, to whom the harm was caused, how much harm was caused, or how future harm can best be prevented. Inability to demonstrate any or all of these offers no legal or moral basis for violating the rights of free people by coercive government intervention.

PS. Thanks to Gavin Chait, at the Cape Argus, for encouraging me to write this column. He has promised to publish a counter-argument. I am indebted to Brian Simpson’s paper, An Economic, Political, and Philosophical Analysis of Externalities, for theoretical background to some of the arguments in this column. Any errors or misinterpretations are all mine. DM

  • Ivo Vegter

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