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Accounting for the Unaccountable: The Case of Externalities

Mises Daily: Thursday, March 10, 2011 by

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Some theorists claim that externalities are probably the most legitimate reason for state intervention in human interactions. The ethical case for intervention is that it can presumably increase overall economic efficiency. This article demonstrates that, even if one accepts this ethical principle, the usual choice of externality-generating actions that are believed to justify state intervention is purely arbitrary.

In fact, according to the definition of actions with external effects, any human action in a multi-individual society would qualify for regulation under the banner of improving economic efficiency (i.e., internalizing externalities). However, the nature of human existence renders this internalization impossible. Thus, we end up with a paradoxical situation where every action inevitably fails the ethical criterion we have put in front of ourselves.

What Are Externalities?

There are varying definitions of externalities, but probably the most common definition is that externalities are beneficial or harmful effects of one's action on others that were not taken into account in the decision to act. For example, one of the common examples used is industrial emissions of gases into the atmosphere. It is said that the factory owner(s) or manager(s) would not take into account the harmful effect of the emitted gases on other members of the society. Consequently, the factories would produce more industrial output than they would have produced had they taken into consideration the negative effects of their actions on others. This would be a negative externality.

However, there are also positive externalities, where one unintentionally produces benefits to others.[1] A frequently used example is education. In this case, too little of the beneficial activity (education) is being performed if left to individuals' voluntary transactions. As a result, both in the cases of negative and positive externalities, "inefficiencies" arise. It is claimed that the total social welfare could be increased by adjusting the amount of the externality-creating activities to their socially optimal levels.

Government intervention is commonly believed to be the correcting mechanism. In the cases where too much of an action is being performed, the government should coercively limit the externality-creating action (regulations, taxesDownload PDF, penalties, quotas, etc.) Alternatively, actions that result in positive externalities should be encouraged using the means available to the government (i.e., subsidies).[2]

These government interventions are supposed to move the economy to the output mix as close as possible to the mix supposedly predicated by the model of perfect competition. In this sense, the model of perfect competition is adopted as a measuring stick for determining the ethical validity of individual action. According to this principle, one ought not act without taking into account the effect of his or her actions on all other individuals within the economy.

The Limits of Externalities

The first question one might ask is how many externality-creating actions there are. One could then start forming a list of the currently official external effects and quickly notice that this list has been expanding over time. One of the most recent additions to the list is the provision of environmental goods and services.

One might then naturally ask where the limit to this expansion is.[3] I will use the basic truth that human knowledge of the relationship between one's own actions and other people's well-being is always incomplete to show that there is actually no limit to expanding the list of actions that create unaccounted external effects in societies (so long as they are composed of more than one individual). The following thought experiment illustrates why this is the case.

Think about all the things you did today. You got up at a certain point in time. You probably had a shower and brushed your teeth. Maybe you ate a nutritious breakfast or perhaps you skipped the breakfast altogether. Maybe you were polite to the people around you but it is also possible that some of you weren't. You might have driven carefully to your work but perhaps some of you weren't particularly attentive while driving. Maybe you went to the gym on your break.

Perhaps, if you got up 15 minutes later, you would have contributed to congestion resulting in some people being late for work. You might have even contributed to an increased number of accidents (without actually being involved in one). The people that were spared from congestion or an accident because you got up 15 minutes earlier benefited from your actions. However, if you did not evaluate these benefits when deciding when to get up, your getting up at a certain point in time constitutes an externality-creating activity.

Having a nutritious breakfast might have contributed to your good mood, which benefits everyone who comes in contact with you. Maybe this effect carries through to the people that come into contact with the people with whom you previously interacted. Maybe you even saved or prolonged some people's lives by creating a chain of events originating from the point of your having a healthy breakfast.

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But what if these same actions saved a life of a woman who gave birth to a serial killer or a genius inventor or a great artist? The possibilities are endless. In any case, you have not taken all these potential effects into account when deciding whether to have breakfast or not. Indeed, it would be a special kind of mental torture to engage in such an accounting procedure every time one makes a decision.

Similarly, if you were kind to the people around you, you might have taken into account the effect that this action has on your own well-being, but if you have not considered the effect of your actions on the well-being of all other members of the society, you have just created a positive externality. On the other hand, maybe you don't care about treating other people kindly and you are rude to everyone you meet. In this case, you impose a negative externality. People are being harmed by your behavior without your having to experience any of the "cost" of your action. If these people were somehow able to make you feel their pain, you might have reduced the extent of your rudeness.

Oh, by the way, how do you look? Do people like your physical appearance? Maybe they are pleased when they see you clean, fit, and slim or with tasteful makeup. But some people might enjoy seeing you in a more natural light, in your everyday looks. There might even be people who find your physical appearance unpleasant in either form.

While you may be working on your appearance to achieve personal benefits in interactions with the people in your immediate surroundings, there may be many people who enjoy your appearance that you never considered when making your decisions. There also may be people who dislike your neat looks. Maybe they envy you and it is painful for them to look at your athletic figure. On the other hand, if you belong to those that don't maintain their personal hygiene, or if you don't have an athletic figure, some people might dislike seeing you in public.

Either way, you are creating external effects on other people by the way you present yourself to them. Some people can enjoy the beneficial effects of looking at you while others might have to face some harmful effects. These effects are external because you have not taken the experiences of all other people into account when making the decision to present yourself in public.

We could continue this list indefinitely only to realize that in order to properly determine the effect of each of our actions on others, we would need to be able to observe a parallel world in which we have taken an alternative action and compare the two outcomes. Then we would need to repeat this "exercise" for all the possible courses of action we can come up with until we find the course of action that we value the most, given its effects on every member of the society. We would need to do this every conscious moment of our lives because we constantly act.

In fact, this is not enough. The second condition for our internalization of externalities through action is that we would need to have insight into everyone's evaluation of different alternative outcomes of our action in order to put our own value judgment on each person's well-being. This is why you will never know the actual effect of your getting up at 6:15 as opposed to 6:30 this morning.[4]

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Thus, anything we do affects many people in many different ways. For most of these interactions we have no means of determining the nature of our effect on others. Even if we had every intention of doing so, it is inevitable that we would not be able to take into account the effect of our actions on other individuals in the society. In other words, anything we do inevitably produces external effects.

Consequently, we tend to focus only on actions for which it is relatively straightforward to identify the most immediate potential cause-and-effect relationships while ignoring all other relationships. For example, if the immigration officials did not allow Nikola Tesla, the inventor of the alternate current (AC) generator, to enter the United States in 1884, we would have never known that this action would have prevented Tesla from building the first AC generating plant in Niagara Falls, New York. The immigration restriction would not have been qualified as an action that could potentially prevent the electrification of the world at the time. Instead, this would have been recorded as one less immigrant on US soil.

The reason we focus on more repetitive and seemingly more "predictable" actions is that these actions allow us to observe some regularity and pattern. Examples of such actions are emissions of gases into the atmosphere, disposal of solids or liquids into water bodies, generation of air vibrations, production of a pleasant panorama (e.g., farm sights), building of human capital (e.g., education).

But there is no objective reason to stop here. The same principle could be applied to other repetitive actions like keeping personal hygiene, being polite (or rude) to others, being a hard worker (or lazy), getting up and going to bed at a particular point in time, being a loving (or incompetent) father, husband, mother, or wife. The list could go on forever.

Thus, according to the definition of externalities, anything we do would qualify for regulation by the state. But a more careful investigation reveals why this would be a superficial conclusion.

The state is not some magical force that acts according to laws different from the laws of human action. The state apparatus is composed of human beings and thus is subject to the same logic as any other group of individuals. Consequently, like any action, the actions of government officials inevitably result in unaccounted-for external effects.

Like any human being, they too are incapabale of identifying the causal relationships between their actions and the well-being of most individuals in society. Thus, even if we assumed that internalization of externalities is the ultimate normative principle, relying on a group of individuals to implement this principle does not make much sense.

Conclusion

Finally, we must conclude that externalities are a consequence of the laws of nature, not some anomaly in a model of perfect competition. This does not, however, mean that one should not care about how his or her actions affect others.

What it simply means is that if we are to be honest about the nature of external effects of human action, we need to admit that internalization of externalities, as an offshoot of the utilitarian theory of rights, is a poor choice for an ethical standard simply because no action can ever meet this standard. Thus, there are good reasons for assessing other methods of evaluating human action.

Notes

[1] Note that the effects of one's actions are always evaluated relative to an alternative outcome. Consequently, avoiding an action that results in negative externalities would constitute an action that produces positive externalities.

[2] This article uses examples of Canadian policies intended to internalize externalities. Comparable policies exist in many other jurisdictions, like the United States, the EU, and New Zealand.

[3] Walter Block noted that this limit might be quite wide by pointing out that even wearing socks produces positive externalities in the form of sparing others from smelling one's feet.

[4] Even if one possessed these two supernatural abilities and were able to identify all possible states of the world originating from his or her actions and had insight into the evaluation of each state by each individual within the society, there is a third obstacle. There is no objective way to use individual valuations to come up with a uniquely preferred state of the world. In other words, even if you knew everything there is to know about the effect of your actions on other people, there is no reason why the action you chose would be preferred by all involved parties. See Kenneth J. Arrow, "A Difficulty in the Concept of Social Welfare," The Journal of Political Economy, Vol. 58, No. 4. (Aug., 1950), pp. 328–346.