One argument frequently made against the free-market is that
there are many economic externalities, both positive and negative, that are not
taken into account in the market price, thus resulting in a ‘sub-optimal’
working of the price mechanism and the production structure. This post will explore the externalities issue and see what implications, if any, for economic policy could follow from it.
A negative
externality is when an activity of one actor negatively affects another,
without the first actor having to pay the second for the cost of his action.
The most commonly cited example of a serious negative externality is that of
air pollution. Factory owners produce products for sale and while doing so,
their factories tend to spew out pollution. This pollution results in a lowered
air quality of the area and, possibly, in an unbalancing of the earth’s
climate, costs that others feel but which the polluters don’t have to pay.
As with many
other negative externalities though, the answer to ‘internalizing’ the external
cost is simply a more complete enforcement of property rights. If the courts
recognized land owners’ property rights in the quality of the air in their
land, than these people who were negatively affected by the pollution would
have an enforceable right to make the polluters pay for that cost, either by
coming to a monetary arrangement for pollution rights or by forcing them to
stop the excessive pollution (minor, undetectable pollution could not really be
proved as harmful and hence would probably not constitute an invasion).
Possible effects of pollution on climate change are a bit trickier, but the
principle is the same: pollution is a violation of property rights, in this
case the property right in a climate not substantially changed for the worse by
the actions of other humans. In this case, after a court case proved damages (in this case, proved that climate change was a clear and present danger that would cause a certain amount of damage to the property of others), some kind of governmental-type body may have to step in and impose a carbon
cap-and-trade system over the area or something. But, this is an exceptional
case due to its dispersed and indirect effects. In most cases, a simple
recognition of property rights would be enough to internalize most negative
externalities. Instead of this, vast governmental regulatory apparatuses are often substituted
for a proper recognition of property rights, to the detriment of the people who
are actually affected by the externality and for people living in society at large.
A positive
externality has a different character than a negative externality. It is when
an actual, or possible, activity of one actor positively affects another,
without the second actor having to contribute to the costs of the activity of
the first. A simple example would be if one person planted an attractive flower
garden on their property that their neighbour liked very much. Planting the
flower garden certainly benefited the first actor (for pure personal enjoyment
and/or to raise the capital value of the property), or else he would not have
done it. But the second actor also benefits, making him a ‘free-rider’ on the
actions of the first. In this case, one might think: where’s the problem? The
first actor clearly benefited from the action, and the fact that the second
actor also did is just an added bonus for the world. This assessment is correct
when we are analyzing an action with a positive externality that has already
been done, but it becomes more complicated when we are talking about potential
actions and incentives. The contention of positive externalities theorists is
that because the benefit received by the second actor does not enter into the
calculation of the first actor, either monetarily or psychically, the provision
of the good in question, in this case the planting of attractive flower
gardens, will be ‘sub-optimal’. The goal of the free-market economy is to
satisfy the demands of the consumers, but if some of these demands take the
form of positive externalities, they will not enter into the calculation of
producers and the consumers will not be as satisfied as they could be.
One serious
example of positive externalities, not often cited by the literature dealing
with this subject, is capital accumulation. Accumulating capital goods, or
goods intended for future production rather than immediate consumption, out of
savings, is the engine of economic growth and benefits almost every market
participant. The person actually doing the savings does receive interest, based
on the current state of the time market, for his trouble, but there are a great
many other benefits as well. As capital becomes more abundant, labour becomes
relatively more scarce and, equipped with the more productive tools that
capital accumulation brings about, becomes more productive. Hence, labour
becomes relatively more valuable, and wage rates, as well as the general
productivity of the economic system, rise. The saver accumulates additional
savings because of his relatively low, compared to the rest of society, time
preference, or preference for present goods over future goods. He has a longer
term view and hence does not mind not consuming his income immediately, instead
letting it grow through investing it and receiving interest payments. But, in
this calculation, the saver is not considering all of the tremendous benefits
that capital accumulation has for the rest of the market society. For him,
these are external benefits, and humanity is very lucky that humans have not
been spendthrift profligates since the beginning, or else we would still be
living as hunter-gatherers in caves.
Another
example is technological innovation. Without governmental interference or IP
laws, the innovator of a new technology earns for himself both fame and a
first-mover advantage, meaning that he can be the first one to market his new
technology. However, the advantages of technology are significantly wider than
this. Soon, other market participants will copy the new technology, thus benefiting from the first’s discovery. With competition, the new technology
will become more widely available to the general public, as was the case in the
computing market. Thus, it is posited that without government encouragement,
whether through subsidies or IP laws (granting of a temporary monopoly),
particularly in the case of technologies requiring large up-front investments
to develop, the fame and first-mover advantages of the innovator will not
always be enough to outweigh the costs, and certain technologies that would
really be of great benefit to all market participants will simply not be produced.
Thus, in the
important cases of capital accumulation and technological innovation, it would
seem that the government could have a role to play in encouraging these
activities, which the market allegedly will not do sufficiently due to the
existence of positive externalities. But there are serious problems with this
solution. How do we know if there really are positive externalities, and if
there are, how do we know their magnitudes? The free-market works on the basis
of demonstrated preference, the various market participants making innumerable
choices between a and b and making exchanges based on these choices generates
the array of market prices on which the entire capitalist production structure
rests. But what characterizes a positive externality is precisely that it is
not based on demonstrated preference. If, for instance, the government takes 1%
of everyone’s income in taxation in order to fund the research and development
of a commercially viable jet-pack how do we know that every market participant
really wanted to pay 1% of their income to advance the future possibility of
having a jet-pack? It is left up to the arbitrary, paternalistic decisions of
governments as to what people really 'should' want. Perhaps people believed that
they had better uses for that 1% of their income. Also, if we can prove that
even one person was hurt by the taking of their income for this purpose, we
then need some kind of ethical theory to justify hurting this person for the
benefit of others.
Thus, in
many cases, abstractly, we suspect that there are significant positive
externalities, and that not factoring these in to market calculations could
result in an under-provision of the good in question, but there is no way of
knowing for sure that they exist or in what magnitude they exist. Also,
potential positive externalities are so prevalent that an over-zealous economic
planner could use this argument to take over the entire economy in the name of
economic ‘efficiency’. However, then we would just have socialism, a system
that cannot calculate economically and thus cannot ever be ‘efficient’.
Therefore, we must be careful with how we use this particular argument, for it
can be taken way too far and the government has motivation to take it too far
in order to exert their control over the economic system for reasons far
different than economic ‘efficiency’. Nevertheless, it would be rash to dismiss
it entirely based on these considerations, especially in important areas such
as capital accumulation, where perhaps a modest forced savings plan could be an
option for consideration, and technology, where IP monopoly grants, with a
modest duration, could also be an option for consideration. In general though,
freedom seems to do much better in even these areas then the government, which
tends to stultify technological innovation and adopt policies which encourage
capital consumption. For this reason, we must always be vigilant and make sure
that the externalities argument is not used to justify tyrannical absurdities.
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