Friday, February 19, 2016

Pigou's Persistence

I recently ran across an interesting working paper by James McClure and Tyler Watts on some lesser-known or lesser-applied critiques of the standard Pigouvian perspective on externalities. The authors note that Pigou's perspective is still the standard in today's undergraduate texts, teaching students that externalities cause all manner of market failures which governments can fix with the appropriate political will.

The author's quote Pigou's 1920 book "The Economics of Welfare"
No "invisible hand" can be relied on to produce a good arrangement of the whole from a combination of separate treatments of the parts. It is therefore necessary that an authority of wider reach should intervene to tackle the collective problems of beauty, of air, and light, as those other collective problems of gas and water have been tackled.
Critiques of this perspective can be found all over the economic literature, but much of it is ignored in today's policy discussions. The authors identify 5 critiques and extensions of externality theory missing in current treatments of the subject: 1) the distinction between pecuniary and technological externalities, 2) the "invisible hand" as a generator of positive externalities, 3) the over-emphasis on negative externalities, 4) ignoring Coase's critique of Pigovian taxes as a solution to negative externalities, and 5) ignoring the potential for negative consequences of policy solutions to negative externalities. I'll discuss 2, 4, and 5 here and leave 1 and 3 to the interested reader.

Adam Smith's concept of the "invisible hand" is well known, if perhaps not well understood by most economists. (Pete Boettke recently wrote a great post on this subject.) McClure and Watts provide some helpful discussion on the subject:
The idea that "the market" generates positive external effects has been clearly articulated among a long line of economists, even though the term "externality" is often absent in their discussions. Since Adam Smith, economists have maintained that the use of scarce resources in ways that foster prosperity throughout society generally is the natural, but unintended, byproduct of economic interactions between individuals each pursuing his or her own self-interest.
I agree with the authors that Smith's concept of the invisible hand can be thought of as a positive externality. Boettke's post above also notes that Smith's concept is fundamentally about institutions, not about perfect information and other elements of individual rationality.

McClure and Watts provide some interesting discussion on Coase's critique of Pigou, focusing on Coase's concept of "reciprocal harm:"
To expose the weaknesses in Pigou's approach, Coase considered the reciprocal harm inherent in two conceptual experiments; in each the production of one economic good interferes with the production of other goods
Since both production processes in question produce economic goods, there is a trade off associated with taxing or subsidizing either process. In a previous post I discussed a column by Dierdre McCloskey in which she discusses a more important insight from Coase regarding externalities. In her characteristic style, McCloskey puts it this way:
Coase is forever saying that this or that proposal for a public policy entails knowing things that no economist can in fact know. He claims, with considerable empirical evidence, that in many cases laissez faire will be in practice better than what we will get from actual governments - though neither is perfect (we live in a second-best world, that is, a world of transaction costs). The methodological point is that Coase does not claim to have proven laissez faire on a blackboard. He says in effect, "If you look at the FCC or the lighthouses or the law of liability you see that governmental attempts to guide things minute-by-minute - as you say, Tom, 'getting the prices right'- don't work very well. Maybe it's better to just deal the cards and play. But in this veil of tears there are no guarantees. It may not work like some curves you have drawn. Life is hard. Knowledge is scarce. Grow up and admit that you can't extract policy from a couple of lines on a blackboard.
Finally, McClure and Watts discuss inframarginal or "irrelevant" externalities that can be relevant to policy decisions. The idea is that a policy designed to correct some problem with market allocations or prices may, on net, harm people if there is some positive externality "hidden" in a negative one.

For instance, when prices of basic necessities skyrocket during a natural disaster, policymakers might feel the need to outlaw "price gouging." However, such a prohibition on higher prices would reduce the incentive to bring in more of the necessities from areas unaffected by the disaster. Aid might come much slower than it otherwise would have.

The authors state the issue more generally:
Any policy that attempts correction of a negative externality while ignoring positive externalities in the form of inframarginal benefits, risks the possibility that corrective policy may impose welfare losses that could, if of sufficient magnitude, end up making matters worse than had the negative externality been ignored. 
The article is an interesting read so, as usual, I recommend reading the whole thing. There are of course many applications of these theoretical insights in agriculture. As the (vocal subset of the) public continues to emphasize the negative externalities associated with production agriculture, it will become more important to bring the insights of Coase, Demsetz, Buchanan, and others to bear.

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