How to Regulate: Externalities

Cite this Article
Thomas A. Lambert, How to Regulate: Externalities, Truth on the Market (February 13, 2017),

Following is the second in a series of posts on my forthcoming book, How to Regulate: A Guide for Policy Makers (Cambridge Univ. Press 2017).  The initial post is here.

As I mentioned in my first post, How to Regulate examines the market failures (and other private ordering defects) that have traditionally been invoked as grounds for government regulation.  For each such defect, the book details the adverse “symptoms” produced, the underlying “disease” (i.e., why those symptoms emerge), the range of available “remedies,” and the “side effects” each remedy tends to generate.  The first private ordering defect the book addresses is the externality.

I’ll never forget my introduction to the concept of externalities.  P.J. Hill, my much-beloved economics professor at Wheaton College, sauntered into the classroom eating a giant, juicy apple.  As he lectured, he meandered through the rows of seats, continuing to chomp on that enormous piece of fruit.  Every time he took a bite, juice droplets and bits of apple fell onto students’ desks.  Speaking with his mouth full, he propelled fruit flesh onto students’ class notes.  It was disgusting.

It was also quite effective.  Professor Hill was making the point (vividly!) that some activities impose significant effects on bystanders.  We call those effects “externalities,” he explained, because they are experienced by people who are outside the process that creates them.  When the spillover effects are adverse—costs—we call them “negative” externalities.  “Positive” externalities are spillovers of benefits.  Air pollution is a classic example of a negative externality.  Landscaping one’s yard, an activity that benefits one’s neighbors, generates a positive externality.

An obvious adverse effect (“symptom”) of externalities is unfairness.  It’s not fair for a factory owner to capture the benefits of its production while foisting some of the cost onto others.  Nor is it fair for a homeowner’s neighbors to enjoy her spectacular flower beds without contributing to their creation or maintenance.

A graver symptom of externalities is “allocative inefficiency,” a failure to channel productive resources toward the uses that will wring the greatest possible value from them.  When an activity involves negative externalities, people tend to do too much of it—i.e., to devote an inefficiently high level of productive resources to the activity.  That’s because a person deciding how much of the conduct at issue to engage in accounts for all of his conduct’s benefits, which ultimately inure to him, but only a portion of his conduct’s costs, some of which are borne by others.  Conversely, when an activity involves positive externalities, people tend to do too little of it.  In that case, they must bear all of the cost of their conduct but can capture only a portion of the benefit it produces.

Because most government interventions addressing externalities have been concerned with negative externalities (and because How to Regulate includes a separate chapter on public goods, which entail positive externalities), the book’s externalities chapter focuses on potential remedies for cost spillovers.  There are three main options, which are discussed below the fold.

The first potential remedy, “command-and-control,” takes direct aim at the primary symptom of negative externalities: their tendency to encourage too much of the activity at issue.  Under a command-and-control regime, some government official determines how much of the activity at issue a specific regulatee may engage in.  The government then issues a permit allowing the regulatee to do that much, but only that much, of the activity.  The permit often specifies exactly how the regulatee must operate in order to keep cost-spillovers in check.  Government thus “commands” some limit and “controls” how it is achieved.  Major American environmental statutes like the Clean Air and Clean Water Acts generally follow this approach.

The primary difficulties with a command-and-control approach to negative externalities are the approach’s high information requirement (the knowledge problem) and its susceptibility to manipulation by private actors (public choice concerns).  With respect to the former, the command-and-control approach requires that the government officials who set permits know the point at which the rising incremental cost of a regulatee’s activity (i.e., the cost of the last unit of the activity) begins to exceed the declining incremental benefit of that activity.  If the permitted level of activity is not set at that “bliss point,” an allocative inefficiency will result: The regulatee will do too much or too little of the activity at issue.  Of course, far-from-the-action government regulators usually have no idea how much benefit and cost are created by an additional unit of the regulated activity.  Their estimates of the optimal level of an externality-causing activity are largely guesswork.

In addition, because a command-and-control approach dictates exactly how regulatees may operate, it can easily be co-opted by firms seeking to gain a competitive advantage over (or limit competition from) their rivals.  A classic example of this sort of misuse of command-and-control occurred when producers of high-sulfur eastern coal successfully lobbied Congress to require utilities to install certain pollution-reducing scrubbers that would not have been needed if the utilities simply used low-sulfur western coal.  Because utilities had to have the scrubbers even if they used clean coal, which was slightly more expensive due to higher transportation costs, utilities had little incentive to purchase western coal.  Command-and-control thus became a tool by which producers of dirty coal could reduce competition from their clean coal rivals.  (This story is recounted in Bruce Ackerman and William Hassler’s wonderfully titled 1981 book, Clean Coal, Dirty Air: Or How the Clean Air Act Became A Multibillion Dollar Bail-Out for High-Sulfur Coal Producers.)

A second option for addressing negative externalities would refrain from specifying exactly how a regulatee must operate or how much of the activity the regulatee may engage in but would instead simply tax the activity.  If the tax rate were set so that it reflected the difference between the actor’s incremental cost and the total incremental cost of the activity—that is, if it forced the actor to bear the full cost of the activity at issue—then the allocative inefficiency symptom would be eliminated.

A polluter, for example, could be forced to pay a tax equal to the amount of cost its activity imposed on others.  Such a requirement would encourage it engage in the polluting activity only to the point at which the total benefit from its last unit of activity, benefit which it naturally captures for itself, equals the total cost from its last unit, some of which would be naturally imposed onto others but, because of the tax, is effectively directed back onto the polluter. The polluter would not produce beyond that bliss point because its added benefit from increased production would be less than its added cost once the tax is figured in.

This second approach is typically called a “Pigouvian” approach after the economist who first suggested it, A.C. Pigou.  The approach hasn’t gained much traction in the United States (at least, not in the environmental arena), but it’s widely used in Europe.

Economists across the ideological spectrum largely agree that Pigouvian approaches tend to be more efficient than command-and-control.  A recent MIT study, for example, compared different means of achieving a 20 percent reduction in gasoline consumption (and thus greenhouse gas emissions) between 2010 to 2050.  One means, a “fuel economy standard” (FES), would mimic current U.S. Corporate Average Fuel Economy (CAFE) standards, the command-and-control approach we now use to control automobile fuel consumption and the resulting pollution. Another option would be a gasoline tax set at the level needed to reduce consumption by the requisite amount. The researchers concluded that the gasoline tax could achieve the target level of fuel consumption at as little as one-fourteenth the cost of the approach mimicking the CAFE standards.

Pigouvian approaches, though, are not without their own problems.  Indeed, Pigou himself acknowledged as much.  He wrote that the case for Pigouvian taxes

cannot become more than a prima facie one, until we have considered the qualifications which governmental agencies may be expected to possess for intervening advantageously.  It is not sufficient to contrast the imperfect adjustments of unfettered private enterprise with the best adjustment that economists in their studies can imagine.

Pigou then identified real-world government limitations that might prevent his textbook approach (i.e., set a tax equal to the divergence between private and social costs) from working well:

Such authorities [charged with setting and implementing the tax] are liable alike to ignorance, to sectional pressure and to personal corruption by private interest.  A loud-voiced part of their constituents, if organised for votes, may easily outweigh the whole.

What Pigou was conceding here is that his approach, like command-and-control, is susceptible to the knowledge problem (“ignorance”) and public choice concerns (“sectional pressure,” “personal corruption by private interest,” and “loud-voiced…constituents…organized for votes”).

With respect to both of those difficulties, a Pigouvian approach probably entails less concern than command-and-control, but the difficulties still exist.  Unlike command-and-control, a Pigouvian approach doesn’t require regulators to know the marginal benefits an activity creates, but it does require an estimate of the degree to which the total marginal cost of an activity exceeds the marginal cost borne by the actor.  Regulators rarely have good data on that matter and must do lots of guessing.  With respect to public choice concerns, a Pigouvian approach is less useful for shutting down a rivals’ activities, but it can still be employed to create a competitive advantage.  Producers of bottled waters, juices, or teas, for example, might do well to fund a lobbying campaign for sin taxes on sugary sodas.  (Such taxes are Pigouvian if designed to reduce obesity-related illnesses that strain public spending on healthcare.)

A third option for addressing negative externalities—one that looks beyond the symptom (allocative inefficiency) to the underlying disease (poorly defined and enforced property rights)—is suggested by the work of Ronald Coase.  Coase famously pointed out that under certain circumstances neither command-and-control nor a Pigouvian tax is required to avoid allocative inefficiencies from cost-spillovers.

Here’s the reasoning:  If my activity imposes some cost on you, you would be willing to pay me up to the amount of that cost to get me to stop.  If I choose to persist in the activity—spurning the chance to be paid (in exchange for quitting) up to the amount of cost imposed on you—then I am really bearing an opportunity cost equal to the amount of out-of-pocket cost my activity imposes on you.  In other words, I don’t avoid the cost of my activity; I just experience it as an opportunity cost rather than an out-of-pocket cost.  The upshot is that if parties whose activities and demands impose costs on each other are able to bargain at a low cost, they are likely to strike a deal that minimizes the total social cost of the conflict between them.  That arrangement, which would maximize each party’s profit, would also generate the greatest possible social welfare, thereby avoiding any allocative inefficiency (i.e., any resource allocation that fails to extract the greatest possible value from the stuff at hand).

Perhaps an example will help here.  Imagine that two landowners, a factory and an eco-laundry that air dries customers’ clothes, are fighting over air quality on a small island.  The factory would like to emit from its smokestacks, but the laundry insists on pristine air.  Here, each party’s demands impose costs on the other: The factory’s emissions raise the laundry’s cleaning costs, but the laundry’s insistence on pristine air threatens to increase the factory’s operating costs.

The factory can emit from zero to five units, and its emission control costs fall as it emits more.  The laundry bears extra cleaning costs that increase as the factory’s emissions rise.  The costs of the two businesses at different emission levels are as follows:

Units Emitted Factory’s Emission Control Costs Laundry’s Extra Cleaning Costs
0 $25 $0
1 $16 $4
2 $9 $8
3 $4 $12
4 $1 $16
5 $0 $20


Under these facts, the optimal outcome would be for the factory to emit three units.  The total cost occasioned by the parties’ competing demands—$16 ($4 for the factory + $12 for the laundry)—is lower than at any other emission level.

Coase’s key insight was that, if bargaining is possible between the parties, one party’s out-of-pocket costs are really the other’s opportunity costs (i.e., the amount it could earn were it to give in to the other’s demands).  The upshot here is that as long as legal entitlements are clearly defined and transferable and the parties can bargain costlessly, the laundry and the factory will agree to the outcome that minimizes total social cost—the allocatively efficient outcome.  And this is so regardless of how the law initially allocates the right to control the air.

If the legal regime were to award control to the factory, allowing it to emit five units, the parties would bargain for a reduction in emissions to three.  Since the laundry could save $4 by having the factory cut back by one unit (its costs would drop from $20 to $16), while the factory’s cost of reducing by a unit would be only $1, we’d expect the laundry to pay the factory some amount between $1 and $4 for a one-unit reduction.  Going from four to three units, then, would benefit the laundry by $4 (its extra cleaning costs would fall from $16 to $12) while costing the factory only $3 (the difference between control cost of $1 and control cost of $4); we’d expect the laundry to pay the factory some price between $3 and $4 for that reduction.  The parties wouldn’t bargain, though, for a further reduction from three to two units.  Such a reduction would cost the factory $5 while benefiting the laundry by only $4.

The same outcome would result if the legal regime instead awarded control to the laundry.  The factory would pay up to $9 ($25-$16) for the right to emit one unit; the laundry would demand at least $4 to cover its extra cleaning costs.  To go from one to two units, the factory would pay up to $7, and the laundry would be better off with anything more than $4.  From two to three, the factory would pay up to $5; the laundry would demand at least $4.  From three to four, though, the laundry’s minimum demand of $4 would exceed the factory’s maximum payment of $3, and the bargain wouldn’t occur.  Thus, even with a different initial allocation of air control rights, we would again expect to see private negotiation to the optimal, allocatively efficient outcome.

All this suggests that government may sometimes be able to address externalities simply by facilitating these sorts of “Coasean bargains.”  Such bargains are likely to occur only when (1) legal entitlements are clearly defined and enforceable (so that it’s clear who’s buying what from whom) and (2) transaction costs (including the costs of bargaining) are sufficiently low.  Government policy can often help with both of these matters.  By adopting a Coasean approach, government officials may avoid the knowledge problem and many of the public choice concerns plaguing command-and-control and Pigouvian approaches to externalities.  It’s sometimes simply impossible, though, to lower transaction costs enough to facilitate Coasean bargaining.

My own view is that Coasean solutions have too often been ignored by policy makers.  (Smoking bans, for instance, employ a command-and-control scheme when a Coasean approach would be more appropriate.)  Unfortunately, academics and government officials often regard the Coase Theorem as a theoretical curiosity without much real-world use.  “Transaction costs are almost always prohibitive,” they say.

How to Regulate offers some responses to that assertion.  But this post is already way too long, so you’ll have to buy the book to see them.