Externalities: Cooperation, Enforcement and Other Issues

Musings on what is apparently our (my?) favorite topic at Economic Forces

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Here at Economic Forces, Brian and I write a lot about externalities. Although many textbooks make it appear as though the topic of externalities is rather straightforward and the policy implications are simple. The typical explanation goes something like this. An externality is just a benefit that goes to a third-party (or cost that is borne by a third-party) that is not reflected in the price of the good or service that is being exchanged. Given that this third-party effect is not reflected in the price, neither the buyer nor the seller in the exchange take this effect into account when making their decision. Since neither party takes into account this third-party effect, the amount of trade done in the market is suboptimal. Either the market participants ignore third-party costs and the equilibrium quantity is too high or the market participants ignore third-party benefits and the equilibrium quantity is too low.

Policy solutions are then treated in a really straightforward fashion. If people are ignoring external costs, the government could impose a tax on the participants in the market. This will cause market participants to internalize that external cost. If people are ignoring external benefits, the government could subsidize the participants in the market to encourage more trade.

Seems simple, right?

And yet, the volume of posts that we write on the topic would seem to suggest that it is a bit more complicated than this straightforward discussion. Thus, today, I’d like to revisit some arguments I’ve written about before and introduce some other arguments that I haven’t yet discussed.

Enforcement Costs

One issue that seems important, but that is often neglected from discussion is the role of enforcement costs when imposing a particular policy solution for externalities. However, costs of measurement and enforcement need to considered. Consider the conventional example of a polluting factory. The production at the factory might pollute the air or the water. This pollution is a cost to all who breathe the air or use that water, but that cost isn’t reflected in the price of the good that the factory is producing. The textbook solution would be to impose a tax.

The government could impose a tax on the pollution itself. This requires that the amount pollution can be precisely measured and that marginal cost of that pollution measure can be precisely estimated. It might be easy to do or it might be hard to do, but the main point is that measurement entails a cost. Alternatively, the government could impose a tax on the production of the good. This potentially makes measurement more difficult since it requires understanding the relationship between production and pollution.

I’ve written about this issue before with regards to vaccines. I noted that are multiple ways to interpret vaccination in terms of the externality argument. One way to think about vaccines is that the vaccinated convey an external benefit on the rest of the population. The typical textbook would say that this implies that a vaccine should be subsidized. A different way of thinking about the issue would be to argue that the unvaccinated are imposing a cost on others. The typical textbook would say that this implies that the unvaccinated should be taxed. Nonetheless, I argued that taxing the unvaccinated would be incredibly costly:

Consider the costs of implementation. In order to get to the optimal level of vaccination, the taxation scheme requires taxing the unvaccinated in proportion to the social cost that they impose. The government cannot simply impose a surcharge on the tax bill of the unvaccinated. Doing so would tax the unvaccinated person who never leaves the house at the same rate as the unvaccinated person whose habits and behavior are largely unchanged after the appearance of the virus. This is not consistent with optimal policy.

One could attempt to put a tax on the in-person consumption of the unvaccinated, but this is also costly. Firms would have to check the vaccination status at cash registers. Furthermore, doing so would incentivize fraud for those unvaccinated people who view the cost of getting vaccinated as greater than the cost of getting a counterfeit vaccination record and the corresponding expected costs of punishment. It is also unclear how one would administer such a tax. A proportional tax on consumption isn’t necessarily accurate since the social cost created depends on how much interaction the consumer has had with other consumers, not how much the consumer spent. (The person who bought a big screen television likely spends less time in the store and comes into contact with fewer people than the person doing grocery shopping.) And that ignores the social and political costs that might be associated with alienating a particular group of people.

Thus, even if you are the type of person who might think this is the best political solution, the measurement and enforcement costs associated with trying to tax the unvaccinated renders this sort action economically infeasible. It is just too costly.

The Numbers Problem

Another problem that might arise in dealing with externalities is something that I have previously called “the numbers problem.” For a negative externality, this problem concerns the number of people who are imposing an external cost and the number of people who are victims of that cost. Is a tax always the best solution to a negative externality?

For example, when there is only one party who is an imposer and one party who is a victim, there is no reason to impose a tax. The two parties can potentially find a contractual solution to the problem.

On the other hand, if there are a large number of imposers and victims, each group could organize itself and negotiate a contractual solution. However, the organizational costs are likely to be prohibitive and therefore a contractual solution is unlikely to result. In that scenario, a tax makes sense.

The situation can get more complicated if there is only one party imposing the costs and a lot of victims. To understand why, consider an example from my previous post about a factory that exists upstream from a fishery:

. . . suppose that there is only one factory that pollutes the river. We will maintain the assumption of a large number of firms in the fishing industry. Furthermore, I will make two additional assumptions. The first assumption is that the marginal external cost imposed on the fishing industry is increasing in the production of the fishing industry. In other words, the more the fishing industry produces, the greater the harm imposed by the factory’s pollution at the margin. The second assumption that I will make is that fishing industry output is decreasing in the amount of factory output. Put differently, the more that the factory produces, the more pollution it creates. As a result, the fishing industry will produce less output as pollution rises. This could be because it is harder to fish in polluted waters or because there aren’t as many fish that survive in polluted waters or that the number of firms engaged in fishing declines as a result of the pollution.

Since there is one imposer and many victims, a contractual solution might still be prohibitive since the fishing industry still faces the same organizational costs and some of the same negotiation costs. Thus, one might be inclined to conclude that the optimal solution is a Pigouvian tax solution in which the externality imposer is taxed at a rate equal to the marginal external cost. However, as Ron Batchelder and Earl Thompson demonstrate, this is not the case. This reason is simple. Since (a) the marginal external cost is a function of the production of the fishing industry, and (b) the fishing industry produces less output when there are greater amounts of pollution, the factory could actually reduce its tax bill by polluting more! The reason is that when the factory increases production and therefore pollution, the fishing industry reduces its production. Since the marginal external cost is increasing in the production of the fishing industry, a decline in the production of the fishing industry produces a decline in the marginal external cost and therefore a decline in the tax imposed on the factory.

In this example, a tax actually provides a perverse incentive to the factory. By producing more, and polluting more, it can actually reduce its tax burden. In fact, the factory could conceivably commit to polluting so much that it drives the fishermen out of business. At that point, the optimal tax would be zero. But note that this perverse incentive only really applies when there is one factory (or a very small number capable of coordinating on this perverse incentive).

In this scenario, the best solution might be to have a zoning law that prevents factories from locating along the river. Alternatively, if the factory needs to be located by the river, a better solution would be to have a quantity restriction on the amount of pollution the factory is allowed to produce.

Coordination Costs

An issue that we have not discussed as much as others is the role that cooperation plays in dealing with externalities. The conventional textbook story is that since the external costs (or benefits) are not incorporated into the price, the participants in the market have no incentive to incorporate these external costs (or benefits) into their decisions. But is that really true?

Elinor Ostrom’s work suggests that people often find voluntary solutions to problems that impose third-party costs. Her work often focused on an idea known as the Tragedy of the Commons. Although this issue is somewhat distinct from the discussion of externalities, the issue with incentives is quite similar. For example, consider a forest that exists outside a small town. No one owns the property rights to the forest. The Tragedy of the Commons suggests that the forest will be exhausted by overuse since no one has the ability to exclude anyone else from the forest and every tree that gets cut down is one fewer tree available to others.

Yet, Ostrom showed that communal forests in Switzerland did not suffer from this problem. The villages near the communal forests created rules that dictated which trees could be cut down, when they could be cut down, and how people would be punished if they violated these rules.

Casey Mulligan’s recent work on externalities builds on this type of argument, pointing out that people have incentives to cooperate to solve externality problems. Because cooperation is costly, the use of cooperation might not get one to the socially optimal outcome. However, the use of cooperation is a clear improvement over the standard result in the absence of some policy solution. In fact, once one takes into account the role of cooperation, policy aimed at correcting an externality might be overkill.

A particularly interesting aspect of Mulligan’s work is in regards to things like pandemics. Most people tend to think of externalities associated with a pandemic in epidemiological terms. In other words, they tend think that when people go out in public or otherwise interact with other people and possibly have an infectious disease (knowingly or otherwise), those people are imposing a cost on others. As was observed during the Covid-19 pandemic, the overwhelming response to this external cost was to enact policies that limit human interaction in public settings. However, what Mulligan points out is that group cooperation often mitigates a number of these effects. Places like schools, hospitals, and workplaces have incentives to come up with ways to mitigate the spread of infectious diseases. What this suggests is that although there are negative externalities associated with human interaction when an infectious disease is present, cooperation enabled by human interaction is often aimed at mitigating those very costs. Thus, attempts to limit human interaction might be counterproductive.

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As I wrote at the beginning of the post, we tend to spend a lot of time writing about externalities. Hopefully, this post has given people a sense of why the topic of externalities is one that warrants deeper thought and discussion than the typical introductory textbook analysis.