tag:blogger.com,1999:blog-2830084253401570472.post8342026973444796444..comments2024-03-28T09:22:36.967+13:00Comments on Offsetting Behaviour: Externalities: A PrimerEric Cramptonhttp://www.blogger.com/profile/15831696523324469713noreply@blogger.comBlogger15125tag:blogger.com,1999:blog-2830084253401570472.post-17752193233473157742012-06-22T12:27:07.789+12:002012-06-22T12:27:07.789+12:00I pointed out the error in Posner's analysis o...I pointed out the error in Posner's analysis of Ricards in my essay on him in the New Palgrave. According to the account in that essay--it's been a long time so I must rely on my past writing instead of my memory--the error was pointed out still earlier by Mario Rizzo and accepted by Posner in his fourth edition. I haven't checked the current edition to see how it treats the case.David Friedmanhttps://www.blogger.com/profile/06543763515095867595noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-73906438846288950942012-06-21T17:57:05.990+12:002012-06-21T17:57:05.990+12:00(Continued from previous - I was over the word lim...(Continued from previous - I was over the word limit)<br /><br />In Weller & Co. v. Foot-and-Mouth Disease Research Institute an infection of foot-and-mouth disease escaped from the research institute as the result of their negligence. Cattle in the surrounding areas were affected and the Minister of Agriculture, acting under statutory powers, closed the local cattle markets in which the claimants carried on business as cattle auctioneers. Since the claimants owned no cattle or other property at risk it was held that no duty of care was owed to them in respect of their loss of business profits.<br /><br />Veljanovski writes <br />“The loss was a pecuniary externality. The negligent act of the defendant did not directly affect Weller’s production activities, but only led to a change in the market for their services – a fall in demand, which was similar to falls caused by other fluctuations in the market resulting from non-negligent factors. The social cost was the technological externality of harm suffered by the farmers, whose loss in physical production would be met by the undisputed liability of the defendant towards them. The compensation paid to the farmers preserved their incentive to raise cattle in the future, and the Institute’s liability to them provides incentives to similar research institutes to take care. Since the farmers’ real rate of return was unaffected the auctioneers suffered no permanent or long-run diminution in the demand for their services or their productive capacity.”<br />If it was a pecuniary externality coming from a shift in the demand for their services (to zero), then presumably the loss to the auctioneers is balanced by a gain to their customers, the farmers (they no longer have to pay the auction fees). But wouldn’t that mean the defendant no longer has to pay these losses – as that reduces the damage suffered by the farmers and the damages payable to them. That is, if it was a pecuniary externality, it may still be desirable to charge the defendant that loss. Sometimes a pecuniary externality is offset and irrelevant, but it may be relevant for determining who lost as a result of the defendant’s negligence.<br /><br />The textbooks seem to be rationalizing these decisions by saying it would be inefficient to charge a pecuniary externality, but is that true? I would have thought the reason for limiting liability is some notion that the victim is the least cost avoider, and not paying damages gives the victim an incentive to minimise these losses, both exp post and ex ante (reduce reliance investment), or they perhaps can insure – although the courts seem to think a problem with pure economic loss is its unforeseeability, which would make it difficult to insure). Or maybe the courts are worried about difficulties in estimating the lost surplus. <br /><br />Further, is this really an example of a pecuniary externality? The defendant wiped out an essential input into the plaintiff’s business. <br /><br />And if the auctioneers and farmers were vertically integrated, could we then say it directly enters the firm’s production function and so is no longer a pecuniary externality? If we are to limit liability for pure economic losses, then whether it is a pecuniary or technical externality doesn’t seem that relevant.Mark Harrisonnoreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-88891493294786174972012-06-21T17:50:44.549+12:002012-06-21T17:50:44.549+12:00And Kiwi Dave is correct about the difficulty in e...And Kiwi Dave is correct about the difficulty in explaining the concept. I’ve just been puzzling over the some law and economics textbook treatment of the reluctance of the courts to award damages for the pure economic loss resulting from a tort. Many law and economics texts claim that is because they are pecuniary externalities and should not be awarded on efficiency grounds. But it isn't clear to me that is a relevant explanation.<br /><br />For example, in Rickards v Sun Oil Co., the defendant’s negligence put the only bridge between an island and the mainland out of commission. Merchants on the island who saw their business dry up as a result of the collision sued the defendant but lost, the court holding they were not allowed to recover ‘pure economic loss’ from customers who would have bought their goods if the bridge had not been destroyed. <br />Posner (and other texts) writes that this was “the right result. Although they did lose money, most and perhaps all of their loss was a gain to mainland merchants who picked up their business when customers could no longer reach the island. Since the defendant could not seek restitution from the mainland merchants of the gains he had conferred upon them, it would have been punitive to make him pay the losses of the island merchants. The net social cost was damage to the bridge.” Dnes even has a little diagrammatic analysis where he shifts demand curves, wrongly shades in the areas between them as change in consumer surplus and the result is somewhat confused (but rationalises the court decision).<br /><br />That explanation seems totally wrong to me. When the destruction of the bridge reduces supply to mainland consumers and drives up the price on the mainland, the gain to mainland firms comes from their customers, not the island resort. Surely the pecuniary external benefit to the mainland merchant is (more than) offset by a pecuniary external cost to the mainland consumers. Take the simple case where there are no island consumers and the producers produce the same good. There is a net loss to mainland producers and consumer combined, so nothing (less than nothing) is left to balance the loss to merchants on the island. (Actually, this is just Friedman's the analysis of an immigrant coming in and adding to the supply curve in reverse). <br /><br />If the Posner analysis were correct, I could fence in a business, or through a picket line up, and say there was no social damage.<br /><br />What if the bridge were privately owned and charged a toll for crossing? Surely the owner could sue for lost toll revenue. And the island merchants sue for lost surplus.<br /><br />Also the destruction of an essential input into the island merchants providing for the customers seems to me to be a real externality, not a pecuniary one. One thing I like about law and economics is how it forces you to apply theoretical concepts to practical real world problems (‘concretize’ them as Friedman says), which usually demonstrates how useful are the concepts. Except perhaps here it reveals I'm not sure what counts as a pecuniary externality. Also, what if the firm was vertically integrated, what would be a pecuniary externality if they were dealing thjrough contract becomes something that affects the firm's production function.Mark Harrisonnoreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-30851809280645975822012-06-21T13:54:21.685+12:002012-06-21T13:54:21.685+12:00I would have modelled the cartel arrangement as ru...I would have modelled the cartel arrangement as running through the production function rather than the cost function.<br /><br />Greenwald & Stiglitz do find more generally that pecuniary effects can matter in second-best worlds.Eric Cramptonhttps://www.blogger.com/profile/15831696523324469713noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-25668437490090250132012-06-21T12:37:10.107+12:002012-06-21T12:37:10.107+12:00“Mark: I'm pretty sure that standard theory sa...“Mark: I'm pretty sure that standard theory says cartels are bad not because of the pecuniary externality but rather because of the Harberger Triangle. ” <br />Yes, that was my point. Something that operates through budget constraints and sees to be a pecuniary externality on your definition can have efficiency effects.<br />For example, take a market distorted by a tax, which drives a wedge between the value of the product to the buyer and its value to the seller. Shifts in demand and supply curves in that market have efficiency effects (represented by the change in revenue from the tax in that market). Likewise in a monopoly distorted market. And imposing a tax or creating a monopoly has pecuniary effects only, but creates a deadweight loss. (Incidentally, I thought Brownings analysis of fiscal externalities raised the issue of whether there was some reason for subsidising medical markets that we forget to account for in the standard analysis).<br />Here is another example. Take Friedman’s analysis of immigration (pp.423-25 of my second edition – figure 14.5). when we add an immigrant, shifting the supply curve, there are pecuniary externalities on existing suppliers and demanders in the market. But, as Friedman shows, the gain to demanders is bigger than the loss to existing suppliers – there is a Harberger triangle gain to the existing residents. The pecuniary externalities do not offset. That is the argument for immigration – that it leads to an efficiency gain for natives as a whole. (In practice, there may be other pecuniary effects through the social welfare system – and also technical externalities if immigrants directly enter our utility functions through cultural effects).<br />Pecuniary externalities are offsetting in competitive markets with a fixed population, but not otherwise.Mark Harrisonnoreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-12594672991448710922012-06-21T12:18:44.371+12:002012-06-21T12:18:44.371+12:00There's also the wonderful Tullock piece on ex...There's also the wonderful Tullock piece on externalities in government. Public Choice, 1998 I believe.Eric Cramptonhttps://www.blogger.com/profile/15831696523324469713noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-48237720264617552942012-06-21T10:53:39.079+12:002012-06-21T10:53:39.079+12:00Definitely!Definitely!Eric Cramptonhttps://www.blogger.com/profile/15831696523324469713noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-21112652041116323652012-06-21T10:48:52.271+12:002012-06-21T10:48:52.271+12:00On (1), that's why I think an awful lot of pla...On (1), that's why I think an awful lot of places need to be more careful in how they teach externalities. We should be focusing far more on the misallocations rather than the "somebody else pays" aspect.<br /><br />On (2), agreed. And that's why I get rather ... exercised about social cost studies that purport to present costs that users bear as being instead borne by others. But I do think too that pointing to externality arguments gives a sciency veneer to it all. It's exactly what Sir Geoffrey Palmer did when he explicitly made a Pigovean case for increased alcohol excise/regulation on the basis of the difference between social cost and excise revenues.Eric Cramptonhttps://www.blogger.com/profile/15831696523324469713noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-589289812022280072012-06-21T10:46:06.551+12:002012-06-21T10:46:06.551+12:00Mark: I'm pretty sure that standard theory say...Mark: I'm pretty sure that standard theory says cartels are bad not because of the pecuniary externality but rather because of the Harberger Triangle. Then you get into all the Tullock stuff about competing to get the position.Eric Cramptonhttps://www.blogger.com/profile/15831696523324469713noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-6809166036631559012012-06-21T08:11:44.937+12:002012-06-21T08:11:44.937+12:00A serious problem with the use of externalities in...A serious problem with the use of externalities in policy arguments is that things often have both positive and negative externalities, as you mention, and that their size may be uncertain. So if you want to ban or tax something, you make generous estimates of the negative externalities, conservative ones of the positive--and perhaps miss some of the latter, since you aren't really looking for them. You then conclude that you have an objective argument for the policy you want. Similarly in the opposite direction if you want to subsidize or require something.<br /><br />In my experience, this is a serious real world issue. I've discussed it at some length in the global warming context on my blog, for instance at:<br /><br />http://daviddfriedman.blogspot.com/2012/03/nordhaus-on-global-warming.html<br /><br />For a much earlier discussion in the context of population issues, see:<br /><br />http://www.daviddfriedman.com/Academic/Laissez-Faire_In_Popn/L_F_in_Population.htmlDavid Friedmanhttps://www.blogger.com/profile/06543763515095867595noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-82203856296665786252012-06-21T06:41:04.505+12:002012-06-21T06:41:04.505+12:00Eric,
I think this was an excellent post. Transl...Eric,<br /><br />I think this was an excellent post. Translating this into policy, however, I see two problems:<br /><br />1. the distinction between pecuniary and technical externalities is a difficult concept to explain even to people with some economics background; it is likely to go way over the heads of many policy-makers, let alone the public.<br /><br />2. more importantly, I think allocative efficiency is not the motivating factor behind healthist policy interventions, even when “market failure” is cited as an economic rationale. What most people – and I think many policymakers – are aiming at remedying is the pecuniary or fiscal externality. The common argument you will hear from the man in the street in favour of healthist interventions is “I don’t care what you do, as long as I don’t have to pay for it.” You never hear random people say “lack of a soft drink tax leads to inefficient societal resource allocation.” What motivates people to support soft drink taxes is that they have to pay for the health costs (either through higher premia or higher taxes) of people who eat drink too much of the stuff. So arguing against healthist policies on allocative efficiency grounds isn’t going to work as a practical matter.kiwi davehttp://www.google.comnoreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-6380530271098481782012-06-21T03:49:45.660+12:002012-06-21T03:49:45.660+12:00Eric,
I'm not convinced that "There is n...Eric,<br /><br />I'm not convinced that "There is no market failure case for responding to pecuniary externalities."<br /><br />Say a set of firms collude and raise their prices above the competitive level, then the effects are totally mediated via price (it seems to affect budget constraints rather than utility functions) but the action of the cartel causes aggregate economic harm. There is no effect on production or consumption, in this case, that is not caused by the price rise. Surely there is at least may be a case for responding to this pecuniary externality? Courts awarded compensation in common law for such actions. <br /><br />More generally, although it is true that pecuniary externalities do not affect the optimality of competitive markets, if markets are distorted (eg by taxes or monopoly), then shifts in supply and demand curves have efficiency effects.Mark Harrisonnoreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-64289140830936209542012-06-20T23:43:59.031+12:002012-06-20T23:43:59.031+12:00Maybe it is only little me, no idea of the externa...Maybe it is only little me, no idea of the externality costs of my life and here in Bangkok the external wife costs are heavy, and that what I say dudes, if Eric can get down these external wife costs well I say he can Canadian go for it in Christchurch, we need a good boss for University there, I said to Brownlee you sack everybody in Christchurch ow dude, and Brownlee said to me you got a good idea dude, but you shut up you,paul scotthttps://www.blogger.com/profile/15675247055484136242noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-76659681015218134092012-06-20T16:30:53.239+12:002012-06-20T16:30:53.239+12:00True. The actual health risks to others from smoki...True. The actual health risks to others from smoking out in the open air are pretty trivial though; the case would likely have to be based on people's distaste for having smokers around. And then we get into what sorts of prejudices ought be given policy effect.Eric Cramptonhttps://www.blogger.com/profile/15831696523324469713noreply@blogger.comtag:blogger.com,1999:blog-2830084253401570472.post-49100707652657179852012-06-20T16:13:40.719+12:002012-06-20T16:13:40.719+12:00Excellent post. Note that bottom line #2 above imp...Excellent post. Note that bottom line #2 above implies that there is a far stronger case for banning smoking on a public park bench than for banning smoking in privately operated bars and restaurants. The establishment internalizes the externality through its p&l.Sunset Shazznoreply@blogger.com