Externalities

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Externalities are a technical term in classical economics: they are those consequences of actions which are not reflected in market prices. Non-economists might think that this must include almost all of human activity, and that to make those external to your study---special cases, as it were---can only be proof of the narrowness of classical economics. The notion that externalities are exceptional, however, is very important in the claim that a small-government world of rule of law and property rights can deal with the impacts of social interaction.

In a testament to the power of economics in policy-making circles, the term has become a standard way to think of environmental questions as well as all sorts of quality of life issues. An interesting view of the evolution of the language of environmentalism is offered by Mike Hulme.

A.C. Pigou provides the classical analysis, and his analysis seems to call for wide-ranging taxation by government to correct market failures. Ronald Coase was the very influential Chicago economist who produced some examples of externalities which did not require taxation to sort out. His proposition was that as long as it is easy for those affected by outcomes to do deals with those causing the outcomes, externality problems could be fixed.

Environmental problems are often extremely diffuse. How can future generations do deals with current generations to reduce emissions of greenhouse gases? Whether a tax to limit consumption today in the interests of the future is clearly not a technocratic matter, but a collective ethical and political choice. Despite such obvious difficulties with Coase and Pigou, their analyses have been very influential in the development of market mechanisms, like rights-based cap and trade policies.

An alternative view is to consider so-called externalities to be pervasive aspects of human action. What is the right attitude towards others---and more broadly other life---when nothing that is done has effects that can be contained? Such a view would tend to emphasise respect rather than freedom.

Additional resources

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Author: Tony Curzon Price