The Undercover Economist Part 4

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0 0-10-20-30-40-50-60-70-80-90-100 Poorest Richest Source: Smith 1992. Chermick and Reschovsky 1997.

On one flank comes the objection that the externality charge is an unfair tax aimed at a disadvantaged group. Consider the idea of charging drivers to drive at congested times. To such propos-als (and they have been widespread) the pro-car lobby argues that drivers pay enough, and it is not fair to price poor drivers off the road. On the other flank come those who strongly object to the activity that is to be taxed on the grounds that after the exter-nality charge has been imposed, the rich will still be able to do whatever it was that was objectionable. In the case of traffic, the anticar lobby claims that it is outrageous that rich drivers can afford to drive around as much as they like, given the environ-mental damage caused by cars.

Are externality charges unfairly redistributive? They are not aimed at poor people but at voluntary activities: if you decide to stop causing trouble for others, you don't have to pay an exter-nality charge. It is true that the rich can afford to drive more than the poor, but it is just as true that the rich can afford to eat more than the poor. This is unfair too, but if you accept the work-ings of the price system for typical goods like food, why not road s.p.a.ce or clean air? We recognize that food, clothes, and houses cannot be free or we would quickly run out of them. It is because roads are free that we have run out of spare road s.p.a.ce.

Furthermore, since the rich do more of most things, externality charges often redistribute money in a desirable way. In the case of congestion charging, the truth is striking: in the United Kingdom, poor people do not drive-they bicycle, walk, or take the bus. The poorest tenth of the population spends almost seven times less on fuel than the richest tenth, as a percentage of their much smaller income. The total spending on fuel by the richest 10 percent is at least thirty times more than by the poorest 10 percent. The conclusion is that congestion charging not only improves efficiency, it also redistributes money by raising more tax from the rich.

That's nice for the defenders of congestion charging in Brit-ain, but useless in the United States, where the poor still drive a lot and so pay larger amounts of tax as a percentage of their in-comes. But this needn't be an impossible objection, because ex-ternality charges can be designed not to redistribute very much. In the case of roads, the government could sc.r.a.p the vehicle ex-cise duty, which is a large up-front tax, while starting to levy congestion charges on each trip. This would capture the effi-ciency benefits of a congestion charge without having major ef-fects on distribution. It is possible to neutralize much of the redistribution caused by the externality charge, while keeping its efficiency-boosting effects. This is a variant of the lump-sum tax on Tiger Woods proposed in chapter 3: we can use lump-sum taxes to redistribute without destroying efficiency.

Having met the attack from the redistributive flank, the econo-mist must face the other way and deal with the enthusiastic charge from the moral high ground of environmentalism. Not every en-vironmentalist opposes pollution and congestion charges, but some do. The reason is that they feel that pollution should sim-ply be illegal, rather than illegal for the poor and affordable for the rich. Why should the rich be allowed to pollute? More generally, some pressure groups protest against externality charges on the grounds that they allow people to pay and thus continue doing whatever objectionable thing it was that they were doing.

A partial response is to say that even the rich do not pollute for fun. It is true that the rich are more likely to be able to pay a congestion charge, but they will not ignore it. Perhaps they will be careful to make one trip to the store rather than two, or even walk to the local shop rather than drive to somewhere farther away. Externality charges make other alternatives look more attractive, both to rich and to poor.

More fundamentally, we must not confuse the strictness of the externality regulation with the method of the regulation. A con-gestion charge can be set at one dollar a day, or ten dollars a day, or a thousand dollars a day. What we know is that whatever soci-ety decides about the seriousness of the externality, externality charges are the most efficient way to deal with it. Well-designed congestion charges, for instance, are the most efficient way to achieve any given reduction of road use. How much of a reduc-tion is desirable is an open question, but congestion charging can deliver no matter what the answer is.

There are alternatives to congestion charging which stop short of the extreme of an outright ban on driving. The trouble is, they don't work as well. For instance, the government could give ev-erybody vouchers, which allow them to drive up to twenty miles per week. The immediate result of such a plan is that some people, mostly poor, would want to sell their vouchers to others, mostly rich: the poor would rather have the money, the rich would rather have the right to drive. If the government allows vouchers to be traded, they have simply imposed a congestion charge by an-other means and probably a slightly less efficient one, given the ha.s.sle of trading. (The charge is whatever the market value of the vouchers turns out to be.) And if the government bans voucher trading, the plan is clearly inefficient, because people who wish to trade are being prevented from doing so.

Other alternatives such as high parking charges are probably less efficient still, although it is harder to prove this in a para-graph. For instance, high parking charges do discourage some drivers; but the relationship between driving and parking is rather indirect. Some drivers spend extra time on the streets, looking for free s.p.a.ces. If the government wishes to discourage driving by causing drivers some expense, better to charge them directly and spend the revenue on something useful.

Some interest groups will always complain that externality charges are not tough enough, while others squeal that they are draconian. The economists' defense is that however tough we agree to be, an externality charge is the most efficient way to be tough. For any other policy, the economist can propose an alternative, using an externality charge, which would make some people better off and n.o.body worse off.

How much is your life worth?

The previous section makes it very clear that the level of any externality charge is bound to be a matter for controversy. For the Undercover Economist, seeking to re-create the "world of truth," the ideal externality charge addresses all the real external costs and only the real external costs.

It's worth thinking about what the ideal system would look like for the externalities surrounding driving. Any driver making a trip, which emitted pollutants that damaged the local area, would be charged for the pollution if he drove in a densely populated area. There would be a different charge, which would be im-posed for every trip, for emitting carbon dioxide, because it con-tributes to climate change no matter where on the surface of the planet it is emitted. In each case, the price of the trip would also depend on how clean the vehicle emissions were. Drivers would face additional charges for trips in congested areas at congested times. Older buses, which emit the worst pollutants, would be heavily taxed, and this is likely to lead to an upgrading of their engines. Heavy vehicles would incur a charge for trips on fragile roads and bridges. SUVs would be taxed because they are more likely to kill other road users in an accident.

Does this mean we should bring back the "luxury tax" on ex-pensive vehicles? Not at all. Such a tax was almost certainly envi-ronmentally counterproductive, because it encouraged people to hang on to old, more polluting vehicles: a cheap old car will gen-erally be much dirtier than a fancy modern car. SUVs may be more heavily taxed because they are fuel-inefficient and because their weight and height poses a danger to other vehicles-but not because they are expensive. The aim is to encourage people to drive smaller, lighter, more efficient vehicles, not to encour-age people to drive cheaper vehicles.

That sounds complicated. Could it possibly work? It's easy to imagine each car having a little computer linked to a global posi-tioning system to track congestion; the computer would also monitor the vehicle's exhaust. A display on the dashboard would flash up the rate at which the charge was being incurred, perhaps with helpful tips. "Tim, your trip is currently costing you nine cents per minute. Did you know that you could halve this if you got your engine tuned?"

The technology will come; much of it is already available. But there is another difficulty: working out what the costs of the ex-ternalities really are. The computer can measure congestion and pollution, but what is the cost of wasting other people's time in a traffic jam? What is the cost of poisoning people with particu-lates or benzene? Many other externalities involve real external costs and benefits that are very hard to measure: time, health, peace, even death.

For the sake of clarity, it may help to focus on the specific example of pricing the externalities caused by driving. It is hard enough to measure physical facts: how much road damage does one more vehicle do? How much noise does one more vehicle cause? How many accidents? How much delay to other vehicles? How much pollution? What ill-health does that pollution cause? But it is harder still to measure psychological consequences. How much do people care about various annoyances: foul air, noise, delay, and stress-even illness and death? Not to mention that every individual values these things differently.

It is very tempting to give up in the face of these problems. Surely it is not possible to set a value on noise or delay, and cer-tainly it seems impossible to set a value on human life. But we're kidding ourselves if we think we can opt out of these decisions. Every policy the government adopts, and every individual choice you make, implies that a valuation has been made, even if no-body has been honest enough to own up to it or even admit it to themselves.

Individually, we constantly make decisions that put a value on our own environment, our own time, and even our own lives. If you pay more to avoid a noisy area when you rent an apartment or a hotel room, then you have implicitly put a value on peace and quiet. If you decide to wait for the bus rather than flagging down a cab, you are implicitly putting a value on your time. If you de-cide you can't be bothered buying a smoke alarm, you have traded off saved time and expense against an increased chance that you will die. However, when you make any of these decisions, you probably don't come clean to anyone, even yourself, about the price you've put on quiet, time, or life.

Governments, too, make decisions that imply that they have worked out how much our lives are worth. Should the govern-ment install extra street signs and markings, or spend more money on speed cameras, or improve health care, or fund cancer re-search-or indeed not do any of these things but cut taxes, im-prove the quality of universities, or spruce up national parks? Such decisions have to be made; when they are made, embedded within them are a.s.sumptions about subjective values, including the value of human life. Estimating externality charges is simply more awkward because, if done properly, it requires that those a.s.sumptions be justified and made explicit. Leaving them im-plicit and unjustified leaves us at best at the mercy of the random drift of political processes, and at worst acquiescing to the self-serving demands of interest groups.

One of the best ways of estimating these subjective values is to look at what people actually do. Economists have a theory of "revealed preference," which is that people's preferences are re-vealed by the choices that they make as consumers. You bought apples when you could have afforded pears: therefore you pre-ferred apples to pears. For an economist, preference is not just deduced but actually defined by such choices. It is a short step to conclude that people are also rational consumers when it comes to less tangible factors, even when it comes to their health and safety. If you are not willing to pay five dollars to catch a cab and save twenty minutes, then the Undercover Economist concludes that you would rather spend the five dollars on something else. This is not a very dramatic conclusion, but some people find it controversial. He also concludes that peace and quiet is worth an extra fifteen dollars a week to you, on the basis of your rental decision; and observing that you have no smoke alarm, he pre-sumes that you are not willing to spend an hour and pay twenty dollars to reduce your chance of death by one in a million.

Two important sources of information about people's prefer-ences are house prices and wages. House prices contain embed-ded information about the value people place on all kinds of amenities: shops, greenery, low crime, quiet, the sun through the window in the morning, and so on. Some of these can be quite accurately measured: for instance, the price of two identi-cal houses facing each other across the same street will probably reveal how much people prefer a house that faces the sun. Mean-while wages can reveal information if there is a salary differential for jobs with very similar skill requirements but different levels of danger.

There are flaws in this method: in particular, what if the peace and quiet comes hand-in-hand with a cul-de-sac, which is safe for your children to play on, and insulation, which will save your heating bills? How much of the fifteen dollars a week is really a payment for quiet surroundings? What if the well-paid but dan-gerous job on the oil rig also requires you to not drink for six weeks at a time and spend all your spare time indoors? Perhaps the payment is nothing to do with danger, and everything to do with inconvenience. It will always be hard to disentangle these different factors, and it is impossible to know how well you have succeeded. But with enough information, economists can have what they think is a decent try.

A second problem is that when you bought your smoke alarm, perhaps you thought that it would reduce your chance of death by only one in fifty million, not one in a million. So before we leap to conclusions about how much you value your own life, we really need to find out how likely you thought the smoke alarm was to save it, and recognize that you may quite rationally not bother to invest too much time in finding out.

Controversial and imperfect as these methods are, they reflect an important presumption of mainstream economics: n.o.body has your best interests at heart quite as much as you do yourself.

Two different gaps in our knowledge The use of externality pricing does rely on shaky information about how much it is really worth to us to reduce externalities such as noise, accidents, pollution, and congestion. But this is not the only gap in our knowledge; we also do not know the cheapest way of reducing noise, accidents, pollution, and con-gestion. It is with this second gap that externality pricing comes into its own.

Externality pricing is no worse than any other policy when it comes to facing up to the first kind of shaky information. We now know that any policy-of regulation, pricing, command and control, tax, or "laissez-faire"-contains implicit or explicit as-sumptions about the scientific evidence on externalities like pol-lution and congestion, and the subjective preferences of people about their time, convenience, and health. No policy can be more successful than the accuracy of its a.s.sumptions.

The real advantage of externality pricing is that it circ.u.mvents the second gap in our knowledge. n.o.body knows the cheapest way of solving our traffic problems-yet. But externality pricing brings pollution, congestion, and the rest inside the world of truth, which markets create for us. As long as individuals have to face the truth, or at least our best estimate of the costs of their ac-tions, they will find a way to reduce those costs. The longer they have to respond, the more surprising and innovative the responses can be, as we are about to see.

The New Orleans effect A visit to New Orleans tells us how profoundly people can react to price signals. New Orleans displays a unique architectural style-the "Camelback" house-based on avoiding tax. In the late nineteenth century, houses were taxed based on the number of stories at the front, so the Camelback design had one story at the front and more at the back. They are charming, but if it was a practical design for a house it would have caught on elsewhere. There is a similar story in Britain, which is full of dingy houses in response to the policy, in force from 1696 to 1851, of taxing people based on the number of windows their homes had.

Advocates of congestion charging believe that it must be easier to persuade people to find a way to make fewer trips by car than it is to persuade people to build their houses in an architecturally innovative but wasteful style. Their expectation is that things wouldn't change much for a few weeks, but over the months and years, we would be living in a society where we could all get around safely and quickly.

Congestion charging can change the small decisions we make every week about whether to drive to a supermarket, or catch the bus, or walk to a local store, or buy food on the Internet. But it will also weigh in the balance with the big decisions. Each year, one in three people change jobs and one in seven people move; every time that happens, there is a clear opportunity to reconsider travel choices in the light of congestion charging.

There's also a domino effect here, as changes in behavior reinforce each other. If more people begin riding buses, there will be more room on the streets and buses will move more quickly . . .

and can cost-effectively run more frequently. If more people join car pools, each person will find potential pool members more quickly and with more similar trips. If more people try to save the congestion charge by working at home a couple of days a week or commuting at a different time of day, more compa-nies will find ways of accommodating them. People may try to live closer to their jobs; or companies may move to more rural areas to allow staff to commute without paying a high conges-tion charge.

We simply do not know. The attractive thing about external-ity pricing is that it attacks the problem but makes no a.s.sump-tion about the solution. The congestion charge gives drivers a signal: by bringing your car into town in rush hour, you are im-posing a cost on everybody else. The drivers then have a choice: pay compensation, or find a way to avoid imposing the cost. There are many, many ways to avoid that cost, and markets can produce the ingenuity needed to uncover them. When no externalities are present, markets automatically take account of costs and pro-vide incentives for producers to reduce them. When externali-ties are present, those costs are invisible to the market, but systems such as externality charging provide the missing signal that the cost exists.

When London introduced a congestion-charging zone in early 2003 (charging 5 or about $9 per day to drive into the city cen-ter) people responded far more quickly than many critics had expected. After a year, car rides fell by nearly a third. Trips that were exempt from the charge became more popular: there were 15 percent more bus rides, 20 percent more motorcycle rides, and 30 percent more trips by bicycle. Drivers who no longer en-ter the charging zone have chosen a variety of responses: one quarter drive around it, 55 percent have switched to public trans-portation, and 20 percent use alternatives like bicycles, car pools, or working from home on some days While the number of trips by car fell, the total delays caused by congestion fell by much more, which suggests that the congestion charge allowed the streets to be much more efficiently used. And as people have more and more time to adjust to the congestion charge, the cost of dealing efficiently with this externality will fall further.

Battling pollution on the cheap In the 1990s the Environmental Protection Agency (EPA) in the United States discovered how cost-effectively an externality charge could fight pollution when it decided to attack acid rain. The EPA wanted to reduce sulfur pollution from power stations. It seemed likely that some reduction would be efficient, but re-ducing pollution has costs as well as benefits. So the regulators were unsure by how much they should demand that pollution be reduced.

The trouble is that polluters will lie to regulators about what the cost of abatement really is. After all, even breathing emits a pollutant, carbon dioxide. But regulators could hardly demand that we all stop breathing to prevent pollution. So which pollu-tion should be reduced? And how? By switching to different methods of power generation? Or reducing power consumption? Or something else? Ask the polluters and they will all tell you that reducing their pollution is like stopping breathing-it would be very expensive to stop, and so somebody else should make the changes.

But it's not really hard to find out the truth. Regulators can find out how much it costs to reduce pollution by telling people either to change their ways or pay a charge. Watch which decision they make. Judge them by their actions.

The EPA tried this in the case of sulfur emissions. They set up an auction for the right to emit sulfur dioxide, which causes acid rain. Polluters were given a quota of emission permits and could either buy more permits in the auction or reduce their emissions by shutting down, installing sulfur scrubbers, or buying cleaner coal. When the EPA simply tried to tell them to install sulfur scrubbers, the power generators argued that it would be very expensive to do so, and they lobbied hard to stop the mandatory regulation. Even the EPA estimated that the cost of reducing sulfur dioxide emissions by one ton would probably be in the range of $250 to $700 and might be as high as $1,500. But when the EPA conducted the auction in 1993, very few polluters made high bids. The companies had been exaggerating their costs. By 1996 permit prices had fallen to $70 a ton, and even at that price many polluters were buying cleaner coal or installing scrubbers rather than buying permits to continue polluting.

The regulators discovered that getting rid of sulfur dioxide was so cheap that few people were willing to pay much for the right to keep producing it. In the end, the only people willing to pay high prices for permits were student environmental groups buying single permits in an attempt to win fifteen minutes of fame. The clever thing about the auction was not that the sulfur emissions were reduced-that could have been required by law- but that legislators all over the world found out how much sulfur scrubbers really cost. It created a basis for further legislation: not making rules in the dark but in full knowledge of the (modest) cost. And it has set an example to the world; for instance, Taiyuan in North-East China is putting a similar plan into place.

Now economists are designing the same kind of auction for carbon dioxide emissions in the hope of reducing the effects of climate change. There is ma.s.sive controversy about how much emission reduction will cost, but an auction of permits to extract oil, coal, and gas would soon start to tell us. An auction could start gently: in 2007, auctioning permits to extract the same num-ber of tons of carbon as were extracted in 2006. This would re-quire that economic growth take place without any growth in carbon emissions. If many environmentalists are to be believed, the auction wouldn't even sell all the permits, because basic en-ergy efficiency measures cost nothing. We'd soon find out.

Then over the next few years, we would auction fewer and fewer permits. Carbon emissions would probably fall faster than the number of permits, because carbon speculators would be buying the permits and h.o.a.rding them. This would cause no problems: the same emissions take place in the end but are delayed. If it turned out that the permits were expensive, then we would have the information for an informed debate. We could ask if the costs of climate change were worse than the cost of emission re-duction. But many economists believe that, like sulfur permits in California, the carbon permits would quickly reveal that decar-bonization is cheaper than we expected, and we will wonder why we took so long to start.

Is the environment too important to be a moral issue?

"How did you travel here today?"

"I'm sorry?"

I'm puzzled. Here I am, going to a panel discussion organized by an environmental charity, and a very earnest young member of staff is grilling me before I even get past the door of the lecture hall.

"How did you travel here today? We need to know for our carbon offset program."

"What's a carbon offset program?"

"We want all our meetings to be carbon-neutral. We ask everyone who attends to let us know how far they came and on what mode of transportation, and then we work out how much carbon dioxide was emitted and plant trees to offset the emissions."

The Undercover Economist is about to blow his cover.

"I see. In that case, I came here in an anthracite powered steamer from Australia."

"Sorry . . . how do you spell anthracite?"

"It's just a kind of coal-very dirty, lots of sulfur. OW!"

The Undercover Economist's wife gives him a sharp dig in the ribs.

"Ignore him. We both cycled here."


Apart from being a good example of how irritating an Undercover Economist can be, this true story should, I hope, provoke a few questions. Why would an environmental charity organize a carbon neutral meeting? The obvious answer is "so that it can engage in debate without contributing to climate change." And that is true, but misleading.

The Undercover Economist in me was looking at things from the point of view of efficiency. If planting trees is a good way to deal with climate change, why not forget about the meetings and plant as many as possible? (In which case, everybody should say they came by steamship.) If the awareness-raising debate is the important thing, why not forget about the trees and organize extra debates?

In other words, why be "carbon-neutral" when you can be "carbon-optimal," especially since the meeting was not benzene-neutral, lead-neutral, particulate-neutral, ozone-neutral, sulfur-neutral, congestion-neutral, noise-neutral, or accident-neutral? Instead of working out whether to improve the environment di-rectly (by planting trees), or indirectly (by promoting discussion), the charity was spending considerable energy keeping itself pre-cisely "neutral"-and not even precisely neutral on all externali-ties, nor even a modest range of environmental toxins, but preserving its neutrality on a single, high-profile pollutant: carbon dioxide. And it was doing so in a very public way.

A kind view would be that the charity was setting a "good example," if acting nonsensically can ever be a good example. An unkind view would be that it was indulging in moral posturing.

This line of reasoning may make economists look too smug for their own good, but it is an important ill.u.s.tration of a wider point. The ethical s...o...b..ating of an environmental charity can be directly connected to the fact that public policies do not make evident the environmental costs of our actions. If they did, envi-ronmentalists could argue their points from an economic stand-point; much of the moral tone would drain out of the environmental debate, but the environment itself would be much more effectively dealt with.

In a world where environmentalism is merely a moral issue, even the environmentalists themselves cannot work out the en-vironmental impact of everyday decisions. Which is worse: dis-posable diapers (which clog up landfill sites) or washable diapers (where the washing process uses electricity and releases pollut-ing detergents)? Even with the best will in the world, it is hard to know how to make the right choice.

More importantly, the diaper problem, like any other envi-ronmental issue large or small, will certainly not be solved by a tiny minority arguing inconclusively over the morally appropri-ate individual action. While the Green minority lacks the right signals about environmental damage to act appropriately, the majority of people would not inconvenience themselves even if they understood environmental problems. Both information and incentives are necessary, and as we discovered in chapter 3, mar-kets can provide both.

Economists have long been in the forefront of a.n.a.lyzing envi-ronmental problems, and this double difficulty is why they advo-cate externality pricing. Economists care about the environment but dream of a world where it is no longer an issue that invites moral posturing, but is properly integrated into markets and the world of truth, which would provide both the information and the incentives necessary to persuade ordinary people to behave in an environmentally responsible way. In such a world, we would all have clear signals about the costs of our actions within a mar-ket price. Plastics might well be taxed, because they do not bio-degrade and so fill landfill sites. This would discourage the use of plastic packaging, disposable plastic bags, and plastic diaper lin-ers. People would use only the more expensive plastics if the con-venience it provided was worth the extra money-as it probably is in the case of diapers but might well not be in the case of plastic packaging. Electricity generation that contributed to climate change would be taxed, too, which would raise electricity prices unless we could develop cleaner fuels. Diaper-washers, and ev-erybody else too, would have an incentive to buy more efficient washing machines and cut down on energy use generally.

Instead of fretting about the environmental impact of our decisions, we would be well aware that if we were willing to pay the externality charge on a product such as a diaper, we would be compensating others for the harm done by our actions, and at the same time we would be confident that that harm was less than our own convenience. We might even find that there are easier ways to improve our environment than by messing around with diapers. They're messy enough already.

Being positive We've spent a lot of s.p.a.ce on what economists call "negative externalities"-unpleasant side effects of actions people get away with scot-free.

Once you start to think about the idea of "negative externali-ties," you quickly realize that there must be "positive exter-nalities," too. These are pleasant side effects of things people do, for which they are not rewarded. If Abraham paints the front of his house and sorts out his garden, the whole street looks better as a result, but n.o.body will offer to pay for his paint or pruning shears. If Belinda opens an attractive sidewalk cafe, the streets are more pleasant to walk along, but her clients will be willing to pay only for their own pleasure, not for the pleasure of bystand-ers. And if Craig decides to vaccinate his son for measles, mumps, and rubella, this means other children are less likely to catch the diseases, but the government can only go so far in encouraging Craig to do this.

"Positive externalities" all seem very agreeable, until you realize that Abraham may decide he can't be bothered to paint his house, Belinda, fearing bankruptcy, may not set up her cafe, and Craig may decide that he is too worried about the possible side effects of the vaccines to take his son to the doctor. The rest of us would have benefited if they had gone ahead, but they each de-cided that on balance it wasn't worthwhile. Just as negative ex-ternalities will tend to lead to too much pollution or congestion, positive externalities will leave us undervaccinated, with scruffy neighbors, and a dearth of pleasant cafes. And while negative ex-ternalities attract all the attention, positive externalities may be even more important: so many of the things that make life worth living are, in fact, subject to positive externalities and are underprovided: freedom from disease, honesty in public life, vi-brant neighborhoods, and technological innovation.

Once we realize the importance of positive externalities, the obvious solution is the mirror image of the policies we consid-ered to deal with negative externalities: instead of an externality charge, an externality subsidy. Vaccinations, for example, are of-ten subsidized by governments or by aid agencies; scientific re-search, too, usually gets a big dose of government funding. But we need to be realistic about how far all this should go, because although externality charges and subsidies seem a great fix for externalities, there may be an unexpected hiccup.

Too much of a good thing?

Solving externalities without the government

When is an externality not an externality? Here's an example. I may complain about my neighbor's tree damaging my wall, but if it really bothers me I can pay him to let me cut it down. If he refuses the offer then I have to conclude that he gets more plea-sure out of the tree than I get nuisance, and in fairness it should stay up. Or perhaps I have the right in law to force my neighbor to cut down the tree. But in that case he can pay me not to exer-cise that right, and I can spend some of the money fixing my wall. If I have the right to decide then I end up richer; if he has the right to decide he ends up richer. But either way the tree stays up if it's worth more to him and it comes down if it's more irritating to me.

Externalities simply aren't externalities if people can easily get together and negotiate. Remember that they were called "externalities" because they stood outside market transactions. But some of the things that we imagine to stand outside the market can easily be brought into it.

Since these pseudoexternalities can in fact be dealt with very well by the private sector, if the government also steps in with an externality charge, we may find ourselves "solving" the external-ity twice. This would be just as undesirable as not solving it at all: instead of having too much pollution from power generation, we exaggerate the cost and overcompensate by switching off our freezers and streetlights and walking to restaurants every evening, in the dark.

How would you get this kind of "overdose" of a remedy for externalities? When mentioning the case of Abraham painting the front of his house, I glibly said that the neighbors wouldn't compensate him for his paint, but in fact such things have been known to happen. It's particularly common for landlords to buy paint for tenants to deal with a positive externality: if the tenants repaint, they get a more pleasant apartment, but the landlord will also find it easier to rent it out in the future. Taking into account the advantage to both landlord and tenants, the apart-ment is worth painting, but without cash from the landlord, the tenants may decide it's not worth the bother. By providing paint the landlord shares the cost as he will also enjoy the benefit. It might well be that in this case, what appeared to be an externality has been "internalized" by bargaining over sharing the costs.

But what if the government has been thinking about subsidies for positive externalities? Imagine that the policy wonks wrongly believe that wherever an apartment is being rented, landlords and tenants will renovate too infrequently and let the place fall apart. It isn't worth it either for the tenants or for the landlord to refurbish more often, but if either of them were taking the other's interests into account, they would agree to do the work. Seeing this positive externality, the government starts dishing out externality subsidies of $500 to tenants who renovate their apartments.

(If you find this implausible, remember that governments certainly grant subsidies for improvements to the energy-efficiency of homes, which produce a positive externality.) Imagine that the redecorating effort is worth $300 of cleaner living to the tenants and $500 of higher future rents to the land-lord, but that it costs $1,000. The government has identified the externality perfectly: $500 of benefits (higher rents) to the land-lord that the tenants do not take into account. But note that since $300 plus $500 is less than $1000, the subsidy is not enough to persuade the tenants to redecorate: nor should it be, because the redecorating is clearly more trouble than it is worth to both land-lord and tenants.

Unfortunately, the tenants have every incentive to pocket the $500 subsidy and ask the landlord to chip in another, say, $350. Then they are doing very nicely, enjoying a $1,000 renovation for only $150-because 85 percent is paid for by the landlord or the government-and which is worth $300 to them. The land-lord is willing to play along, because he pays $350 for a renova-tion, which is worth $500 to him. But the redecoration should never have happened: after all, the government has spent $500 but managed to make tenants and landlord only $150 each better off: not a very effective way to give money away.

Why does the problem arise? Because the positive externality has been dealt with twice over, once by a government subsidy and once by a process of bargaining. Either solution alone repre-sents an efficient way for a society to deal with externalities and to come to the right conclusion, which in this case is that the positive externality is not large enough to justify the decoration work. Both solutions together mean that there is too much sub-sidy of positive externalities. The same thing could happen for negative externalities too. If the government taxes my neighbor's dirty gas-powered lawnmower and I also offer to pay him to get rid of it because I dislike the noise and smell, the combination of the taxes and my own offer may persuade him to ditch the monster, even though the fun and convenience he gets from the thing outweigh any damage to anybody else and he really should be keeping it.

Yet, many externalities are very real. Outside the cozy (if cracked) walls of our gardens or our unpainted apartments, we still have clogged, choking streets. Traffic congestion is not eas-ily solved by sitting down over a cup of coffee and making a deal. There are too many people involved, enforcing the agreement would be impossible, and there would always be a temptation for many to avoid the costly negotiations but hope to enjoy the ben-efits for free.

Government-imposed externality charging is far more likely to be appropriate in situations where a negotiation over the ex-ternality will not work, as in the case of the noise from low-flying aircraft . The more likely people are to be able to sit down around the table and work something out, the more likely government intervention is to screw things up: first, because governments can be swayed by interest groups and so they do not always act in the public interest; second, because of the "overdose" problem; and last, because people know the truth about their costs and benefits better than any government ever could. Externality pric-ing will work very well for problems such as congestion and cli-mate change, for which individual negotiation is nearly impossible. For smaller-scale situations we must ask whether the government-imposed cures are worse than the disease.

Epilogue: what is economics really about?

This chapter has proposed ways of dealing with some of the major blights on our society: pollution, congestion, and fights with neighbors. We've learned that an externality charge on waste or on driving in congested areas, or a subsidy for research or for vaccinations, is the most efficient way of dealing with many of the problems that the market leaves to one side. Externality charges give people both the information to make the right choices, and the incentives to do so. Such charges do not automatically answer the question of how tough regulation should be, or what should be regulated, but once our political processes have produced a view about what we want, they provide the most cost-effective way of getting there.

Yet you will often hear so-called experts complaining that taxes on driving or on pollution would be bad for the economy. That sounds worrying. But what is "the economy"? If you spend enough time watching Bloomberg television or reading the Wall Street Journal you may come to the mistaken impression that "the economy" is a bunch of rather dull statistics with names like GDP (gross domestic product). GDP measures the total cost of pro-ducing everything in the economy in one year-for instance, one extra cappuccino would add $2.55 to GDP-or a little less if some of the ingredients were imported.

And if you think this is "the economy," then the experts may be right. A pollution tax might well make a number like GDP smaller. But who cares? Certainly not economists. We know that GDP measures lots of things that are harmful (sales of weapons, shoddy building work with subsequent expensive repairs, expen-ditures on commuting) and misses lots of things that are impor-tant, such as looking after your children or going for a walk in the mountains.

Most economics has very little to do with GDP. Economics is about who gets what and why. Clean air and smooth-flowing traffic are part of the "economy" in this sense. It's possible that congestion charging would increase GDP because people would get to work more quickly and produce more, and prices in stores would be lower because of more efficient distribution. But it's perfectly possible that congestion charging would reduce GDP. This does not, in fact, matter in the slightest. We know for cer-tain that it would make us better off in a much more meaningful sense: that we would have many new choices open to us about where we go and what we do. There is much more to life than what gets measured in accounts. Even economists know that.

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