A Fallacy of Economic Externalities

See here for background.

According to most political moderates, a just function of government is to serve certain functions that will maximize the greatest good for the greatest number. For certain questions, it’s possible that if we are all pay $1 into a hypothetical pot, we may all receive back $2, but only if we are actually are forced to do so, requiring government intervention. These dollars only represent our total materialistic happiness -our economic utility- and not literal money. There is an entire branch of economics devoted to finding ways to increase utility for the entire economy.

In ideal circumstances, prices reflect all costs to society. This means that if a pencil costs $0.30, it cost the rest of society $0.30 to provide that pencil to you, the potential buyer. If the pencil is worth more than $0.30 to you, you will buy it. This mechanism means that whenever trade happens, given that you will do the best of your ability to spend your income on what means the most to you, trade is good for everyone. In fact, if prices perfectly reflected the cost to society, resources would be allocated in such a way that everyone is the best they could possibly be given their income level. There would be noise involved when people don’t really know what is best for them, such as in the case of addiction to drugs, but that is beyond the scope of this question.

However, there are certain times when prices do not match the cost imposed on the rest of society. For instance, if a factory owner dumps chemicals into a river passing by, a cost that society has to deal with (a river that is less useful because it is contaminated or bearing the cost elsewhere to clean it up) is not reflected in the price charged for the good. If the industry producing this good all the sudden had to bear the cost, certain firms on the margin would be forced to shut down. Other firms would likely produce less and at a higher cost. This would not be undesirable, nonetheless. Individual purchasers of each good were not communicated all the information they needed. They did not understand with their wallets that part of the cost of producing this good was causing that pollution. The economy therefore, in free market conditions, devote too many resources for this good at the expense of others. That is to say, the labor, raw materials, and other inputs in manufacturing the good would have provided greater total utility if they were to be dedicated towards other ends. This is known as a negative externality.

Conversely, other goods may be underallocated, meaning we produce too few of them at too low of a price. Abstractly, this is analogous to how we economize our time and use our own property. Just as the polluter’s actions affect others, our personal decisions do as well. If someone keeps her house looking nice and her lawn is perfectly manicured, the values of all other houses on the block rise. The homeowner still has the incentive to make her house look nicer because it increases the value of her own property and most people enjoy living in a better looking home. However, the social benefit of her doing so, which is the best interest of everyone in society, is more than she realizes when she does it on her own accord. Homeowners thus spend less time and resources on keeping their houses looking nice than would be warranted from a societal viewpoint, ceteris paribus. This is a positive externality.

Lastly, a spin on positive externalities is when certain circumstances benefit the economy in general through a nebulous, serpentine path. Parents may usually care deeply for the wellbeing of their children. Even if the government didn’t support it, even middle-lower class Americans would spend some of the meager disposable income they have to give their children a degree of education. Despite that being the case, too few children may receive education because a more educated society benefits each and every member within that society. Take a day laborer or a cashier at fast food chain. The poorer end of society will likely take these jobs regardless, but if they are better educated, they may do them more effectively. Is it really that tough to imagine that effective communication skills may benefit the day laborer or better math skills may benefit the cashier? Of course, these are to a certain extent inevitably reflected in the wages they receive, meaning that well-meaning and scarcely financially-able parents have already considered them. Despite this, it may still stand to reason that free academic training will benefit everyone since employers will no longer need to choose between the margin (those who have the equivalent education of junior high) and the margin of the margin (those who have no education whatsoever). If everyone is able to push society forward somewhere, everyone is better off.

So, if we tax those who cause negative externalities and give it to those who either make choices that benefit everyone else or purchase products that help more people than the single consumer, we should be collectively better off. If we can say how much damage or benefit they cause society, the government would be advised to tax and subsidize so the economy will allocate properly.

The fallacy lies in treating an economy as single unified force rather than a collection of individuals attempting to maximize their own happiness with what they have. If we tax the polluter, assuming we can accurately ascertain the damage to the environment caused by his pollution, we can force the industry to begin polluting at a rate that best benefits society. If you look at the opinion of the lower 10% and upper 10% on what the true price of polluting is, you will get very disparate answers, but that is not my point here. Rather, I wish to consider who is receiving the money the taxes generate. Preferably it is “society” in general, meaning everyone equally, since that is what economists arguing for taxes against pollution assume, but it really isn’t. Instead, it’s whomever the government is spending tax dollars on at that moment, whether that be the rich, the poor, the majority, or the minority. If you believe the government should spend more on one of those groups, that’s fine, but again, it is not in the scope of this discussion.

So let us tax that polluter, while assuming the money he pays in tax equitably goes to society. He pays an extra 10% per unit, as does his competitors. An extra $100,000 goes into the public coiffures. We now may decrease taxes elsewhere. Supposedly, this $100,000 is expected to counteract the negative effect of dirtier water caused by the pollution. On the producer’s side it does reduce it, but who is reimbursed for the cost of pollution? Everyone. In reality, everyone isn’t affected by that pollution, just those who locally use the river. Through a reduction in taxes or in an increase in public services, those who use the river continue to bear costs that do not match the governmental benefits that are provided to them. Meanwhile, everyone else is able to take a very slight profit out of the situation since they feel some benefit and no cost. Considering the multitude of situations in which the government is somehow involved, these costs add up.

The total effect of averaging each situation, ignoring that the correct people are not paying or receiving societal costs or benefits of their individual actions, is a classic problem that statisticians and economists fall into. It is said that a statistician can have his head in an oven and his feet in ice, and he will say that on the average he feels fine. Slowing pollution or providing allowances to those make their houses more attractive is only one side of the problem. The neighbors are the ones who should be paying the homeowner to paint that fence, not someone across town who will never see it. Unless the nature of humanity changes, it is not a behemoth of averaged and weighted tastes and beliefs, but an unorganized mess of personal values. The goods are allocated “efficiently” as far as the society in general is concerned, but not each of the individuals.
This does not “disprove” the use of taxes and subsidies to promote welfare. In fact, as long as the externality is calculated properly, taxing and subsidizing respective externalities will unequivocally increase utility. Yet, the question is far more complex. Economists and policymakers must come to terms with the fact that unless the tax and subsidization solution is dealt with ingeniously, the government will either tax or give money away to some people for no reason at all. To put it playfully, there are externalities to attempting to solve externalities. This issue, in conjunction with several other established, applicable, economic arguments questioning the effectiveness such government intervention renders the political question far more muddled than it appears in most textbooks.