Negative Externality : A ‘Market Failure’

Rothbard and Reisman make good discussion about externalities but I think psychology is also relevant in understanding why “market failure” is not a valid argument. In experimental studies, it appeared that cooperation was higher when the persons can make interaction of some sort. More revealingly, interaction through messages is not as great as (if not meaningless) interaction face-to-face. Why this weakens the “market failure” argument is easily understandable if government intervention does not induce people to interact with each other because they all rely on the government as the intermediate. This helps to propel free-riding problems. See, De Gustibus Est Disputandum (Satoshi Kanazawa, 2001), as well as, The Savanna Principle (Satoshi Kanazawa, 2004). He argues that anonymity related to large scale collective action renders defection more profitable. At the same time, Frédéric Bastiat (1850) advanced the idea that early mutual-aid societies would do a better job to keep free-riding under control, since mutual supervision and monitoring emphasize on the sense of responsibility without which these societies would be in great perile. Under the government control, however, all individuals tend to exert pressure, as much as possible, on the government in order to get more benefit (necessarily at the expense of others) because they believe they have the “right” to demand such services if they continue to pay taxes.

Man, Economy, and State, 2nd edition, Murray N. Rothbard, 1962.

Chapter 12 : The Economics of Violent Intervention in the Market

Appendix B

“Collective Goods” and “External Benefits”: Two Arguments for Government Activity

… Molinari, for example, trying to establish defense as a collective good, asserted: “A police force serves every inhabitant of the district in which it acts, but the mere establishment of a bakery does not appease their hunger.” But, on the contrary, there is no absolute necessity for a police force to defend every inhabitant of an area or, still more, to give each one the same degree of protection. Furthermore, an absolute pacifist, a believer in total nonviolence, living in the area, would not consider himself protected by, or receiving defense service from, the police. On the contrary, he would consider any police in his area a detriment to him. Hence, defense cannot be considered a “collective good” or “collective want.” Similarly for such projects as dams, which cannot be simply assumed to benefit everyone in the area. 143 […]

We come now to the problem of external benefits — the major justification for government activities expounded by economists. 148 Where individuals simply benefit themselves by their actions, many writers concede that the free market may be safely left unhampered. But men’s actions may often, even inadvertently, benefit others. While one might think this a cause for rejoicing, critics charge that from this fact flow evils in abundance. A free exchange, where A and B mutually benefit, may be all very well, say these economists; but what if A does something voluntarily which benefits B as well as himself, but for which B pays nothing in exchange?

There are two general lines of attack on the free market, using external benefits as the point of criticism. Taken together, these arguments against the market and for governmental intervention or enterprise cancel each other out, but each must, in all fairness, be examined separately. The first type of criticism is to attack A for not doing enough for B. The benefactor is, in effect, denounced for taking his own selfish interests exclusively into account, and thereby neglecting the potential indirect recipient waiting silently in the wings. 149 The second line of attack is to denounce B for accepting a benefit without paying A in return. The recipient is denounced as an ingrate and a virtual thief for accepting the free gift. The free market, then, is accused of injustice and distortion by both groups of attackers: the first believes that the selfishness of man is such that A will not act enough in ways to benefit B; the second that B will receive too much “unearned increment” without paying for it. Either way, the call is for remedial State action; on the one hand, to use violence in order to force or induce A to act more in ways which will aid B; on the other, to force B to pay A for his gift. […]

It is amusing that while each line of attack is quite widespread, each can be rather successfully rebutted by using the essence of the other attack! Take, for example, the first — the attack on the benefactor. To denounce the benefactor and implicitly call for State punishment for insufficient good deeds is to advance a moral claim by the recipient upon the benefactor. We do not intend to argue ultimate values in this book. But it should be clearly understood that to adopt this position is to say that B is entitled peremptorily to call on A to do something to benefit him, and for which B does not pay anything in return. We do not have to go all the way with the second line of attack (on the “free rider”), but we can say perhaps that it is presumptuous of the free rider to assert his right to a post of majesty and command. For what the first line of attack asserts is the moral right of B to exact gifts from A, by force if necessary.

Compulsory thrift, or attacks on potential savers for not saving and investing enough, are examples of this line of attack. Another is an attack on the user of a natural resource that is being depleted. Anyone who uses such a resource at all, whatever the extent, “deprives” some future descendant of the use. “Conservationists,” therefore, call for lower present use of such resources in favor of greater future use. Not only is this compulsory benefaction an example of the first line of attack, but, if this argument is adopted, logically no resource subject to depletion could ever be used at all. For when the future generation comes of age, it too faces a future generation. This entire line of argument is therefore a peculiarly absurd one.

The second line of attack is of the opposite form — a denunciation of the recipient of the “gift.” The recipient is denounced as a “free rider,” as a man who wickedly enjoys the “unearned increment” of the productive actions of others. This, too, is a curious line of attack. It is an argument which has cogency only when directed against the first line of attack, i.e., against the free rider who wants compulsory free rides. But here we have a situation where A’s actions, taken purely because they benefit himself, also have the happy effect of benefiting someone else. Are we to be indignant because happiness is being diffused throughout society? Are we to be critical because more than one person benefits from someone’s actions? After all, the free rider did not ask for his ride. He received it, unasked, as a boon because A benefits from his own action. To adopt the second line of attack is to call in the gendarmes to apply punishment because too many people in the society are happy. In short, am I to be taxed for enjoying the view of my neighbor’s well-kept garden? 150

150. “If my neighbors hire private watchmen they benefit me indirectly and incidentally. If my neighbors build fine houses or cultivate gardens, they indirectly minister to my leisure. Are they entitled to tax me for these benefits because I cannot ‘surrender’ them?” (S.R., “Spencer As His Own Critic”).

One striking instance of this second line of attack is the nub of the Henry Georgist position: an attack on the “unearned increment” derived from a rise in the capital values of ground land. We have seen above that as the economy progresses, real land rents will rise with real wage rates, and the result will be increases in the real capital values of land. Growing capital structure, division of labor, and population tend to make site land relatively more scarce and hence cause the increase. The argument of the Georgists is that the landowner is not morally responsible for this rise, which comes about from events external to his landholding; yet he reaps the benefit. The landowner is therefore a free rider, and his “unearned increment” rightfully belongs to “society.” Setting aside the problem of the reality of society and whether “it” can own anything, we have here a moral attack on a free-rider situation.

The difficulty with this argument is that it proves far too much. For which one of us would earn anything like our present real income were it not for external benefits that we derive from the actions of others? Specifically, the great modern accumulation of capital goods is an inheritance from all the net savings of our ancestors. Without them, we would, regardless of the quality of our own moral character, be living in a primitive jungle. The inheritance of money capital from our ancestors is, of course, simply inheritance of shares in this capital structure. We are all, therefore, free riders on the past. We are also free riders on the present, because we benefit from the continuing investment of our fellow men and from their specialized skills on the market. Certainly the vast bulk of our wages, if they could be so imputed, would be due to this heritage on which we are free riders. The landowner has no more of an unearned increment than any one of us. Are all of us to suffer confiscation, therefore, and to be taxed for our happiness? And who then is to receive the loot? Our dead ancestors, who were our benefactors in investing the capital? 151

151. There is justice as well as bluntnesss in Benjamin Tucker’s criticism: “What gives value to land?” asks Rev. Hugh O. Pentecost [a Georgist]. And he answers: “The presence of population — the community. Then rent, or the value of land, morally belongs to the community.” What gives value to Mr. Pentecost’s preaching? The presence of population — the community. Then Mr. Pentecost’s salary, or the value of his preaching, morally belongs to the community. (Tucker, Instead of a Book, p. 357)

An important case of external benefits is “external economies,” which could be reaped by investment in certain industries, but which would not accrue as profit to the entrepreneurs. There is no need to dwell on the lengthy discussion in the literature on the actual range of such external economies, although they are apparently negligible. The suggestion has been persistently advanced that the government subsidize these investments so that “society” can reap the external economies. Such is the Pigou argument for subsidizing external economies, as well as the old and still dominant “infant industries” argument for a protective tariff.

The call for state subsidization of external economy investments amounts to a third line of attack on the free market, i.e., that B, the potential beneficiaries, be forced to subsidize the benefactors A, so that the latter will produce the former’s benefits. This third line is the favorite argument of economists for such proposals as government-aided dams or reclamations (recipients taxed to pay for their benefits) or compulsory schooling (the taxpayers will eventually benefit from others’ education), etc. The recipients are again bearing the onus of the policy; but here they are not criticized for free riding. They are now being “saved” from a situation in which they would not have obtained certain benefits. Since they would not have paid for them, it is difficult to understand exactly what they are being saved from. The third line of attack therefore agrees with the first that the free market does not, because of human selfishness, produce enough external-economy actions; but it joins the second line of attack in placing the cost of remedying the situation on the strangely unwilling recipients. If this subsidy takes place, it is obvious that the recipients are no longer free riders: indeed, they are simply being coerced into buying benefits for which, acting by free choice, they would not have paid.

The absurdity of the third approach may be revealed by pondering the question: Who benefits from the suggested policy? The benefactor A receives a subsidy, it is true. But it is often doubtful if he benefits, since he would otherwise have acted and invested profitably in some other direction. The State has simply compensated him for losses which he would have received and has adjusted the proceeds so that he receives the equivalent of an opportunity forgone. Therefore A, if a business firm, does not benefit. As for the recipients, they are being forced by the State to pay for benefits that they otherwise would not have purchased. How can we say that they “benefit”?

A standard reply is that the recipients “could not” have obtained the benefit even if they had wanted to buy it voluntarily. The first problem here is by what mysterious process the critics know that the recipients would have liked to purchase the “benefit.” Our only way of knowing the content of preference scales is to see them revealed in concrete choices. Since the choice concretely was not to buy the benefit, there is no justification for outsiders to assert that B’s preference scale was “really” different from what was revealed in his actions.

Secondly, there is no reason why the prospective recipients could not have bought the benefit. In all cases a benefit produced can be sold on the market and earn its value product to consumers. The fact that producing the benefit would not be profitable to the investor signifies that the consumers do not value it as much as they value the uses of nonspecific factors in alternative lines of production. For costs to be higher than prospective selling price means that the nonspecific factors earn more in other channels of production. Furthermore, in possible cases where some consumers are not satisfied with the extent of the market production of some benefit, they are at perfect liberty to subsidize the investors themselves. Such a voluntary subsidy would be equivalent to paying a higher market price for the benefit and would reveal their willingness to pay that price. The fact that, in any case, such a subsidy has not emerged eliminates any justification for a coerced subsidy by the government. Rather than providing a benefit to the taxed “beneficiaries,” in fact, the coerced subsidy inflicts a loss upon them, for they could have spent their funds themselves on goods and services of greater utility. 152

Capitalism: A Treatise on Economics, by George Reisman, 1990, 1996, 1998.

Chapter 3 : Natural Resources and the Environment

Environmentalism and the Externalities Doctrine

The influence of the environmental movement has been promoted in the science of economics by a pernicious doctrine known as the theory of “external costs and benefits” or, sometimes, simply the theory of “externalities.” 76

The externalities doctrine must be understood against the background of the fact that economists realized early that the pattern of spending adopted by consumers determines the pattern of spending adopted by businessmen, whose products must sooner or later serve to satisfy consumers. They saw, for example, that if consumers spent more money for shirts and less for shoes, businessmen would be impelled to spend more money in producing shirts and less in producing shoes. The economists recognized in this the operation of a profoundly benevolent principle enabling people to obtain what they wanted by virtue of the ways in which they spent their money.

The supporters of the externalities doctrine are not satisfied with the fact that the spending pattern of consumers determines the spending pattern of businessmen. They add the further arbitrary demand that the individual should be able to lay claim to compensation for all the benefits his action causes to the rest of mankind and should be liable for all the costs it imposes on the rest of mankind, even though the benefits and costs in question are not subjects of purchase and sale in the normal context of the individuals concerned. From the perspective of the externalities doctrine, it is a flaw of capitalism whenever an individual’s action provides any kind of benefits to others for which he is not compensated, or imposes any kind of costs on others for which he does not compensate them. It calls upon the government to enter the scene and set matters right by deciding who owes what to whom and then effecting the necessary redistribution of wealth and income.

The alleged environmental damage caused by economic progress is regarded as falling under the heading of external costs, and it is urged that those responsible be held liable for damages. For example, it is argued that everyone whose car or factory emits any chemical into the air should be made to pay a share of whatever damages may be caused by the total volume of emissions of that chemical.

[…] In their eyes, the demand for compensation for all the benefits one causes is merely the principle of being paid for one’s work; the demand for liability for all the costs one imposes on others appears to them as an implication of the principle of accepting responsibility for one’s actions.

The externalities doctrine is a further confusion respecting the responsibilities of individuals. Even apart from imposing responsibility on individuals for results that individuals qua individuals do not cause, the error of the externalities doctrine is that it states matters far too broadly. A moment’s reflection will show that one should not be compensated for all the benefits one causes, nor be made liable for all the costs one imposes. One should be compensated only for those benefits one gives to others which those others freely contract to receive. One should be liable for damages to others only insofar as one’s action causes demonstrable physical harm to the persons or property of specific, individual others.

The broader standard of the externalities doctrine is an invitation to chaos and tyranny, for it opens the door to all kinds of arbitrary claims. According to the logic of the doctrine, beautiful women and the owners of beautiful homes and gardens should demand compensation for the pleasure the appearance of their persons or property brings to others without charge. Even the senders of unsolicited merchandise through the mail should also be able to demand compensation, if their merchandise confers any benefit on the recipients. Indeed, on the basis of the externalities doctrine, it is arguable that people are liable for payment for all the benefits that now come to them freely in the form of the work of all the inventors and authors whose discoveries or creations are not eligible for patent or copyright protection, starting with such contributions as fire and the wheel. Whether or not these payments are to be made to the descendants of the inventors or innovators, to the government, or to some other party, is a separate question. The principle holds that payment must be made for benefits received.

Whatever it may hold about the specific claims of the descendants of inventors and innovators, the doctrine implies that every living inventor or innovator should be prepared to meet demands for compensation by those displaced by the competition he inaugurates. For example, the doctrine implies that Henry Ford should have been made to pay for the support of unemployed black-smiths and horse breeders, as though the latter had a right to go on in their routine irrespective of Ford’s improvements and irrespective of the voluntary choices of the buyers of means of transportation.

It is a distortion of sound principles and totally inappropriate to call for payment for every benefit bestowed or to demand compensation for every cost imposed. It is in the nature of a division-of-labor, capitalist society to bestow enormous benefits for which people do not have to pay. Indeed, in such a society perhaps 99.9 percent or more of everyone’s standard of living comes to him as an “external benefit” provided by the thinking of others past and present. It is also in the nature of such a society to impose various costs of a minor and transitional nature in the process of improving the methods of production and raising the general standard of living. The externalities doctrine implicitly represents a two-pronged attack on a division-of-labor, capitalist society: its logic would deprive people of the benefits such a society freely gives them, by making them pay the equivalent of those benefits. And, by making those who are the source of the benefits bear unnecessary and unjust costs in the process of bringing them about, it would operate to prevent the achievement of the benefits in the first place. 77

77. It is worth noting that in a division-of-labor, capitalist society everyone normally does earn his standard of living, even people of average and below average ability. But he earns it very easily. The essential thing that is required of the great majority of people is merely the expenditure of the mental effort required to learn the new skills made necessary by the work of the innovators. Thus, someone with the muscles and brawn of a caveman, or a blacksmith, is enabled to enjoy a standard of living that includes such things as automobiles and television sets, merely by being willing to acquire an elementary education, to learn some new skills throughout his life when others introduce further advances, and, above all, to respect the rights of such others to their greater gains. For elaboration on the economic position of the average person under capitalism, see in particular Chapters 9 and 14, below.

… It is argued that insofar as important benefits are obtainable without individuals having to pay for them, a free market cannot function successfully. A typical case advanced to illustrate this claim is that of lighthouses, which, once they exist, benefit all the ships passing in the night, whether the ships’ owners have helped to pay for the lighthouses or not. It is argued that in this case, the possibility of avoiding payment and getting by as a “free rider” on the strength of the contributions of others will result in large numbers of shipowners refusing to pay for lighthouses and thus in either preventing their construction altogether or making their construction and operation less adequate. More broadly, as a general principle, it is argued that in such circumstances vital services will not be performed, or will be performed inadequately, because too many people will be hoping to take advantage of a “free ride.”

The substance of the free-rider argument is the gratuitous assumption that people lack sufficient rationality to act in their own interest in cases in which they cannot receive corresponding direct payment, and hence must be forced to act in their own interest in such cases. The clearest contradiction of this belief is the success of the activities carried on by countless private charities. In their case, individual donors give without expecting to receive any corresponding material payment, direct or indirect. Although the free-rider doctrine’s supporters are focused on such cases as lighthouses, the logic of the doctrine implies that all charitable activities should be performed by the government. The doctrine also implies that in every case in which there are benefits of any description which are not paid for, the government is to be put in a position in which it can demand a blank check, since no one can actually determine what voluntary payments made by the citizens on their own would be “adequate.”

The truth is that private citizens are capable on their own of providing for necessary activities for which it may not be possible to arrange the normal system of payment for goods or services received. This is true even in cases requiring the cooperation of millions of individuals. There is no reason why in such cases individuals could not agree to contribute to the financing of a project on a contingency basis, namely, on the basis of a sufficient number of other individuals making the same pledge. Whether it is a matter of a hundred ship owners concerned with constructing a lighthouse or a million property owners concerned with building a dam to prevent flood damage (or perhaps installing catalytic converters on their automobiles to reduce smog), there is no reason why an arrangement could not be made whereby the individual pledges his contribution on the condition of an equal or otherwise comparable contribution being pledged by a certain percentage of other such individuals. For example, the individual ship owner or property owner might agree to pledge a definite sum on the condition that half or two-thirds of the other ship owners or property owners made the same or a comparable pledge. Only when it was established that the necessary number of pledges had been made, would the pledges of the various individuals become binding. In such cases, there might be a class of free riders, but they would certainly not stop the activity from proceeding. (To some people, of course, such a procedure may appear cumbersome. Nevertheless, it is an insignificant price to pay for maintaining consistent respect for the rights of the individual.)

Finally, although the payment for a good or service in such circumstances might be less than it would be if somehow the usual circumstance prevailed of receipt of the benefit being directly contingent on payment being made, it by no means follows that the amount of benefit provided would be any less under private control than under government control. Government is inherently wasteful. As a result, it needs to spend much more money than a private organization to provide the same amount of goods or services. True, if it spends still more than that, it may provide more of the good or service than would be provided privately. But no objective basis exists for showing that it should provide more. In fact, the one outstanding objective fact in the situation is that in taking responsibility for activities beyond defense against the initiation of force, the government does something it should not do: namely, it initiates physical force against people. 78

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