Free Market

What is an Externality?

The Free Market

The Free Market 19, no. 8 (August 2001)


British economist A.C. Pigou was instrumental in developing the theory of externalities. The theory examines cases where some of the costs or benefits of activities “spill over” onto third parties. When it is a cost that is imposed on third parties, it is called a negative externality. When third parties benefit from an activity in which they are not directly involved, the benefit is called a positive externality. The study of such situations, a part of welfare economics, has been an active area of research since Pigou’s efforts early in the twentieth century.

There are standard examples given to illustrate both types of externalities. Pollution is a typical case of negative externality. Let’s say I operate a factory along a river, making foozle dolls. As a byproduct of my manufacturing, I dump lots of foozle waste into the river. This is a terrible cost to people downriver because, as everyone knows, foozle waste stinks to high heaven.

If neither my customers nor I have to pay this cost, our choice as to how many foozle dolls to produce will be, in a sense, incorrect. If we had to pay these costs, we would have chosen a smaller number of dolls. Instead, we chose to produce “too many” dolls, while the people downriver are forced to foot the bill for part of our activity.

Pigou recommended taxing activities that produce negative externalities. Emission taxes on factories are an example of this approach. Another common policy adopted has been to regulate the amount of the activity legally permitted. Laws that forbid loud parties after a particular time of night illustrate this solution.

A positive externality will arise when some of the benefits of an activity are reaped by those not directly involved. A typical example would be improving the appearance of one’s property. If I paint my house, not only do I benefit, but so do all of my neighbors, who now have a nicer view. When such a positive externality exists, it can be contended that I will produce “too little” of the activity in question, since I don’t take into account the benefits to my neighbors.

The traditional policy responses to positive externalities have been for the state to subsidize or require the activities in question. For example, the US government subsidizes research into alternate energy sources. Primary education, often said to have positive externalities such as producing “informed citizens,” is mandatory (as well as subsidized) in most countries.

Lionel Robbins challenged Pigou’s analysis in the 1930s. Robbins pointed out that, as utility is not measurable, it is invalid to compare levels of utility between different people, as Pigou’s analysis required. Robbins recommended using the criterion of Pareto optimality as the basis of welfare economics. A policy has to make at least one person better off and none worse off before economists can say it is unambiguously better. But Robbins held that if we just assume people have an equal capacity for satisfaction, then economists still can recommend certain state interventions.

The notion of justifying economic intervention on the basis of welfare analysis was dealt a severe blow in 1956, with the publication of Murray Rothbard’s paper, “Toward a Reconstruction of Utility and Welfare Economics.”

Rothbard pointed out that it is only through preference demonstrated in action that we can gauge what actors really value, and that to try to deduce values from mathematical formulas, without the evidence of action, is a hopeless cause. When people demonstrate their preferences by exchanging we can say that both parties felt that they would be better off trading goods than not. Since Pigou’s solution involves imposing taxes and subsidies by fiat, without voluntary exchange, the numbers arrived at are mere guesswork.

Nobel Prize-winner Ronald Coase further undermined interventionist welfare analysis with the publication of his paper, “The Problem of Social Cost,” in 1960. Coase demonstrated that as long as property rights are clearly defined and transaction costs are low, the individuals involved in these situations can always negotiate a solution that internalizes any externality.

Consider the case of river pollution from the foozle factory. If the people downriver from the factory have a property right in the river, the factory will have to negotiate with them in order to legally discharge waste through their property. We can’t say what solution the participants might arrive at-the factory might shut down, the people downriver might be paid to move, or the factory might install pollution control devices or simply compensate those affected for suffering the pollution. What we can say is that, within a system of voluntary exchange, each party has demonstrated that it prefers the solution arrived at to the situation that existed before their negotiations.

Furthermore, we should note that negotiating between the parties affected allows them to use the “particular circumstances of time and place,” with which they alone are familiar, to arrive at a solution. The factory owner may be aware of an alternate foozle material that does not pollute the river, or the people downriver might know that the river is stinky anyway and that it’s best to move. Regulators generally cannot take such specific knowledge into account in their drafting of edicts.

Case studies have illustrated the resourcefulness of voluntary exchange in accounting for potential externalities. An oft-used example of a positive externality in economics is in the production of fruit trees and beekeeping. The growers of fruit trees provide a benefit to beekeepers: flowers. And beekeepers provide a benefit to the growers: pollination.

The standard analysis, however, contended that neither party had an incentive to take account of the benefit to the other. Thus, there would be “too few” orchards and beekeepers. Economist Steven Cheung has studied these markets, however, and has found that the parties involved had accounted for the externalities quite well, contracting with each other to raise production to optimal levels.

Social pressure also plays a role in handling potential externalities. If I don’t paint my house, my neighbors will start to grouse. I may not get invited to the next block party. Hayek contends that those who value liberty should prefer social pressure against “deviant” behavior to outright bans. (”Deviant,” in this case, meaning simply behavior of which many people disapprove but which does not violate their right to life or property.) If I highly value having a house painted mauve, I can ignore my neighbors’ mocking glances and jeers. But if the government regulates house colors, I’m stuck.

Walter Block, now at Loyola University, has continued work on externalities in the tradition of Rothbard. Block has challenged the traditional distinction between public goods, which must be produced collectively because of the positive externalities they create, and private goods, the production of which may be left to the market. The proposed list of public goods often has included such items as postal delivery, roads, schools, garbage pickup, parks, airports, libraries, museums, and so on-just think of the activities your city undertakes. The consensus has run that unless such goods are provided through government action, people will attempt to become free riders, enjoying some of the benefits of such goods while letting other people pay for them.

Block points out that this sort of analysis is flawed in that almost any good could be said to provide some benefits or costs to third parties. What about socks? Doesn’t the fact that other people wear socks, and I don’t have to smell sweaty feet all day, provide me with a benefit for which I’m not paying? Must socks, therefore, be considered a public good?

The free market is not a panacea. It does not eliminate old age, and it won’t guarantee you a date for Saturday night. Private enterprise is fully capable of awful screwups. Both theory and practice indicate that its screwups are less pervasive and more easily corrected than those of government enterprises.


Gene Callahan works in the securities industry and writes frequently for He is also author of Economics for Real People: An Introduction to the Austrian School, forthcoming from the Mises Institute (2001).


Callahan, Gene. “What is an Externality?” The Free Market 19, no. 8 (August 2001).

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