Externalities: A Primer

It is far too easy to come away from a lazy version of Econ 101 thinking that, because externalities are pervasive, the range of meliorative government policy is very broad indeed. It's hard to think of any part of life that doesn't involve external costs of one sort or another.

When you get past Econ 101, you start getting all the caveats. The range of externalities that actually generate inefficiencies is pretty small relative to the universe of externalities. And, even those that can potentially be fixed by policy aren't necessarily best handled by policy. Private solutions to some kinds of externality problems do emerge; layering policy on top of private solutions can make things worse than leaving things alone.

Let's start by walking through a narrative version of Buchanan and Stubblebine's seminal work. And, we'll start by separating out two very different kinds of ways that other peoples' behaviour can affect you.

Suppose that you and I both attend a house auction. I show up wearing a t-shirt that is so offensive that you feel physically ill.* In fact, you would have been willing to pay me $100 to have worn a different t-shirt this morning. I would have been willing to have changed shirt for any payment greater than $20. Despite your nausea, you are able to bid on the house. But, because I'm bidding against you, you wind up paying $10,000 more than you otherwise would have.

My bidding against you at auction imposes a cost on you, but one that does not change the efficient outcome. The house goes to the person who values it most: you. And while you have to pay more for it, the seller receives more for it: my action has caused a transfer from you to the seller. When we model things more formally, these effects run through your budget constraint rather than your utility function. You have less money with which to do things, but we have no reason to expect that anybody is choosing the wrong mix of goods given their budgets. We call these budget-affecting externalities "pecuniary externalities". When economists say, "Oh, but that's only pecuniary", that means that it's something that we don't really need to worry about if what we care about is efficiency. We only care about externalities because they induce resource misallocation; pecuniary externalities don't do that. There might be other justice-based reasons for worrying about pecuniary effects, but to the extent that we do, we generally conclude that those kinds of concerns are really best handled by just giving money to poor people.

But the nausea that I imposed on you with my careful choice of t-shirt is a real external cost. It's easy to imagine that you'd be willing to pay some amount to change the state of the world - that means it's potentially Pareto-relevant. A Pareto-efficient outcome is one where it's impossible to make anybody better off without making somebody else worse off at the same time; a Pareto-improving move is on that makes at least one person better off while making nobody worse off. A Pareto-relevant externality is one where a Pareto-improving move is available: the total willingness to pay to change the outcome, aggregated across all the people affected, is enough to generate a change in the outcome. You suffered costs of $100; I would have been willing to accept $20 to avoid imposing those costs. Eighty dollars worth of value was forgone by my having worn the wrong shirt. So the externality was Pareto-relevant: had I chosen a different shirt, the gains to you would have outweighed the losses to me. We call externalities of this sort technological: they affect others directly through their utility functions rather than indirectly through the budget constraint.

We expect technological externalities may induce inefficient outcomes. The real costs that I impose on you through your utility function are not factored into my decisions and so I can wind up choosing the wrong consumption bundle. But, again, not necessarily. If it would have cost me $100 to change shirt, and the burden on you was only $20, the efficient result is that I wear the t-shirt. The externality was only potentially Pareto-relevant, not actually Pareto-relevant.

Eli Dourado's Mercatus Working Paper on cybersecurity walks nicely through the difference between inframarginal externalities and marginal externalities, along with a host of policy and private solutions to externality problems. David Friedman's treatment is excellent; he also cautions in Law's Order of problems that can arise when we couple Coasean solutions to externality problems with tax-based approaches [see Chapter 4 in particular].

What about externalities that affect you through the tax system? Edgar Browning calls these "Fiscal externalities". They would count as pecuniary by the Buchanan and Stubblebine definition, but they also are effects that operate outside the market process. David Roberts worries about these when weighing the case for taxes on sugary drinks. In the presence of a public health system, any decision you make that affects your health also has effects on others through the tax system. To what extent is it efficient to worry about them?

First, imagine the limiting case in which nobody's behaviour changes as consequence of health care costs being borne by others: everyone behaves as though they had private insurance that charged actuarially fair premiums. In that limit case, every health cost borne through the tax system is only a transfer. It's a transfer from richer and healthier people to poorer and less healthy people, and it's a transfer from risk-averse to risk-preferring people, but it has no efficiency consequence. There is no simple efficiency case for worrying about it, though you could build complicated cases around the cost of raising money via taxes versus the costs of abating health care costs via other mechanisms.

Now, let's take the more realistic case where individual behaviour is at least somewhat responsive to that somebody else is paying for your hospital care and that your premiums do not vary with your costs. There's reasonable evidence for this: Jon Klick and Thomas Stratmann show that when state governments mandated that private insurance plans cover substance abuse treatment, people increased their alcohol consumption by an amount equivalent to about "48 extra beers per person per year".

What are the policy implications? Let's recall first that the cost imposed by the behavioural change is likely to be small if consumption changes are small relative to the total amount that would otherwise have been consumed: average per capita beer consumption in the US is 78 litres according to Wikipedia. Imagine that we had no public health insurance but instead we gave a lump sum of cash to everybody and required that they use it to purchase health insurance; insurers could charge what they liked. How much would we really expect anybody to cut back on their consumption of sugary drinks? People bear very direct personal costs of being in poor health; the monetized value of that will not be trivial even relative to expensive insurance premiums. In other words, the effect may mostly be inframarginal. I refrain from engaging in extreme mountain biking even though ACC would cover all of my health costs: I really don't like pain and injury. I would pay multiples of the cost to the health system of a broken arm to avoid breaking my arm.


So any policy seeking to internalise the external costs of individual health-affecting decisions ought to focus on the incremental costs caused by the extrernalisation of those costs through the public health system, not the aggregate burden of related diseases. Browning, in the piece above-linked, shows that the set of taxes and subsidies that would be necessary to nudge everyone back to what they would have been doing if the health system didn't distort behaviour winds up replicating the insurance premiums individuals would have been paying under private insurance but at very high administrative cost. Private insurers can set premiums based on individually specific characteristics; governments are more typically constrained to using linear tax schedules. But for things like sugary drinks, health costs are likely exponential in consumption, not linear; for alcohol, it's a J-curve with health benefits from moderate consumption and costs from excess consumption. Your insurer might decide only to increase your premiums if you're a heavy drinker; governments are restricted to linear taxes on alcohol that overcharge moderate drinkers and undercharge heavy drinkers.

Setting excise taxes to try to internalise the largely pecuniary effects of consumption decisions can induce technological externalities by causing some would-be moderate consumers to consume too little.

A few bottom lines study notes for the exam, as this will also now be part of the readings for my Economics & Current Policy Issues class:

• There is no market failure case for responding to pecuniary externalities. 
• While there can be a market failure case for policies addressing technological externalities, we have to be awfully careful because private markets often have already internalised them. A decent rule of thumb: if people are linked through a contractual or quasi-contractual nexus, intervening is likely a bad idea. We don't need policies to address the costs screaming babies impose on other airline passengers; the airlines are residual claimant.
• Most of the "cost to the taxpayer through the public health system" aspect of individual consumption is pecuniary rather than technological. Any policy in this area has to be very careful to address only the parts of consumption behaviour that are directly caused by the potential for public defraying of health care costs; the risks of inducing inefficiency by setting policy to address pecuniary effects are real.
• Note too that the actual burden on the health system may be pretty complicated. Smokers cost the health system more in every year that they are alive, but potentially save the health system money in the long run by dying early - and they definitely save the government money in total when we consider that smokers die before drawing too much in superannuation. It's even pretty plausible that healthy people wind up costing the health system more in total because they impose costs for a long period of time. What do we do if we find out that it's the gym rats who wind up costing everybody more because they spend ten years in a publicly funded dementia ward instead of dying of a heart attack at 67?

This is part 2 of a two-part series; in part 1, I took a more rights-based approach. And see here for prior posts on externalities.

* Only weirdos would be offended by these fine shirts, but they count in the social welfare function too. Anybody stumped for Christmas presents for Crampton can send me one of these shirts; I'm likely a medium.