So, About That Externality Business…

I have a friend who isn’t a big fan of the word “externality”.

I’m an economist, and we’ve been force-fed gallons of the stuff back when we were in college, so I couldn’t for the life of me understand why anybody would object to such a simple, obvious and (to me, at any rate) useful term.

My friend, who happens to be a lawyer, explained that his disdain from the term was because externality is a word that didn’t say anything at all about intent, which was a major problem. And it is from here that we begin our journey today down a rather surprising path.

A couple of things to bear in mind: this is just a quick trip down what seems to be a very interesting rabbit hole. Second, the legal nuances are well beyond my ken.

First, what do we economists mean by the word externality?

In economics, an externality is a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit.

The canonical example that every single student of economics knows is that of the fishery and the steel mill. It is to be found in Stigler’s “The Theory of Price”, but has been made famous because of Coase’s seminal paper, The Problem of Social Cost:

To give another example, Professor George J. Stigler instances the contamination of a stream. If we assume that the harmful effect of the pollution is that it kills the fish, the question to be decided is: is the value of the fish lost greater or less than the value of the product which the contamination of the stream makes possible.
It goes almost without saying that this problem has to be looked at in total and at the margin.

Think of it this way: there’s a steel mill upstream, that releases effluents into the river. Said effluents kill the fish in the river, which puts the downstream fishery out of business. The steel mill didn’t mean to kill the fish, and so the steel mill releasing effluents into the river is an externality. An unintended consequence. Or as per Wikipedia’s definition above, “a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit

Me, personally, I prefer the Naseeruddin Hodja story.

Still, that’s what externalities are.

And as I said, I have for all of these years been perfectly ok with the word and what I thought was its meaning. But after the discussion, I asked myself a question: when did we economist start using the word externalities?

Milton Friedman has a paper on education, which I chanced upon a while back, in which he uses the concept, but doesn’t mention the word. He uses instead the term “neighborhood effect”:

A stable and democratic society is impossible without widespread acceptance of some common set of values and without a minimum degree of literacy and knowledge on the part of most citizens. Education contributes to both. In consequence, the gain from the education of a child accrues not only to the child or to his parents but to other members of the society; the education of my child contributes to other people’s welfare by promoting a stable and democratic society. Yet it is not feasible to identify the particular individuals (or families) benefited or the money value of the benefit and so to charge for the services rendered. There is therefore a significant “neighborhood effect.”

The Wikipedia article on externalities has this rather intriguing line, unfortunately without a citation:

Similarly, Ludwig von Mises argues that externalities arise from lack of “clear personal property definition.”

Exactly the kind of thing that’ll raise the hackles of a lawyer!

And so I asked myself, do we have any paper that saves me the research I might have to do in terms of trying to figure out how the term came about?

And I’m happy to report that we do!

Donald J. Boudreaux and Roger Meiners have a paper titled “Externality: Origins and Classifications“.

Marshall, in his oft-cited 8th edition of his Principles of Economics, explained that external economies were factors relevant to a firm that were from the outside, such as better technology that could be adopted. Internal economies were factors under the control of those running a firm, for example, a clever manager figuring out how to run a firm better. “External economies,” Marshall wrote, are related to scale of production; they are “those dependent on the general development of the industry,” whereas “internal economies” are “those dependent on the resources of the individual houses of businesses engaged in it [a particular kind of production].”

Boudreaux, D. J., & Meiners, R. (2019). EXTERNALITY. Natural Resources Journal59(1), 1-34.

Would that mean that externalities and what we would these days call “exogenous” factors are the same thing? I’d say no, because as I understand it, it is up to us, the modeler, to decide which factors to exclude from our analysis. That is, labeling something as ‘exogenous’ to the model is a deliberate act of omission on our part. But legal/economic theory experts reading this, please do tell me if I’m wrong!

They go on to point out that Pigou builds upon the concept – but neither Marshall nor Pigou use the specific term “externality”, and neither does Tibor Scitovsky, who appears next in chronological order. He identifies, as the authors of the paper point out four types of “direct interdependence”:

  1. “when one’s satisfaction is related to the satisfaction of another person (what we’d call, I think, interpersonal comparisons of utility”. Think 3 Idiots, when Madhavan and the other guy find out that Aamir has come first in class);
  2. “when one’s satisfaction is affected by inconveniences, such as smoke from production”; (the topic of this blogpost)
  3. The third would be what we would recognize today as increased producer efficiency because of competition (which merits a longer discussion that I will not attempt here)
  4. And the fourth would be also what we would today recognize as a positive externality. The example cited in the paper is that of the apple orchard and beekeepers. Should beekeepers get a cut of the profits made by apple orchard owners?

The term “externality” seems to have been mathematically explained for the first time in a paper written by FM Bator . His definition in this paper is the following:

But I think it more natural and useful to broaden rather than restrict, to let “externality” denote any situation where some Paretian costs and benefits remain external to decentralized cost-revenue calculations in terms of price

(Bator, F. M. (1958). The anatomy of market failure. The quarterly journal of economics72(3), 351-379.)

The footnote associated with that quote is also instructive:

Recall that it is the existence of such “externality,” of residue, at the bliss-point, of Pigouvian “uncompensated services” and “incidental uncharged disservices” that defines market failure. It may be objected that to generalize the externality notion in this way is to rob it of all but descriptive significance. But surely there is not much to rob; even in its strictest neoclassical formulation it begs more than it answers. In its generalized sense it at least has the virtue of suggesting the right questions.

(Bator, F. M. (1958). The anatomy of market failure. The quarterly journal of economics72(3), 351-379.)

But to understand both of these points above, we also need to understand the definition of nonappropriability:

If a competitive advantage is to form the basis of corporate success, it must also be appropriableAppropriability is the capacity of the firm to retain the added value it creates for its own benefit.,creates%20for%20its%20own%20benefit.

But as Bator goes on to say, that is not the only way to think about externalities. The gain from bridges, as is mentioned in his paper, are non-appropriable, but is precisely the point of the bridge being built by the government. Alex Tabarrok has a view on this we’ve mentioned earlier, but that’s a separate story.

Bator then goes on to speak about three different types of externalities: ownership externalities (apples and bees), technical externalities (bridges) and public good externalities (national armies, for example. We’d call these “pure” public goods today).

At which point, in our chronological history, we get to Coase, and the story from there on on is familiar (should be, at any rate) to both students of law as well as economics. (If it ain’t, to you, then please listen to this podcast. And that’s just for starters!)

Although I would still recommend that you read “Externality: Origins and Classifications” for its entertaining take on the “Stiglerian, Hayekian and Stiglitzian responses” to the presence of externalities.

So, ok, if you’re still here, what does this have to do with the disdain my lawyer friend has for the word externalities? We reach what I think is the core point of that discussion with this definition of externalities:

In sum, in a world in which people adjust activities to reflect their expectations, externalities exist only when spillover effects are unexpected.

Boudreaux, D. J., & Meiners, R. (2019). EXTERNALITY. Natural Resources Journal59(1), 1-34.

They have another (I think better) definition in a footnote later on: “That is, externalities occur only when an existing property-rights arrangement is changed or violated.”

So all spillovers need not be externalities, but all externalities are spillovers.

Words matter, and so I’ll try and use the word spillover rather than the word externality, but it’ll involve breaking the habit of a lifetime – so it might well take time.

Still, the discussion did give rise to this blogpost after all, when I least expected it to.

Externality, or spillover?