11 Replies to “What Is An Externality?”

1. It’s not an externality to a system of law that is designed to, and does, protect capital. It is essential..

   1. That is more true than you might intend! Because the system has given the factory the entitlement, it does not have to pay for the costs that it is causing. To me, that’s an externality.

2. The entry in OED under “externality” as it pertains to economics reads, “A side-effect or consequence (of an industrial or commercial activity) which affects other parties without this being reflected in the cost of the goods or services involved; a social cost or benefit.” So, it seems the reasons you have rejected are in fact what Dukeminier et al. intend here. The foregone payment, the rejected offer from A, is reflected in the cost of X’s activity.

   That the injury is a side-effect or consequence isn’t what makes it an externality, as you appear to argue here. It’s an externality because its effect isn’t “reflected in the cost…” Otherwise, why would we use the word “externality,” rather than “side-effect” or “consequence”? Had X accepted A’s offer, the activity would have changed. That new activity would have produced different side-effects or consequences. Would or would not those side-effects/consequences, for which A bargained, be externalities?

   1. I would most definitely call them externalities. As for why using the word “externality” rather than “side-effect,” Milton Friedman and Friedrich von Hayek referred to externalities as “neighborhood effects” or “spillovers” — the idea that a discipline would use a technical term for a common-sense notion is pretty common. The foregone payment is reflected, but the damage to the neighbors is not. So I don’t see why it isn’t an externality. The fact that the law gives the factory the entitlement to produce, and forces the neighbors to pay them to stop, doesn’t change its character as an externality. At least as far as I can tell.

      1. Indeed, the OED entry concludes, “Cf. SPILLOVER n.” (I take this as reflecting a disciplinary usage akin to but distinct from the more commonly used term.) It should be obvious that IANAE, so I will continue to draw from OED, this time one of the quotes, from Nature magazine in 1973, that illustrates the entry: “The most economical way of controlling both pollution and congestion in cities must depend on what the economists call an internalization of the externalities—making the motorist bear not merely the costs of operating his vehicle but the costs of what he does to other people.” This quote highlights the ambiguity we’ve been addressing, that between “externality” as side-effect (your view) and “externality” as an economic characteristic of a side-effect (Dukeminier’sn view). Does the “internalization of the externalities”–the burden of costs reflecting side-effects that affect other people–make internal what once was external? If so, those side-effects are no longer externalities. (This is Dukeminier’s view.) Or does the elimination of externalities (qua externalities) require the driver to choose to drive less? (This is your view. Payment reflects cost, but the injury remains if the side-effects persist.)

         I’m inclined to suspect that Dukeminier et al. are trying to impose a strict technical definition for the term, which they perceive as having been used figuratively and sloppily so. Externality-as-mere-side-effect stands for externality-internalized. The relationship is either synecdoche: the genus side-effect refers to the species of side-effects for which costs have been internalized; or metonymy: the two kinds of side-effects (one external, the other not) come to stand for each other, owing to their close association (in this case, their identity).

3. I agree. This is confusing. What exactly is it if not an externality? An externality is a cost foisted upon another which seems to be exactly what is described above.

4. Apologies for keeping on this, but it’s interesting. In the entry for “externalities” in the New Palgrave Dictionary of Economics, 2d ed. (2008), J.J. Lafont has much to say, most of it beyond me. At the outset, a definition:

   “Externalities are *indirect* effects of consumption or production activity, that is, effects on agents other than the originator of such activity which do not work through the price system.”

   Dukeminier et al. illustrate in simple form an activity the ill effect of which does work through the price system. If the cost to A were greater than $50, A would offer X $51 to discontinue the activity.

   More Lafont: “Consider for concreteness a firm polluting a consumer. One potential solution is to create a market for this externality. Before producing, the firm must buy from the consumer the right to pollute. If both actors were behaving competitively with respect to the price of this right, the competitive equilibrium in the economy with an extended price system would be Pareto optimal, since there is no externality left.”

   If I read this correctly (a BIG “if”), Lafont is saying both that we are okay with the situation on efficiency grounds AND the residual effect is no externality. I do not believe he is saying the effect has disappeared.

   1. *Laffont

5. Thanks for bringing this up, Jonathan.

   I think the casebook writers are right, on their (economic) terms. Once the polluter forgoes a payment that reflects the cost he is imposing on others, he is taking the cost of pollution into account when deciding on his activity, and thus there is no market failure or inefficiency.

   The way I see it, the problem is not with their definition, but the fact that the economic concept of externality is very close to a different–distributive–problem, that of someone carrying out an activity and imposing its costs on other parties (without their consent). It is really the distributive problem that bothers many of us, but since the concept of “externality” is available and close in meaning, we often use that term, when the problem that we are imagining is a slightly different one, that of one party benefiting from an activity while forcing its costs on others.

   This is yet another example of the remarkable way in which economic theory has taken over many fields, to the extent that it becomes almost impossible to think about an environmental problem–say pollution–without invoking economic terminology. We need to make more of an effort, economic thinking is just one methodology, and is blind to what really concerns us in many cases.

6. I think the confusion stems from the explanation that “it is not an ‘externality’ because X has taken account in forgo the payment offered by A.” This seems to suggest that this has something to do with X’s knowledge or intent in accounting for it. Of course in the economic definition, “taking into account” has nothing to do with whether a cost is an externality. The question is whether the cost is reflected in the price system for the good or service. What changes the price system isn’t X’s taking into account A’s offer, but A’s ability and willingness to pay. Once A became a buyer for X’s pollution, it changes when X will exit the market: in this case, if the price of the good were to drop by a dollar. The example illustrates that payment from A to X to stop polluting has the same effect on the price system as payment from X to A to continue. This is just an illustration of the Coase Theorem wrapped up in a very confusing definition of externalities.

   Its nice to know that hiding the ball is alive and well in legal textbooks.

7. Congratulations Jonathan. Excellent article.

   I teach Envrironmental Law and Land Management at Catholic University in Montevideo, Uruguay and follow daily Legal Planet.

   Best regards

   Ricardo

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