A Fallacy about Negative Externalities
An argument that is often used to support government intervention relies on “negative externalities.” People’s behavior, it is claimed, sometimes generates avoidable costs for others in this way: you do something in order to gain an advantage over someone else. But that person may try to do the same thing to you. Even if he doesn’t, he will at least take measures to counter what you did to him. Your attempt to gain an advantage thus fails, and you would both be better off if you were put back at your starting point.
An example will clarify this. Suppose you are watching a football game. You stand up to get a better view of the action. If everybody else stayed seated, you would in fact get a better view of the action. But they won’t. If enough people stand up, this will block everybody else’s view. The rest of the people will also rise so that they can still see. The result will be that you don’t get a better view, and you and the others are worse off than before you got up, because you are now standing rather than sitting.
How does the government get into this? People can usually handle the football case by themselves. If after a few plays they see that standing up doesn’t help them get a better view, a norm of behavior will develop for them to stay seated. But, it is claimed, many cases where people get into such self-frustrating situations can’t be handled by voluntary restraint. An external force, the government, needs to restrain people for their own good.
I’d like to elaborate on this line of thought, and what I think is wrong with it, by discussing Robert Frank’s account of it in his influential book Luxury Fever (The Free Press, 1999). Frank thinks that people spend too much on luxury goods that don’t make them happy and that the government can make us all better off by imposing high consumption taxes on this spending. The key to Frank’s argument is that everyone is made better off by the high taxes, and this will be the point at which I challenge him.
Frank sets the stage for his argument by belaboring the obvious point that the rich have extravagant tastes. The Calibre ’89 Patek Philippe wristwatch sold for a minimum of $2.7 million. For the less financially secure, bargain Patek Philippes can be had for $17,500. In Beverly Hills, California, seventeen mansions with more than ten thousand square feet of living space were sold in 1997 Yachts can cost over $1.5 million per year to maintain. And so on and so on. The book came out twenty years ago. From his point of view, luxury spending has gotten worse since then.
Why is luxury spending a problem? If rich people spend their money in a way that Frank considers wasteful, isn’t that their business? Frank answers that the luxury spenders are making a mistake. They think that buying these items will make them happier, but after an initial thrill their level of satisfaction will go back to its previous level.
The assured results of modern psychology, he says, tell us this. "What the psychologists call subjective well-being is a real phenomenon. The various empirical measures of it have high consistency, reliability, and validity." These measures bring bad news for luxury spenders. "One of the central findings in the large scientific literature on subjective well-being is that once income levels surpass a minimal absolute threshold, average satisfaction levels within a given country tend to be highly stable over time, even in the face of significant economic growth."
This appears paradoxical but in fact is not. How can it be that if you get the goods you want, you do not continue to feel subjectively better? The answer, Frank thinks, lies in the fact that people quickly adjust to a higher standard of living. If you sell your three thousand–square foot home and purchase one twice as large, you may at first feel elated. Soon, though, you will treat the new conditions as normal, and the extra space will give you no special thrill. You will have gone to a good deal of trouble and expense to wind up about as happy as you already were.
Frank has resolved his paradox only to raise another in its stead. If the pursuit of material wealth beyond a certain point does not lead to greater happiness, why do people continue to seek more and better things? If "the more we have, the more we seem to feel we need," won’t at least some people after a while realize that the quest for more leads nowhere? If so, won’t they rest content with what they have?
A further fact explains our getting and spending, Frank points out. People become happier by improvements from their position in the recent past. To an even greater extent, they dread a reduction in their standard of living. "The economist Richard Thaler coined the term loss aversion to describe this tendency. Loss aversion means not just that the pain of losing, say, $1,000, is larger, for most of us, than the pleasure of winning that same amount. It means that it is much larger." People don’t want to weaken their positions compared to others who increase their luxury spending.
Once more, Frank has resolved a difficulty only to confront an even more formidable obstacle. If he is right, he has explained luxury spending: people wish to beat out others in the battle for prestige and power. They may find, once they have gotten their Patek Philippe watches, that these items produce no long-lasting pleasure. Nevertheless, the struggle counts more than the arrival, and people always act to increase their happiness.
But here precisely is the problem for him: there appears to be no issue that requires government action. If people did not have rivalrous impulses, maybe they would find it much easier to be happy. But it would be futile for Frank to suggest a program to extinguish these desires, since he holds that evolution has implanted them firmly within us. What, then, can an interventionist like Frank do?
Here is where the negative externalities argument enters the scene. Like me, Frank gives a football example, but in his example the problem is more severe than people’s inability to get a better view by standing up. Among offensive linemen in professional football, it is an advantage to weigh more than your rivals. “Other things being equal, the job will always go to the larger and stronger of two rivals. Because size and strength…can be enhanced by the consumption of anabolic steroids, individual players confront compelling incentives to consume these drugs. Yet if all players take steroids, the rank ordering by size and strength–and hence the question of who lands the jobs—will be largely unaffected." Given the danger of steroids, wouldn’t players all be better off if the drugs were banned? In fact, they are now banned.
Frank generalizes the point of his example: a progressive tax on consumption will cut out much of the wasteful spending that rivalrous luxury spending involves. Once more, the spending is wasteful not just because he disapproves of it, but because people engage in it only to forestall their rivals.
I don’t think that Frank’s ingenious analysis gives us a good reason to institute the consumption tax he favors. He has made without evidence a crucial and questionable assumption. Let us return to his football example. He assumes that the rank order of players remains the same whether or not they take steroids. Resources devoted to steroids are then a deadweight loss.
But why assume this? We have no grounds to assume that the ban leaves everything besides access to the dangerous drug as it otherwise was. Maybe, if people were free to take the steroids, some would gain more weight and get stronger than others. They would still be at an advantage even when the other players took the drugs. And some players would give up the battle after the dosages increased, leaving those willing to take more risks at an advantage.
You might object that I’m missing something essential. Even if some players did get an advantage from steroids, isn’t it still better for them to maintain their health unimpaired? Aren’t they risking too much? If you say this, though, you are not going where Frank wants to go. You have a different value judgment from that of the players, and Frank doesn’t want to rely on that. He wants an argument that shows that everybody is better off from his own point of view.
Like Frank, we may generalize our conclusion. Frank has not shown that a consumption tax will affect all rivals equally. Absent this showing, he has failed to show that rivalrous consumption generates pure waste. His argument collapses.