Open a textbook in your typical economics classroom (at the undergraduate or graduate level) and you are not likely to find any discussion of externalities outside of being a one-off problem. Textbooks tell you externalities can be fixed with regulation, a tax, or, alternatively, by establishing rights to pollute and then allowing the trading of those rights. Externalities are spillovers to society of the private costs of production (and consumption). They are costs not paid directly by the producer (consumer) — usually because they don’t have to be paid.
A typical example presented is a single company dumping untreated waste waster into a nearby river. The company gets a free lunch that the public pays for in the form of downstream direct (and indirect) consequences of the untreated water. The consequences are often not known fully, aside from seeing and smelling the dirty water, making the problem more complex.
I remember driving along the Naugatuck River in Connecticut south of Waterbury during the 1960s and always seeing large pipes spewing green and red slimy waste water into the river. We used to hold our noses because the smell was so bad. The brass industry and other manufacturers lined the river during those years. This was before the Clean Water Act was passed. Regulation forced an end to this misbehavior.
Textbooks usually present diagrams of the private marginal costs of a producer alongside the firm’s marginal social costs (the full cost to make the product). If the government requires a firm to spend money to treat the water it coerces the company to operate on its social marginal cost curve (assuming all the externalities have been internalized as a result). This means that in the standard model output will need to be reduced (in theory) and prices will be higher (pricing-in the externality). The consumers and producers of those products now incur the added costs, instead of the fish in the river, the ecosystem and people affected by the untreated water (who are not directly party to the private transactions of the companies who were doing the polluting).
There are many problems here in terms of standard model analytical treatment of externalities and their impact on welfare economics. E.K. Hunt’s (and Ralph C. d’Arge’s) brilliant concept of the “invisible foot” of capitalist markets (Journal of Economics Issues, June, 1973), for example, shows how externalities are the “Achilles heel” of the idea of Pareto optimality of free markets. The pervasiveness of externalities (instead of being an exception to the rule of markets) is Hunt and d’Arge’s main point. If considered in their full complexity, the ubiquitous presence of negative externalities undermines the heart of microeconomics (especially its normative message in welfare theory). Yet conventional economists have ignored Hunt’s and d’Arge’s concept when assessing their models of efficiency and normative claims that free markets by definition will produce socially optimal outcomes. Here is one example of a very perverse outcome when paying firms not to produce greenhouse gases, which shows the “evil twin” of Adam Smith’s positive aspects of markets, the “invisible hand.” For a full explanation of the “invisible hand” vs. its evil twin, the “invisible foot” you can read this excellent post.
Leaving Hunt’s critique aside for now, I want to turn to the existence in the real world of corporate power and its externalizing muscle-flexing in markets, another dimension textbook economics never enters. In a recent Guardian column about climate crisis and capitalism, the externalizing machinery of capitalism is explained in a no-nonsense real-world way. The Guardian columnist gives a great example using the oil industry: This is an article I would have shared with my students in a microeconomics class.
As documents seen by the The Guardian reveal, the oil industry has known for half a century that pollution caused by the burning of fossil fuels poses severe threats to human health. By the late 1960s, Shell’s internal documents warned air pollution “may, in extreme situations, be deleterious to health”, while by 1980, Imperial College was warning of “birth defects among industry worker offspring”.
Here the social costs (birth defects, etc.) of their profit making are pushed onto society (externalized from their balance sheets). To this we could add, in light of the climate crisis, that we really don’t even know the ultimate true social costs of this reckless behavior in the pursuit of profits by the oil industry. Yet, the corporate power of the oil industry has captured the political system and prevented the public, through its elected officials, from curtailing this anti-social behavior. The columnist continues:
And yet the same industry actively lobbied against clean air regulations proposed to protect health and save lives…. The remorseless search for profit – and an economic system that enables the capture of our political systems by multinational companies with bottomless pockets – represents a fatal threat to our health, to our lives, and to our planet. Without a determined effort to drive back the political power of these corporate titans – which means questioning the very fundamentals of our economic system – our planet will continue to perish. Time is not on our side.
Clearly, the key point is that multinational firms have taken control of political systems to prevent efforts by society to regulate their bad behavior and to deny them a free lunch. As mentioned above, power is hardly ever discussed outside of a company having some markup pricing ability. Class power and class conflict, moreover, are never discussed (except to say they don’t exist). The modeling framework precludes any discussion of class and class conflict, but this is a matter for a future post.
Despite his valid point, the columnist fails to fully spell out the implication of what he is saying. Yes, seeking to maximize profits is purely rational in a capitalist system, a well known undertaking by multinational companies. But what is not stated clearly is that the collective behavior of individual firms competing to maximize profits, by externalizing anything they can possibly externalize, leads to a socially irrational outcome — as the case of the oil industry illustrates. Taken together with other leading producers of greenhouse gases, it has produced a climate crisis, and perhaps eventually the end of society as we know it. The author does not actually say this explicitly. Still, he does describe the mechanisms at work:
This may cause moral revulsion, but the behaviour is perfectly rational. An economic system based on accumulating profit will downgrade all other considerations, including the sanctity of human life. There is no economic incentive for a fossil fuel company to willingly support measures that minimise the detrimental impact of their relentless search for profit: indeed, quite the opposite.
What society needs to do is take back political power from the boardrooms of a few hundred companies. Time to put an ankle bracelet on capitalism’s invisible foot to keep it from stumping all over us. Most importantly, students need an antidote to the fairy tale of the one-sided (viz., favorable) view of markets they get in their textbooks in the form of a narrow view of Adam Smith’s “invisible hand” pro-social narrative. While markets can produce desirable social outcomes, they more generally need to be coerced into serving society.