In economics, an externality is a spillover of an economic transaction which has an impact on a party not immediately involved in the transaction. The significance of externalities arises when a consumer in a free market makes an economic transaction out of his own self-interest which has an effect on either individuals around him or on society as a whole.
Externalities can be positive or negative. An example of a positive externality would be someone having their house fireproofed, as that act makes all of her neighbors safer, therefore benefiting those not involved in the economic transaction. An example of a negative externality would be a company polluting the air or a river, imposing costs on other people in healthcare or in cleaning up the pollution.
Now in a free market, if there is a difference between individual benefit and social benefit (individual demand and social demand), or between social cost and invdividual cost (social supply and individual supply), then a purely free market outcome will not meet pareto efficiency.
So how would a free-market (anarcho-capitalist/minarchist economy) account for externalities? or would they?
inefficient in the sense that a change in the allocation of goods could make one party better off without making any other party worse off. It’s called pareto efficiency.
Most negative externalities can be handled by property rights. For example, a polluter can be forced to compensate the victims of pollution because this is a violation of their property rights.
Positive externalities can be dealt with by mutual agreement. For example, if the residents of a given area would all benefit from the funding of a defense militia for that area, then they would all be able to agree to contribute money to that end. It may be objected that the free-rider problem remains, but it’s hard to believe that the creation of an institution with the power to coerce payment out of supposed free-riders would increase economic efficiency (aside from the ethical issue). This institution would have to determine how much the suspected free-rider actually values the public good, and how could they possibly do this?
The only externalities that remain unaddressed are those that are so vague that they are unquantifiable (such as “an educated workforce”), and the so-called “market externality.” For the first kind, if individuals can’t figure out how to deal with them, then how can the government? For market externalities, this occurs when the value of property held by a person is affected by external changes in supply and/or demand. This shouldn’t be too much of a problem, because most people buy things because of the value it has to them or to others in the present, not because of the value it has to other people in the future. Those who speculatively purchase assets long-term with the intention of selling them later at a higher price should know that they are engaging in risky business.
If people can figure out that such a change is possible, then they will do it, because none of them are worse off for it.
In all of this, however, remember that if a truly free market is shown to lead to inefficiencies, then this does not justify violating the free market. All we can say is “So much the worse for efficiency.” Morality always comes first, and economists and entrepreneurs can figure out how to achieve maximum efficiency within the bounds of natural rights and non-aggression.
Pareto efficiency is a transaction where both individuals benefit from the transaction is left none the worse off. The typical Austrian objection to it is that it does not address the question of how original titles of ownership came to be.
Gee, who knew! Externalities reduce to problems of transaction costs. Either individuals will decide to deal with them or they will decide the solutions are not worth the cost. Property rights will internalise them for the most part by allowing owners to sue for damages if they so will (if the “externality” is actually harm, e.g. a factory emiting pollution over and above what it’s homesteaded the right to.) There’s certainly no reason for a massive externality like the government.
This illustrates pareto efficiency quite well actually. In that final scenario, both are content with their items right? No change in the allocation of goods from that final scenario can make any person (either A or B) better off, without making the other person worse off. If you give A the tie, B is made worse off. If you give B the watch, A is made worse off. That outcome is pareto efficient.
And yes I’m aware that the concept of pareto efficiency does not take into account the ethical aspect of a possible reallocatoin of goods; it’s a purely economic tool, used to measure the efficiency of economic outcomes, not necessarily the equity or justice of them.
Well I don’t think my fireproofing example could be done this way. Or consider a situation where someone refuses to pay (or can’t pay) for a private fire service, putting everyone around her at danger.
Consider things like public roads or bridges. Public roads increase economic activity, especially for those businesses located on a highly traveled one. If roads are privatized and people all of a sudden have to pay for their use, they won’t utilize them as much, and possible economic activity will be lost. In this case, a public road could be more efficient for the economy as a whole.
that being said yes I recognize the ethical issues with such a proposition.
Or things like systemic risk in financial markets.
right. I’m no utilitarian/consequentialist, so I recognize that rights/ethical duties cannot be circumvented just to achieve a desirable end (desirable for whomever).