Comments on Externality Theory

So, I got into a Twitter discussion about libertarianism, the need for regulation, and the theory of externalities. I came across this paper and noted down my comments as I read it:

Brian P. Simpson: “If all of those who created a negative externality were required to pay for the cost they imposed on others and those who created a positive externality were paid for the benefits they bestowed upon others, it would lead to economic stagnation and even regression.”

Me: Perhaps true. But, we don’t have to enforce government intervention in ALL cases. If an action leads to bad consequences — and economic stagnation IS bad — we must avoid it. The rightness/wrongness of an action should be decided solely based on its consequences. Therefore, a government intervention is justified (and, as I explain below: necessary) only in those cases where it leads to a net benefit.

Brian: “While such fresh thinking is rewarded by those who purchase the products or services offered by the innovators, these original thinkers are not paid by those who copy them. Therefore, this is a benefit bestowed upon the imitators (and their customers) for which they do not pay. They are provided with an innovative idea free of charge. The number of payments that would be required, if one implemented laws consistent with externality theory, could be multiplied as many times over as there are innovations that are easy to copy but that are not eligible for protection. This would lead to an enormous number of payments.”

Me: So, the claim here is that innovation is being under-produced because there are people benefiting from it who aren’t paying for it. And requiring payments in ALL such cases will be too complicated. Well, I agree. But the author doesn’t follow his argument to its end. If requiring payments for all innovations will be too cumbersome and therefore a bad outcome, consequentialism demands that it MUST not be done. However, “all” is not “some”. If requiring payments for some innovation leads to overall better consequences, it MUST be done. Hence, some intellectual property rights are, in fact, justified. BECAUSE they lead to good consequences. Just because I disagree with extremist libertarians, it doesn’t mean that I am a statist. I happen to be a consequentialist with a libertarian bent.

According to the laws of logic, the one who makes a stronger claim, needs to produce a stronger evidence. Libertarians need to realize that they are the ones making a stronger claim: “market always gives optimal outcomes”. I, on the other hand, am making a weaker claim: “I’m not sure. But we must do whatever leads to optimal outcomes — be it government intervention or not.”

Brian: To remedy the situation, Ford should have compensated them. One can easily imagine the large number of payments that would have to be made by those who created this type of negative externality. If payments were actually required to be made for positive and negative externalities, the result would be an endless series of payments, very little production, and a much lower standard of living. This result could hardly be deemed “a success.”

The author again seems too focused on “an endless series of payments” but he stops here and doesn’t carry forward with the thought. Yes, an endless series of payments are a problem. Now, is there any way to fix that? Well, let’s see. The complexity comes from N agents transacting with M agents on the other side, leading to number of transactions being of the order NxM. A very straight-forward method to reduce this complexity is to introduce an abstraction layer in the middle: an entity that transacts with both sides separately and removes the need for them to transact directly with each other. This reduces the complexity from NxM to N+M — which is an order of improvement! And (unless you are arguing for anarchism), such an entity already exists — the government! We already have a tax-system in place — to fund the courts and the armies — so this role seems to be a perfect fit for the government. Is it a coincidence that all countries have a government playing this very role?

This solution — an abstraction layer that reduces the complexity of number of transactions required — is exactly the solution which the market comes up with on its own in similar situations — brokers, marketplaces, agents etc. So, this is in fact a solution. Government is in a very convenient place to play this role. So, why shouldn’t we use this solution? It does seem to correct the externalities to some extent. “Some” is good enough!

Brian: “The second thing to note is that Ford’s actions do not necessarily create a positive externality for the customers of the horse breeders, buggy makers, and blacksmiths. In fact, his actions may create a negative externality for these people or they might create no externality at all. A negative externality might occur if it becomes more difficult or impossible for those who want to continue to purchase horses and buggies to find producers of these products because Ford has driven so many of them out of business.”

This seems like a case of sloppy thinking. While some of those customers indeed wanted horse-carts in particular, what most of them wanted was a means of transport. It just happened to be the case that horse-carts were THE means of transport. And therefore, Ford’s introduction of cars did create a positive externality for those who would have had to buy horse-carts earlier. In fact, that is the reason why the demand for horse-carts plummeted in the first place! The author is taking a weird stance here: that competition creates negative externalities. That’s the opposite of what most libertarians believe!

I find it hard to disagree with the claim that effects of pecuniary externalities offset each other and therefore, can be ignored.

To be continued…