Anatomy of Externalities

by Pablo Paniagua, Research Fellow, King’s College London

 

1. Introduction

Like the long-lasting tradition in neoclassical theory to classify and taxonomy the core aspects of market failure (Bator, 1958), political economists have also been interested in unravelling the anatomy of government failure, showing how it is a much bigger problem than standard analysis implies (Wolf, 1979). Similarly, there is also a consolidated tradition in economics concerning the classification and taxonomy of goods and services according to certain intrinsic properties (Buchanan, 1965; Ostrom and Ostrom, 2002). These lines of inquiry have been recently taken forward under a new lens by social scientists (Rayamajhee and Paniagua, 2021). Alas, attempts to carry forward the debate over externalities and their nature—akin to exploring government failure and classifying goods—have yet to see similar efforts. This lack of focus changed after 2019 due to the COVID-19 pandemic and the viral externalities it generated (Paniagua, 2022). As a result of the pandemic, and the severe challenges that it spawned both to welfare and individual liberties (Paniagua, 2021), social scientists have again started to pay serious attention to externalities and their properties.

Yet despite these recent efforts, the focus has mainly drifted towards an applied analysis of public health concerns and viral externalities. Consequently, the debate has remained narrow in its scope, disregarding the broader picture about the modern nature and properties of complex externalities and their broader challenges to governance. The main motivation of this essay is threefold: first, to guide readers into the nature and conceptualization of externalities; second, to indicate the relevance of creating property rights and transactions costs, in parallel to the market-versus-state debate over the governance of externalities; lastly, to show recent advances of how to conceptualize and taxonomize externalities beyond the market-versus-state dichotomy, considering the most pressing and difficult human challenges related to externalities, such as pandemics, climate change, and the depletion of global fisheries.

 

2. Externalities: positive, negative, and property rights

Externalities are net costs (negative externalities) or net benefits (positive externalities) that a person’s actions impose on other people in society for which such person does not account for during the decision-making process and when deciding how to behave. In other words, externalities are positive or negative effects of economic actions and transactions on other individuals who are not directly part of such transactions (i.e., third-party effects).[1]

British economist Arthur C. Pigou (1920) in his book The Economic of Welfare developed the notion of a negative externality through the pollution example: consider a company that produces some good X near a river stream. The company in producing good X uses certain production techniques that pollute the river. This process thus affects the neighbors and individuals living nearby, independently of whether or not they are customers of the company polluting. Thus, the neighbors are third parties outside of the market transactions of the company, yet they are receiving a net cost imposed on them by the company’s actions. When the effects are undesirable, such as pollution, they are called negative externalities; instead, when they are favorable, positive externalities. Pigou suggested that the existence of negative externalities is sufficient justification for government intervention. If someone is creating a negative externality, such as pollution, that person is engaging in ‘too much’ of the activity that generates the externality. Pigou thus advocated a tax on such activities to discourage them. This is what economists refer to as ‘Pigouvian taxes.’

A classic example of the other type, a positive externality, is the pollination process created by a honey producer’s bees (Meade, 1952; Cheung, 1973). Individuals could benefit from pollination regardless of if they buy honey. Beekeepers take part in a market for honey; they raise and keep bees to harvest honey and sell it. Yet, in the process, bees must fly around and pollinate plants, which enables them to grow. This is beneficial to people who grow flowers and vegetables for a living, causing a third-party effects in relation to the honey market. Without the bees, these vegetable and flower growers would have to manually pollinate their plants—a very tedious labor-intensive process. Yet, they are able to free-ride and benefit from the local bees by relying on the presence and pollination efforts; the bees enable their business models to work without paying for these services, thus they reap positive externalities from the beekeepers’ activities. The presence of bees to pollinate plants is a positive externality that arises from the presence of honey farmers.

Nobel prize winning economist James Meade (1952) argued that in the presence of those positive externalities, there would be a transaction failure or ‘market failure’ among the interested parties. In this situation, Meade argued, both apple farmers and beekeepers could benefit from expanding their activities in collaboration; but acting independently following their own narrow self-interest, they had an inappropriately low incentive to collaborate. In Meade’s (1952) scenario, their private benefits from expanding did not coincide with the social benefits of doing so. Meade saw this as an example of a positive externality leading to a ‘market failure,’ where government intervention in the form of subsidies might be useful; he thus argues that “we can obtain formulae to show what [and when] subsidies and taxes must be imposed” (ibid.).

The underlying, yet imprudent, conclusion that social scientists took from Pigou’s and Meade’s examples was that in the face of both positive and negative externalities, private transactions and markets would fail to align private with social benefits and/or private with social costs, and therefore government interventions are not only justified but must be ever-present in the economic system (Bator, 1958).

This hasty ‘government intervention’ conclusion was questioned by Nobel Prize winning economist Ronald H. Coase (1960) in his famous essay, “The Problem of Social Cost.” Coase pointed out that many problems of externalities could be better understood in terms of the existence or absence of property rights in those markets affected by externalities. Hence, Coase argued, if we can create property rights in specific sectors plagued by externalities—to assign those property rights to one of the interested parties—then, it is feasible that the interested parties could bargain and exchange those rights in markets in order to solve the externality, without needing explicit government intervention via taxes or subsidies. Thus, in many real-life externality situations there is no need for the government to regulate or tax economic activities directly; rather, it only needs to create clear property rights and let the private parties bargain accordingly. This is what economists know as ‘Coasean bargaining.’

Coase drew legal implications from his idea about the bargaining of property rights: instead of debating whether something is an externality, Coarse argued that it is more productive to ask about the existence of high transactions costs and the absence of property rights that might be affecting the possibility of parties to bargain and exchange to solve externalities by themselves. If transactions costs are reasonably low, then the affected parties are more likely to negotiate and reach tolerably efficient solutions without needing specific government intervention. Nobel prize winning economist George Stigler (1966) sought to formalize Coase’s brilliant insight about the crucial relevance of property rights and transaction costs into what is known today as the ‘Coase Theorem’ (Medema, 2020).

Following Coase, Steve Cheung (1973) proved James Meade wrong concerning the need to subsidize the pollination efforts of beekeepers, by applying Coase-style logic of property rights in his essay, “The Fable of the Bees: An Economic Investigation.” Cheung demonstrated that while Meade and others had interpreted the positive externality of bees as a reason for government intervention, the actual real-life beekeeper industry had dealt with the ‘externality situation’ for decades through property rights and Coasean bargaining. Hence private parties, exchanges, and markets more generally are perfectly capable of solving several positive and negative externalities insofar as: (i) transaction costs in those markets are relatively low and (ii) those markets have clear and easily definable property rights. If those conditions do not hold, then government intervention might be warranted.

It is clear from this summary that this entire debate has been ideologically charged with polarizing positions, creating a sort of market-versus-state dichotomy in the social sciences (Ostrom, 2010). On one side are the ‘Pigouvians’ advocating government intervention whenever externalities arise, seeing ‘market failure’ as an endemic feature of reality (Bator, 1958; Meade, 1952); on the other side are ‘Coaseans’ advocating for privatization, the creation of property rights, and the use of markets to solve externalities (Stigler, 1966; Demsetz, 1996). Demsetz (1996, p. 566), for instance, argues that Coase’s main contribution was his proposal for the ‘privatization’ of the externality problem—via the legal creation of tradable property rights—rather than his broader insights on transaction costs and comparative institutional analysis (Coase, 1992).

This correct, but narrow, interpretation of Coase’s work generated numerous insights regarding the previously ignored costs and limitations of state-led solutions; it also shifted the focus away from blackboard theorizing to instead examine real-world problems and legal systems (Cheung, 1973). However, this also made the intellectual discourse contentious and polarized, rupturing the suture connecting the market approach—facilitated by private property rights—and the governmental regulatory approach supporting it. There must be a way to shed this unproductive market-versus-state dichotomy and move the analysis of externalities forward to the modern world plagued by complex externalities such as the recent pandemic (Paniagua, 2022). This has been the task of recent work examining and classifying externalities (Paniagua and Rayamajhee, 2023).

 

3. The anatomy of externalities: classifications and nestedness

Social scientists have been preoccupied with categorizing externalities owing to diverse motivations. Some examples of influential classifications include those proposed by Meade (1952), Bator (1957), and Pigou (1920). As seen in the previous section, an entry-point to classify externalities has been the standard approach of costs and benefits; that is, if externalities are either ‘positive’ or ‘negative’. Following these attempts at classification, a crucial contribution came from Buchanan and Stubblebine (1962) from their classification of ‘Pareto-relevant’ and ‘inframarginal’ (or Pareto-irrelevant) externalities. Alongside Coase’s (1960), their analysis is probably one of the most relevant works on externalities. Buchanan and Stubblebine (1962) sought to tackle two crucial questions: how do we define third-party effects? And, perhaps most importantly, do they all have to necessarily be internalized?

While answering these questions, Buchanan and Stubblebine (1962), introduced the concept of inframarginal externalities: externalities for which the costs and hassle of internalization far exceeds the personal benefits, or what Buchanan (1973) referred to as Pareto-irrelevant externalities. For example, the costs of creating rules, organizing collective action, and establishing a special police force to prevent smelly subway passengers from affecting other passengers far exceeds the benefits from keeping smelly passengers off the subway. Similarly, consider the fact that someone might define bus passengers listening to loud music on their phones without headphones a negative externality; nevertheless, the costs, risks, and hassle associated with trying to solve that externality far exceeds the benefits. Thus, there are certain externalities that—despite their existence—are simply not worth addressing. These could be seen as ‘just suck-it-up’ types of externalities.

A crucial implication derives from inframarginal externalities: the only externalities that should matter for social welfare (i.e., be policy relevant) are those that would affect the actual outcome in final equilibrium. However, if there are negative effects on agents’ values at the margin, it means that some unrealized gains from trade could remain and—as Coase (1960) would also suggest—we should not ‘leave money on the table’ and instead negotiate and figure out how to internalize such effects. We could internalize the externality through Coasean bargains or cooperative arrangements if the marginal benefits of doing so exceed the marginal costs of dealing with the externality. If they do not, just leave them alone, since it would be unreasonable to address such externalities, as seen in the above examples.

Hence some externalities, such as smelly subway passengers, are ultimately not policy relevant since—if the transaction costs are sufficiently low—then in such cases, contractual and market-based approaches to policy will lead to superior and more cost-efficient outcomes, relative to the potential costs of establishing a bureaucracy or other regulatory state-led approaches to solve them (Wolf, 1979). This implies that we should focus on creating regulatory environments and institutions that can reduce transaction costs and foster the development of markets by creating property rights, so that cooperation among individuals can internalize ‘Pareto relevant’ externalities. According to Buchanan and Stubblebine (1962), “this point has significant policy implications for it suggests that the observation of external effects, taken alone, cannot provide a basis for judgment concerning the desirability of some modification in an existing state of affairs. There is not a prima facie case for intervention in all cases where an externality is observed to exist” (ibid., p. 381).

Similarly, Nobel Laurate Elinor Ostrom (2012) pushed forward an interesting but yet underdeveloped research agenda on how complex externalities such as climate change could be considered “nested” in nature (Paniagua, 2020).[2] The recent pandemic has also evidenced that top-down or centralist policymaking cannot easily manage or solve contemporary complex social dilemmas. It has highlighted that some of the world’s most pressing challenges relate to issues concerning multilevel coordination, nested externalities, intangible commons, and governance at different scales (Paniagua, 2021). Hence, it seems that several of the most poignant challenges we face have either a nested or complex nature or require an overlapping set of actors to be effectively managed at multiple scales (Paniagua, 2022).

As Elinor Ostrom (2012, p. 356) recognized, “nested externalities” are those in which “actions taken within one decision-making unit simultaneously generate costs or benefits for other units organized at different scales”. There are certain forms of externalities that affect society at different scales and at multiple levels of governance. For example, the recent pandemic saw that actions taken at home, at school, in hospitals, in private companies, etc., all have implications and spillover effects at higher and lower levels of governance; similarly, national-level actions by the World Health Organization (WHO), and at the state level, reciprocally have also spillover effects on lower levels of governance (Paniagua, 2022).

Other challenges stemming from climate change, pollution, the depletion of fisheries, international migration, and global banking instability all seem to have a higher degree of “nestedness” (Ostrom, 2012; Paniagua, 2020; Paniagua and Rayamajhee, 2024). If this way of framing certain complex externalities is accurate, then two important conclusions follow: first, a high degree of nestedness increases transaction costs, thus making bilateral Coasean bargains and the assignability of tradable property rights difficult, if not impossible, in some instances. Second, and as a corollary of the first point, the simple use of markets or top-down ‘command and control’ solutions to such problems are unlikely to be successful. Therefore, neither the ‘Coaseans’ nor the ‘Pigouvians’ seemed to be well-equipped analytically to deal with these modern and pressing challenges. This does not mean that markets and bilateral (private) solutions are unnecessary or superfluous, but it does suggest that they can only become a fraction of the solution at some levels of governance, and thus not a panacea.

The main takeaway is that to internalize some modern externalities we must move beyond Coasean bargains and top-down state interventions, whilst promoting multilevel and bottom-up institutional craftmanship so that different governance structures and market-like arrangements can govern fractions of a particular challenge at different levels; in such a manner that each local set of rules and incentives seeks to coordinate and align with the rules and objectives of other larger governance structures. All this should challenge the standard way in which social scientists conceive of governance and externalities, thus revitalizing the political economy of externalities going forward.

 

4. A novel classification of externalities

A significant portion of the intellectual efforts of economists have thus far been that of codifying, taxonomizing, and unravelling the anatomy of externalities from different perspectives. The final objective is akin to what Ostrom and Ostrom (2002) did for the entire public versus private goods debate in economics, to transcend it in a constructive way. In her words, “given the wide variety of ecological problems that individuals face at different scales, an important design principle is getting the boundaries [of governance] to roughly fit the ecological boundaries of the problem it is designed to address” (Ostrom, 2005, p. 258). This change of analytical focus emphasizes both scales and the multilevel aspects of governance, in turn highlighting coordination and co-production as enabling the assessment of multilevel and cross-jurisdictional institutions.

By integrating insights from Coase (1960), Buchanan (1973), and Ostrom (2012), I present here a novel taxonomy of externalities that is better suited for mapping externalities to appropriate institutional solutions. I consider two main attributes that drive the nature and structure of externalities: (a) the assignability, enforceability, and tradability of property rights, and (b) the size or scale factor. The former lets us acknowledge the existence of externalities involving non-tradable rights and bundles of property rights, whereas the latter allows us to account for both its policy significance and implications for collective action. This helps to unbundle the abstract notion of transaction costs along its scalar (scale/size) and institutional (property rights) dimensions.

Scholarly works have focused on establishing formal legal and tradable private property rights as an alternative to top-down regulatory approaches to mitigating externalities. Simply put, the solution has been to convert non-tradable situations into tradable ones by creating marketable legal rights. The transaction cost perspective can benefit from recognizing the possibility of collective action at different levels to manage non-tradable property rights (Ostrom, 2012); these rights, despite being nonexchangeable, grant the rights holders certain authority to control specific aspects of a good or resource system to varying degrees. Non-tradability of property rights can arise due to legal or customary barriers. Yet, internalizing an externality can be feasible even when property rights are not tradeable (Paniagua, 2022). Groups of individuals in such situations can devise other types of hybrid and creative solutions such as unbundling of (non-tradable) property rights into separate assignable components to avoid conflicts and overcome dilemmas (Ostrom, 2003).

In addition to property rights, the scale or size of the externality should be an obvious starting point to determine its policy relevance or to classify it. If we attempt to internalize large-scale externalities at a singular jurisdictional level, mass coordination problems arise across different layers of government and between different institutions. This is far more challenging than small-scale and linear externalities with fewer coordination problems. Thus, large-scale externalities are large also in a policy-coordination sense, because their effects are cross-jurisdictional and run along different institutional and political boundaries. The taxonomy in Figure 1 captures these different types of externalities categorized according to (a) the assignability and tradability of property rights, and (b) their size or scale.[3]

 

Figure 1: A taxonomy of externalities

Source: abridged version of Paniagua and Rayamajhee (2023).

 

 

5. Concluding remarks

I have introduced the reader to the concept of externalities as well as some recent advances concerning how to conceptualize and taxonomize externalities in relation to recent human challenges. It has also introduced a taxonomic framework to evaluate alternative institutional solutions to address different types of externalities according to, (a) the assignability and tradability of property rights, and (b) the size or scale of the externality. The suggested framework follows Coase’s (1992) institutional vision by going beyond the simple market-versus-state dichotomy; it paves the way forward to compare a wide diversity of institutional solutions based on their relative strengths and weaknesses. Conventional approaches in economics tend to focus solely on either an externality’s intrinsic attributes (such as scale) or overemphasize its institutional and technological environment (such as property rights). The interplay between the two aspects remains largely ignored, as they are often conflated. Building on insights from Nobel laurates Coase, Buchanan, and Ostrom, social scientists can untangle the scalar and institutional dimensions of an externality and closely examine the implications of the interaction between factors. These insights applied to externalities will be an enduring and long-lasting contribution of how to better think about modern externalities, opening new and unexpected avenues of research.

 

 

References

 

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Buchanan, J. (1965). An Economic Theory of Clubs. Economica, 32(125), 1–14.

Buchanan, J. (1973). The institutional structure of externality. Public Choice, 14(1), 69–82.

Cheung, S. (1973). The fable of the bees: An economic investigation. The Journal of Law and Economics, 16(1), 11–33.

Coase, R. (1960). The Problem of Social Cost. The Journal of Law & Economics, 56(4), 87–137.

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Demsetz, H. (1996). The core disagreement between Pigou, the profession, and Coase in the analyses of the externality question. European Journal of Political Economy, 12(4), 565–579.

Meade, J. (1952). External economies and diseconomies in a competitive situation. The Economic Journal, 62(245), 54–67.

Medema, S. (2020). The Coase theorem at sixty. Journal of Economic Literature, 58(4), 1045–1128.

Ostrom, E. (2005). Understanding Institutional Analysis and Diversity. Princeton University Press.

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Ostrom, E. (2012). Nested externalities and polycentric institutions: Must we wait for global solutions to climate change before taking actions at other scales? Economic Theory, 49(2), 353–369.

Ostrom, V., and Ostrom, E. (2002). Public Goods and Public Choices. In M. Michael D. (Ed.), Institutional analysis. Polycentricity and local public economies: Readings from the Workshop in Political Theory and Policy Analysis (pp. 75–103). The University of Michigan Press.

Paniagua, P. (2020). Governing the (banking) commons: Polycentric solutions to bank runs. In P. Boettke, R. Herzberg & B. Kogelmann (Eds.), The political economy & social philosophy of Vincent and Elinor Ostrom (pp. 115–144). Rowman and Littlefield.

Paniagua, P. (2021). Introduction to the Special Issue: The Political Economy of Pandemics. Cosmos and Taxis, 9(5-6), 1–6.

Paniagua, P. (2022). Elinor Ostrom and public health. Economy and Society, 51(2), 211–234.

Paniagua, P., & Rayamajhee, V. (2024). Governing the global fisheries commons. Mercatus Working Paper.

Paniagua, P., & Rayamajhee, V. (2023). On the nature and structure of externalities. Public Choice, forthcoming. https://doi.org/10.1007/s11127-023-01098-1.

Pigou, A. C. (1920). The Economics of Welfare. London: Macmillan.

Rayamajhee, V., & Paniagua, P. (2021). The Ostroms and the Contestable Nature of Goods: Beyond Taxonomies and toward Institutional Polycentricity. Journal of Institutional Economics, 17(1), 71–89.

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Notes

[1] For a thorough and analytical definition of externalities, consult Buchanan and Stubblebine (1962).

[2] To clarify, ‘nested structures’ could be interpreted as Russian dolls: they are small social orders within larger social orders that are governing fractions of a particular challenge, in such a manner that each local set of rules and incentives seeks to coordinate with the rules and objectives of other larger scales. Hence, externalities that can be ‘nested’ in nature means that “actions taken within one decision-making unit simultaneously generate costs or benefits for other units organized at different scales” (Ostrom, 2012, p. 356). Modern externalities such as pandemics, climate change, global fisheries, and banking instability could all be conceptualized as nested (Paniagua, 2020, 2022).

[3] Readers interested in an in-depth exploration of the four types of externalities in the taxonomy and empirical examples should consult Paniagua and Rayamajhee (2023).