Wednesday, January 18, 2012

A quick clarification on the externality thing...

...because there's some interesting conversation going on here.

First, commenter Mark was wondering about some of the things I said about subjective value in response to this sentence in Don's post: "This is not science; it is metaphysics: value judgments and political goals will enter into the determination of whether externalities occur in our world." When I concurred with this, noting that we're dealing with subjective value (i.e. - peoples' value judgements) I didn't mean that it's debatable or subjective whether there are externalities. There absolutely are. But those externalities are introduces by individual subjective valuation - value judgements - and these alone don't make externalities "unscientific" any more than anything else in economics is unscientific.

One tricky thing about the way that subjective valuations impact externalities is that there are really two layers of value judgements: first, peoples' own subjective valuations of externalized costs and benefits, and second - our decision as a society whether we want to recognize or give standing to those subjective values. For example - thieves like to take money from people. OK, that's their subjective value. As a society, we say "tough shit" to thieves. We don't really care about that subjective value and we give it no standing whatsoever. That seems like a silly example, right? It's actually quite relevant to these arguments that economists have over whether markets or government solves externalities more effectively. One "market" solution is to have the two parties bargain - people can pay to have polluters reduce pollution. Sounds fine, and if you draw it out the model, it looks fine. But this is still entirely contingent on a social value judgement. Think of it this way - why don't we say to people "well, you can pay the thief not to steal your money". We don't accept this. We give standing to polluters to impose costs, but not to thieves.

"Crime" is just the word we use to describe the actions that impose externalized costs that we consider it unreasonable to expect people to make a Coasean bargain over. We are OK talking to students about swimmers paying polluters not to pollute. We generally don't like to talk to students about paying a murderer not to kill you. Another way of saying this is that ransoms are just a type of Cosean bargain.

These are all value judgements, so coming out and saying "the market does better than the government" or "the government does better than the market" is not a question you can answer unless you can clarify what you mean by "better".

The other thing about this whole bargaining issue (which is central to the question of governments vs. markets in externalities) is that a lot of externalities involve public goods (and bads). Cleaner air is non-excludable, for example. So when we think about bargaining over this stuff we have to think about public goods issues too.

I do agree with some of Mark's points about just figuring out an objective measure of these things. We do that all the time. There's a ton of literature over the discount rate (as Current alluded to in his comment), and over the value of a human life. People estimate all sorts of demand elasticities precisely for this reason - to get a rough estimate of what these costs and benefits might look like.

That's all pragmatic application of the economics, and in my opinion it's much better than flying blind.

But it's important to recognize that these are rough estimates. It's not a measure of "utility" it's a measure of willingness and ability to pay. We need to be careful about two things when we do this: (1.) make sure we always recognize we're not really measuring subjective value - we're just trying to get better acquainted with the costs and benefits, and (2.) make sure we understand that we still have to bring value judgements about who has standing and who doesn't!


  1. Wow, for once, you and I are in complete agreement.

  2. Yes, that clarifies things nicely. I agree with you completely. I will have to do some more reading of Coase theorem. The type of "intervention" selected for a particular issue is definitely a consideration. The social validity of paying thieves is very low, while it may be more acceptable to pay swimmers to pay polluters not to pollute (but still seems counter intuitive).

    I see that Coase theorem has been used in determining financial liability in court - has it been applied successfully to internalizing externality in a variety of situations or contexts?

  3. re: "The social validity of paying thieves is very low, while it may be more acceptable to pay swimmers to pay polluters not to pollute (but still seems counter intuitive)."

    I agree. It also seems like the fact that externalized costs are often diffused costs is to often ignored by people who talk about this.

  4. This is off-topic.

    Are you under a lot of pressure lately, Daniel? I've noticed a bit more profanity in your posts than in the past. It is just an observation, not a critique. After all, I am a former sailor.

  5. Ronald Coase and his eponymous -- though elusive -- theorem must be among the most misunderstood institutions in all of economics. (Some links here if anyone is interested in that discussion.)

    The Coase Theorem has indeed been applied to many different circumstances. One of the most celebrated of these is divorce rates.


    Speaking of subjective valuation, courts and the like... This old post might be of interest. (I was arguing that the slavish fixation with property rights by certain libertarians would lead to an absurd situation if taken seriously, where all industry could be shut down due to the whims of a few hippies. That is, unless, someone overrides the primacy of subjective value... another supposedly inviolable standby of deontological libertarians.)

  6. The "objective" vs "subjective" questions are more interesting than Daniel makes them, in my opinion. To begin with, whether or not the person and property of one person has an effect on that of another is a strictly objective question. Sound waves, light waves, chemical pollution and so on can all be measured, we could call these "objective externalities". What's strictly subjective is the importance attached to what happens. What Daniel is saying is that the law attributes a high importance to some types of objective externality, and no importance to others.

    As Daniel says there are things each individual will view as subjective externalities and things the law views as externalities and they won't be the same. An example of this I used to give was seeing two beautiful lesbians kissing as they walk down the street. Is this a positive or a negative externality? Well to some people it could be negative and some positive, to some people it could depend on their mood. Different societies treat it differently, in western societies the law would have nothing to say about it, but in some muslim societies it would be punishable.

    The discount rate enters into this in situations where harm is accumulative. The simple situation is that a certain level of a toxin will cause death and any less will do nothing. All real cases come somewhere in-between, some damage is done that may shorten a person's life, even if only marginally. So, how do we judge if a law should be put in place against that objective externality? That's where discount rates come in.

    I'm not sure Daniel is really right about money. This brings up the economist's meaning of "objective value", i.e. price. Let's suppose that a factory pollutes the fields of a farmer. In that case how much should the factory pay the farmer in compensation? This is not really as difficult as the situations that deal with people and consumption. I gave the example before of the smells coming from a chocolate factory, the problem there is that it affects people directly. In the farm case though the farmer loses income and that can be given a money value. If the farmer were a self-sufficiency advocate farming for himself it may be different. So, a court can award damages. But, in this case the court is performing a role that's somewhat entrepreneurial because it must estimate how an externality will affect future capital value. That is, the court may believe the crop or land to be less valuable than the farmer does. But, when present goods are concerned things are quite clear, if a present good has been damaged then a person has lost at least the money value of that good, because the good can be sold and anything else of that money value bought with the proceeds. So, I think the case of stealing money is quite a clear.

    Daniel is, of course, right that there is no measure of subjective value, it isn't comparable interpersonally. The law is providing very rough estimates.

    But, in a sense I don't really agree with this. Although it may be a possible model for the law, I don't think it's how it has worked. Let's take an arbitrary time in the past where there was something resembling the rule of law. Inevitably there would be many subjective externalities that the law wouldn't consider. It could be said that what matters in the long term is how well these externalities are dealt with. One part of that is if the things that are left to Coasian effects can be dealt with that way. I don't think that's the whole story though. What matters is just as much is what economic progress can be made within the framework of laws. Let's suppose there are two countries. In the country X the laws are careful about personal externalities, but less so about commerce. In country Y things are the opposite way around. Though the citizens in country X may be happier in the short run, over time economic growth may be higher in country Y.

  7. Stickman,

    I'd love to get into the nitty gritty of these sort of things its very interesting. You're is quite right about the "absurd situation if taken seriously, where all industry could be shut down due to the whims of a few hippies", what Rothbard says in "For a New Liberty" points in exactly that direction.

    1. Thanks for the tip, Current. I often find myself in stark disagreement with Rothbard (albeit usually on macroeconomic matters and epistemology). It would be nice to find some agreement with him for a change... Even if he is a racist ;)


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