The Misuse of Externality Arguments
If you own a steel mill and want workers to run it you have to offer them terms at least as attractive as their next best option. If you want coal and ore, you have to offer the miners at least what it costs them to get it out of the ground. The costs of producing steel are transferred from the people who produce your inputs to you by the payments you must offer to get them to do so. Similarly, the value of what you produce is transferred from your customers to you in what they pay you for your steel. If the value of what you produce is more than the cost, it pays you to produce it and you do. If value is less than cost it does not pay you to produce it and you donÕt. That is a short version—the long version requires a year of price theory and/or a good textbook—of why a market society produces things if and only if they are worth producing.
There is, however, a problem. In addition to consuming labor, ore, and coal and producing steel, you also produce sulfur dioxide, which makes things less pleasant for those who breath downwind of you. That is a cost of producing steel but, in a society without government regulation, tort law, or anything similar, it is a cost for other people, not you. So it may pay you to produce steel even if total cost, pollution included, is greater than total benefit. Similarly, if you produce external benefits for other people, such as the pleasure passers by will take in looking at your beautiful building, you will ignore those benefits in deciding whether to build it. Even if the total benefit is greater than the cost it may not pay you to.
Economists refer to such effects as externalities—negative (external costs) and positive (external benefits). Their existence is one of the arguments economists offer for government interventions in the market. Air pollution is a negative externality, so regulate or tax it. Knowledge produced by basic scientific research is a positive externality, so subsidize it. The argument is correct in theory. Externalities are one example of what I described in Chapter 52 as market failure, so a government that forces people to take account of them can, in principle, improve on the result of the unregulated market.
There is, however, a practical problem. In order to do the job properly, the government needs to know the sign and size of the externality. Without that information, they might provide the wrong tax or the wrong subsidy or even tax something they ought to subsidize or subsidize something they ought to tax.
Today the problem that all the experts insist must be solved
immediately if not sooner is global warming. Forty years ago it was population.
It was widely asserted that the more people there were on earth the worse off
we would all be. Quite a number of people went further, claiming that we were
facing immediate catastrophe. In The
Population Bomb, published in 1968, Paul Ehrlich wrote that ÒThe battle to feed all of
humanity is over. In the 1970s hundreds of millions of people will starve to
death in spite of any crash programs embarked upon now. At this late date
nothing can prevent a substantial increase in the world death rate... .Ó
While his position was more extreme than that of many others, his work was
taken seriously and less extreme versions were as widely accepted then as
concerns about global warming are now.
My first piece of published economics was a
pamphlet written for the Population Council at the request of its president. He
observed that almost all discussion of the issue was coming from one side of
the ideological spectrum and was sufficiently open minded to want to see how
the question looked from a different viewpoint, so asked me to write a piece on
population issues from a pro-market point of view.
The economic issue was one of externalities: If one
more child was born, were other people worse off as a result, and if so by how
much? My conclusion was that not only could I not tell how large the
externality was, I could not even tell whether it was on net negative or
positive. Nor, as best I could tell, could anyone else, although quite a lot of
people thought they could.
Increases in population have both positive and
negative effects. More people means more people to create pollution and commit crimes,
more people to go on welfare, but also more people to make inventions, pay
taxes, write books and compose music. The effects in both directions are large
and, since they are spread over a long and uncertain future, very hard to
estimate.
The simple argument for the conventional view, that
more people meant less land and natural resource for each, was simply bad
economics, at least in the context of a private property society. A new born
baby does not arrive with a deed to his per capita share of the worldÕs
resources clutched in his fist. If I want my child to own land on which to
live, either he and I will have to produce something of value that the present
owner of that land is willing to accept in exchange, in which case obtaining
land for him has not made the rest of the world worse off.
Some other arguments went in both directions. The
more children, the greater the cost of putting them through the public schools,
a cost not born directly by their parents. Children, however, grow up to be
taxpayers. Match up the cost of schooling each child with the taxes he will
later pay for schools and the two roughly cancel, making a net externality
close to zero.
Some externalities are clearly positive. More
people means less of the national debt for each to pay. Some are clearly negative. Overall, I
did not see how one could estimate the externalities, positive and negative,
accurately enough to sign the sum.
Many years later, I encountered the same problem in
the context of global warming. Most of the public argument was about whether
global temperature was going up, whether the reason was carbon dioxide produced
by human activity, and how large future warming was likely to be. Practically
everyone took it for granted that warming was a bad thing, probably a very bad
thing.
I could not and can not see why. The current
climate was not designed for us, nor we for it, global climate having varied
quite a lot over the history of our species. Humans presently live and prosper
across a range of climates much larger than the predicted change. The only a
priori reason I could see to expect change to be bad was that we are
currently optimized to our current environment. That might be a serious problem
for rapid change. But the global warming being projected was at a rate of about
a third of degree centigrade per
decade. That should be more than slow enough to let farmers adjust their crops,
home owners their housing, to the change at little cost.
If we cannot produce an a priori reason to
expect warming to produce net negative externalities, perhaps we can work out
the consequences and simply add up their cost. Warming can be expected to raise
sea levels a foot or two by the end of the century. Looking at the other side
of the equation, human habitability at present is limited by cold not by heat; the
equator is populated, the poles are not. An increase in global temperature that
raised sea levels by a foot or two would push temperature contours in the
northern hemisphere hundreds of miles further north, increasing the area of
earth warm enough for human habitation by about a thousand times the area lost
to sea level rise. On average, the land gained would be less valuable per
square mile than the land lost, but would one expect it to be a thousand times
less valuable?
Warming will have other effects negative and
positive. Since we are talking about effects over a period of a century or
more—William Nordhaus, an economist who has specialized in studying the
warming issue, runs one of his calculations out for two hundred and fifty
years—it is impossible to make any reliable estimate of their size.
Readers interested in a longer discussion of my reasons for thinking that the
net effects are at least as likely to be positive as negative will find it on
my blog.[1] My
point here is a more general one—an explanation of why the attempt to
base policy on estimates of external costs and benefits led to mistaken
conclusions about population fifty years ago and very dubious conclusions about
global warming today.
Consider someone adding up externalities in order
to decide what policy should be, whether government should encourage or
discourage population growth, tax carbon or subsidize it. If he starts out believing
that the net effect of warming is negative he is likely to make generous
estimates of the negative externalities, conservative estimates of the
positive, and miss some of the latter because he is not looking very hard for
them. He ends up honestly convinced that the objective evidence supports the
position he started with. If he starts with the opposite belief his
calculations will have the opposite bias and he will reach the opposite result.
A few years ago, I came across a striking example
of this pattern in the work of William Nordhaus. His research on the effects of
global warming found negative externalities sufficient to justify imposing a
carbon tax to slow it, although both the externalities he found and the
measures he proposed were modest compared to the views of some other
researchers, still more so compared to the views of activists such as al Gore.
In order to get even that modest result it was necessary to
include in his estimate of costs not only predictable effects such as sea level
rise but also possible but unlikely consequences of warming that, if they did
occur, would impose large costs. In a book coauthored with Joseph Boyer, the
authors wrote that Òthis approach is taken because of the finding of the
first-generation studies that the impacts on market sectors are likely to be
relatively limited." [2] Or in
other words, without including the costs from unlikely but catastrophic risks,
global warming did not seem to be a serious problem.
There is a curious asymmetry to
their approach. They took account of low probability high cost consequences of permitting global warming. But, so far
as I could tell, they made no similar attempt to take account of low
probability, high cost consequences of preventing
global warming. That might make sense if we could be reasonably confident that,
absent the effects of human action, climate would never change. But we have no
grounds for such confidence, since climate has been changing, sometimes quite
radically, since long before human beings were able to influence it.
We are currently in an
interglacial, a relatively warm period within an ice age that began more than
two million years ago. We do not know what causes interglacials to
start—or end. Long term estimates of global temperature suggest that it
has been trending slowly down for a very long time, possibly since the
beginning of the current interglacial, a trend reversed by current warming. It
is at least possible that global warming is all that is preventing the
interglacial from ending. The result, judging by past glaciations, would be a
drop in sea level of more than three hundred feet, leaving every port in the
world high and dry. Also half a mile or so of ice over the present locations of
London and Chicago.
I do not think the prevention of global warming
would be likely to set off that particular catastrophe. It is, however,
possible, and there may be other unlikely but possible catastrophes that have
not occurred to me. Nordhaus, looking for negative effects of global warming,
included the unlikely ones. He did not, so far as I can tell from that book, a
later one,[3] or
correspondence with him—when writing this chapter I wanted to make sure
that I had not misread his work—include any estimate of unlikely effects
in the other direction.
Which I take as evidence of the problem of using externality arguments to produce policy conclusions. When balancing costs and benefits, it is only too easy to put an unconscious thumb on the scale.
[1] The blog is http://daviddfriedman.blogspot.com. To search it for my posts on global warming, use the URL: http://daviddfriedman.blogspot.com/search?q=global+warming
[2] Roll the DICE again: Economic Models of Global Warming by Willaim D. Nordhaus and Joseph Boyer, at http://www.econ.yale.edu/~nordhaus/homepage/web%20pref%20102599.PDF
[3] A Question of Balance by William D. Nordhaus, at:
http://www.econ.yale.edu/~nordhaus/homepage/Balance_2nd_proofs.pdf