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. Continue Reading…