Pricing externalities is not necessarily economically efficient

by Orborde1 min read9th Nov 20199 comments


[A]s long as externalities exist and are not internalized via Pigouvian taxes, the result is inefficient. The inefficiency is eliminated by charging the polluter an emission fee equal to the damage done by his pollution. In some real world cases it may be difficult to measure the amount of the damage, but, provided that that problem can be solved, using Pigouvian taxes to internalize externalities produces the efficient outcome.

That analysis was accepted by virtually the entire economics profession prior to Coase's work in the field. It is wrong—not in one way but in three. The existence of externalities does not necessarily lead to an inefficient result. Pigouvian taxes, even if they can be correctly calculated, do not in general lead to the efficient result. Third, and most important, the problem is not really externalities at all—it is transaction costs.
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Suppose that, in a particular case, the pollution does $100,000 a year worth of damage and can be eliminated at a cost of only $80,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land down wind to a new use unaffected by the pollution—growing timber instead of renting out summer resorts, say—is only $50,000. If we impose an emission fee of a hundred thousand dollars a year, the steel mill stops polluting and the damage is eliminated—at a cost of $80,000. If we impose no emission fee the mill keeps polluting, the owners of the land stop advertising for tenants and plant trees instead, and the problem is again solved—at a cost of $50,000. In this case the result without Pigouvian taxes is efficient—the problem is eliminated at the lowest possible cost—and the result with Pigouvian taxes in inefficient.

This seems to be the only part of the article that argues for what the title says, "Pricing externalities is not necessarily economically efficient", however it assumes that the Pigouvian tax is set to $100,000 instead of the opportunity cost of the pollution (in this case $50,000) which would be more natural for anyone with an understanding that "cost" ought to mean "opportunity cost" in most situations when thinking about economics. So I think the title is misleading.

Also I think Coase’s choice of terminology "transaction costs" tends to give people the wrong impression about what's preventing markets from solving externalities, because it seems to suggest that the costs involved in physically doing a transaction is the main problem and if markets could be made more frictionless they would automatically solve externalities. In actuality "transaction costs" includes loses from inefficient bargaining (i.e., lost opportunities for mutually beneficial deals) caused by asymmetric information, which (until we invent mind readers or lie detector) is an inevitable part of how voluntary transactions work in general, so this limits how much the problem of externalities can be solved via voluntary transactions in a fundamental way.

One might ask why asymmetric information isn't an issue in regular markets, and the answer is that it is (it's responsible for deadweight loss of a monopoly for example), but the problem is much less serious in competitive markets where having private information about (for example) the cost of making something isn't very relevant because if you set your price above that, someone else will underbid you anyway.

Another question one could ask is why isn't asymmetric information a problem for policy makers setting a Pigouvian tax? The answer there is that the policy maker only needs to estimate the total cost (or benefit) of an externality, whereas the market / voluntary transactions approach (to be efficient) requires that the true cost/benefit for each individual affected person to be revealed (which can't happen because that's not incentive compatible). See my "government funding of information goods based on measured value" for a concrete example of this difference.

it assumes that the Pigouvian tax is set to $100,000 instead of the opportunity cost of the pollution (in this case $50,000)

How are you calculating "opportunity cost"? Is it simply the land use conversion cost ($50,000)?

I think subsuming several dimensions of coordination failure under transaction costs is the same mistake the externalities people were making.

What a wonderful page to come across -- I had misunderstood this for a decade.

An interesting implication, taking the high-level proposition at face value, is that one would expect to see a lot of behavior (more than one might naively expect) with negative externalities whose costs fall under the threshold of the transaction costs which would be required to compensate those affected.

The statement says “if transaction costs are zero, the market produces the efficient outcome”, but what is most interesting is the equivalent contrapositive “if the market didn’t produce the efficient outcome, it was because of transaction costs”.

I would add that the problem is not only transaction costs but also irrationality. You will not get the efficient outcome if the transaction costs are sufficiently low but the agents are not rational enough to think of the transaction or to consent to it. Also, some transaction costs can be worked around, so the problem is irreducible transaction costs and irrationality.

I would also add that I think the conclusion applies to other coordination problems, market failures, and games in general, not just externalities. Many aggregation mechanisms can always produce the efficient outcome in most or all such problems if transaction costs are low enough and the agents rational enough. The market mechanism is not the only one; if you allow all agents to self-modify and prove to other agents that they did so, that should also be able to solve these problems if transaction costs are low and agents rational enough.

But no mechanism will always be able to produce an efficient outcome even with high transaction costs or bounded rationality. For example, I think we can conceive of games in which producing an efficient outcome requires logical omniscience and a halting oracle (we might design a game in which producing an efficient outcome requires knowing the googolplexth Mersenne prime). Such a game might be solved by the market mechanism only if the agents were as rational as AIXIs.

Coase basically applied the insight that value is not the same as price, and there's no way to set a price that satisfies all the stakeholders. It's an idea that needs to be more central to thinking about human interaction.

Here's a category-theoretic perspective. (Check out the rest of the lectures and the associated free textbook.)

Posting because the title of this linkpost was a big surprise for me.