State Externality Solutions: In Search of Optimal Quantities
The common solution to externalities is to fight them with taxes and subsidies, but this overlooks the problem of discovering the optimal amount of the thing being taxed or subsidized.
When man acts, he tends to produce ripple effects which are not localized to the immediate parties of the action but instead extend outward in unpredictable ripples.
These effects, whether negative or positive, are generally termed “externalities” because they impose effects on parties that are external to the original transaction.
A negative externality occurs when a foundry produces steel ingots and pockets the proceeds from their sale but also imposes costs in the form of sulfur dioxide pollution on people in the vicinity of the factory. A positive externality occurs when large numbers of people are vaccinated against an infectious disease to create “herd immunity” which lowers the risk that a given person will contract the illness.
In these situations, a problem becomes clear: The polluting steel mill did not pay the full cost of making its steel and the people getting vaccinated did not reap the full benefit of their immunization. Because of this, the incentives for both activities are misaligned. If the steel producer does not pay the full cost of production, it will produce more steel than it would otherwise. If the vaccinated do not get all the benefits of their immunization, fewer people would get vaccinated than they would otherwise.
The textbook economic solution is for the state to step in with a Pigouvian tax or subsidy which compensates for the external costs and benefits by taxing the polluting steel mill and paying the vaccinated. As is usually the case in economics, the clean proposition of command-and-control management of externalities does not measure up outside of the textbooks. As Hayek wrote in his book The Fatal Conceit, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
The first problem is finding out what the optimal level of the activity being taxed or subsidized is. One major positive externality is scientific research since a theoretical breakthrough can lead directly to commercial applications, which can be lucrative. Even so, the scientist seldom reaps enormous gains from his research unlike the businessman who transforms it into products, which could lead to an inefficiently small amount of research being produced.
Murray Rothbard discussed this question in his book Science, Technology, and Government, and asked a vital question: How much research should be conducted? One might be tempted to answer “as much as possible” since that would seemingly discover the largest number of profitable opportunities, but this misses the point. All things in life have tradeoffs, and striving for the maximum amount of scientific discovery means pouring enormous amounts of resources into research, resources which could be used to alleviate real demands today.
Myopic maximization of one goal, even one as universally laudable and sometimes lucrative as scientific research, to the exclusion of others is untenable. A reductio ad absurdum of pursuing a goal single-mindedly is Bostrom’s Paperclip Maximizer, though one does not need to invoke artificial general intelligence to see the folly of failing to recognize tradeoffs.[1]
The bottom line is this: All actions have opportunity costs, and resources spent doing X are not available for doing Y, and it is not possible to costlessly increase one thing without foregoing something else.
Thankfully, the market has a build-in tool to solve this—The price system. People and institutions can “buy” research by funding it, and they can continue to “buy” more until they judge that their funds would be better spent in another way. Prices are the only non-arbitrary way to solve the coordination problem of different actors having their own plans in the presence of scarcity.
The Pigouvian argument assumes this problem away by saying that the state will define what the optimal amount of X is. Of course, the state can attempt to answer this question by deploying the tools of econometrics, but they will do little better than throwing darts blindfolded.
The information needed to determine the optimal amount of X doesn’t come from equations, it comes from the demonstrated preferences of all actors in an economy and is thus heavily dispersed, resistant to aggregation, and contextually dependent. Put differently, each person has a role to play in deciding the optimal amount of X by demonstrating his preferences with action, the information created by said action is not easily passed onto state planners, and said information does not even exist outside of a market forum where people can demonstrate their preferences.
Without the ability to non-arbitrarily determine optimal amounts of X, the Pigouvian argument becomes unworkable, but this still fails to address the possible “overproduction” of negatives, and “underproduction” of positives.
The market has a ready-made solution for the externality problem in the form of the expansion of property rights and institutions which lower the transaction costs of bargaining between said rights. On the property rights point, David Friedman has a helpful example in his textbook on price theory:[2]
“An example is the case of British trout streams. Trout streams in Britain are private property. Each stream is owned by someone--frequently the local fishing club. An industrial polluter dumping effluent into such a stream is guilty of trespass, just as if he dumped it on someone's lawn. If he believes the stream is more valuable as a place to dump his effluent than as a trout stream, it is up to him to buy it. If he believes (and the fishing club does not) that his effluent will not hurt the trout, he can buy the stream and then--if he is right--rent the fishing rights back to the previous owners.”
The example of Trout streams in Britain is one example among many, Walter Block has an entire book on privatization of bodies of water which deals mostly with externality questions in one shape or another, ultimately finding privatization to be the best answer.[3] This leads to a formula: Privatization (or quasi privatization in cases where the genuine article is impractical) of the thing being imposed upon and the use of institutional bargaining to address grievances. If the British Trout Club found their fishing spots despoiled with industrial runoff, they can take the offender to court and sue, forcing a wealth transfer that rectifies the original injustice.
Postscript: I have been thinking a fair bit about externalities these past days and am considering writing a series of articles about them. If you are interested in this, please leave a comment below to that effect.
[1] https://philpapers.org/archive/BOSEII.pdf
[2]http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_18/PThy_Chap_18.html
[3] https://mises.org/library/book/water-capitalism-case-privatizing-oceans-rivers-lakes-and-aquifers