Among the most misleading – and hence, most objectionable – terms used in modern economics is “externality.” As summarized in my previous essay,
Externalities are third-party effects, such as when Steve and Sarah’s actions have an impact on Silas’s welfare, with Silas not being consulted by either Steve or Sarah.
If this impact improves Silas’s welfare we call it a “positive externality” – such as if Sarah pays Steve to renovate her house, thereby raising the market value of next-door neighbor Silas’s house. If this impact worsens Silas’s welfare we call it a “negative externality” – such as if Steve, while working to renovate Sarah’s house, creates loud noises that distract Silas as he does yoga or as he is Zooming into an important meeting.
The point of my previous essay was to decry the carelessness with which people leap from the fact that your actions affect me to the conclusion that you therefore necessarily act inappropriately whenever you fail to take fully into account the consequences that your actions have on me. Because we humans are social creatures, we constantly affect other individuals in ways that we are unaware of. Some of these effects are “positive” while others are “negative.” Yet only some of these effects carry ethical or legal implications.
To repeat an example from my previous essay: You might well disturb my equanimity by wearing a polka-dotted shirt in public and then walking within eye-shot of me. But your doing so violates no ethical duty or law. Thus, I have no right to complain. And I have no standing to have the state compel you either to stop wearing polka-dotted clothing or to compensate me for any psychological discomfort that I suffer as a result of my seeing you don polka dots.
Although simple, the example of you wearing a polka-dotted shirt is useful because it captures the essence of most of the interactions that we have with each other in modern society. In most of these interactions we affect, or potentially affect, countless strangers. Yet we have no obligation to refrain from these actions simply because the effects on strangers are negative. Nor are we typically obliged to increase the frequency of those of our actions that affect strangers positively. If you’re a pretty woman who I enjoy seeing walk by, you aren’t thereby obliged to walk by me more frequently.
The above, I hope, sounds trite. It is trite. But there’s a group of third-party effects that, merely by giving them a technical name, economists have fooled themselves into mistakenly thinking are relevant and deserving of special consideration. The technical name is “pecuniary externalities.”
This impressive-sounding term refers to the effects that Sarah’s buying, selling, or investment actions have on the market value of Silas’s property.
Everyone agrees that if Sarah negligently drives her car physically into Silas’s car and thereby inflicts on it $1,000 worth of damage, Sarah violates Silas’s property right in his car and should compensate him for the damage. But suppose, instead, that Sarah, by agreeing to put her car up for sale, causes the price for which Silas can sell his car to fall by $1,000. Although the negative effect in the second example of Sarah’s action on Silas’s welfare is identical to the negative effect of Sarah’s action in the first example, only in the first example does Sarah incur an obligation to take account of the consequences on Silas of her action.
Impressed by this difference separating example one from example two, economists call the consequence of the first of Sarah’s actions – her negligently causing physical damage to Silas’s property – a “technological externality,” while calling the consequence of the second of her actions a “pecuniary externality.”
Economists then proceed to wonder why the law requires compensation only for technological externalities but not for pecuniary externalities. After all, in both cases Sarah’s action harms Silas without his permission.
The answer economists give is this: The benefits to society from actions that cause technological externalities are generally lower than are the costs to persons who suffer technological externalities, while the benefits to society from actions that cause pecuniary externalities are generally higher than are the costs to persons who suffer pecuniary externalities. And so to ensure maximum possible economic growth – or, to increase the social welfare – the law punishes technological externalities but tolerates pecuniary ones.
Economists are here correct in their cost-benefit assessments. But they cause themselves and their audiences unnecessary confusion with this labeling. The reality is that, even though it does cause the market value of his car to fall, Sarah’s decision to sell her car imposes on Silas no externality of any sort.
The chief basis for this correct conclusion that no pecuniary externality exists is that, by putting her car up for sale, Sarah takes from Silas nothing to which Silas is entitled. Yes, Sarah’s decision to sell her car decreased the market value of Silas’s car. But Silas has no property claim to his car’s previous market value. Silas, being a reasonable person (as we must assume him to be), knows that the market value of his car can change in response to the economic decisions made by strangers. Stated differently, Silas expects, with some probability greater than zero, that the market value of his car will fall. Therefore, Sarah’s decision to sell her car was already “internalized” on Silas. He took account of this possibility in his earlier decisions regarding what kind of car to buy and how long to maintain his ownership of that vehicle.
But to show why “pecuniary externalities” is a mistaken concept, we need to do more than note that Silas’s expectations include the possibility that the market value of his car will fall because others might sell cars in competition with him. Another factor in play is that Silas would not want to be relieved of this expectation if such relief meant that everyone enjoyed relief of this expectation. To relieve everyone of the expectation of the possibility that the market value of their cars will fall would require that Silas himself no longer be free to offer his car for sale whenever doing so might cause a fall in the price of Sarah’s or Steve’s car.
Because Silas (it is reasonable to assume) wants the right to sell his car whenever he chooses and at whatever price he can fetch, he cannot legitimately assert ethical or legal standing to prevent Sarah from exercising the same right over her car. By giving this right to all persons, the law effectively recognizes that everyone under its jurisdiction agrees that all people have a right to sell their cars even if some car-selling actions harm some people at particular points in time by causing the market values of their cars to fall.
The law, therefore, doesn’t merely tolerate “pecuniary externalities” on the grounds that such toleration promotes economic growth. Rather, the law treats each person as ‘purchasing’ the right to sell his or her car by giving to all other persons the right to sell their cars. The law, in short – and unlike most economists – understands that “pecuniary externalities” are not externalities at all. They are mirages in economists’ minds.
The Relevance of Getting the Language Straight
Perhaps my long discourse on “pecuniary externalities” strikes the reader as ponderous or even pointless. Ponderous it probably is, but pointless it is not. If the above reality were more widely understood, many fewer people would complain about foreigners using their exports as a means of “stealing our jobs.”
Just as Silas is not entitled to prevent Sarah from engaging in commerce that causes a fall in the market value of his car, Silas also is not entitled to prevent Sarah from engaging in commerce that causes a fall in the market value of his labor services. If Sarah’s decision to buy more imports causes the demand for Silas’s labor to fall, neither Sarah nor the foreign merchant from whom she buys the imports takes from Silas anything to which Silas is entitled. Silas’s job has not been “stolen,” as one cannot suffer the theft of that to which one has no property claim.
If ordinary people understood this reality they’d realize that the assertion “Foreigners steal our jobs!” is deeply inaccurate. People – nearly all of whom rightly oppose theft – would thus be less prone to embrace protectionism.
Likewise, if economists understood this reality, their case for free trade would become even stronger. No longer would this case include the claim that, empirically, the gains from free trade exceed the costs of the negative “pecuniary externalities” suffered by trade’s “losers.” Instead, the case for free trade would feature a recognition that, with free trade, there are no negative “pecuniary externalities” that, to be tolerated, must be offset by other benefits. Peaceful commerce violates no one’s rights and, thus, unleashes no harms that must be either offset or compensated.
Economists should at once reject both the concept and language of “pecuniary externalities.”
This article was first published by the AIER, and can be found here.
Chart of the Day
Grab a snack and chew on today’s lessons from a man who went from dropping out of college in 1943 to serve in the U.S. Army, studying meteorology, graduating from Harvard Law School to giving up the practice of law to get into investments and becoming a billionaire partner with Warren Buffet at Berkshire Hathaway! He’s Charlie Munger and here’s my take on his Top 10 Rules for Success Volume 2!