Why We (Sometimes) Shouldn't Internalize Externalities

At the end of my previous post, I suggested that we might not always want to force people to internalize externalities. This is anathema to most economists and indeed believers in the market as the most efficient allocator of resources. After all, if the market allocates efficiently, and externalities are market failures, then externalities should be corrected. In many cases this will be true, but not, I think in all.

First the argument in favor of internalizing externalities. In the case of positive externalities, if the people generating the benefits are not able to capture the value of those benefits, then they will tend to not produce those goods. Even if these are not public goods, wealth creation is good for its own sake as people will tend to enrich others' lives with their innovations as well as use their wealth to employ other people*. In other words, we want people who are capable of creating new things to create those things, ceteris paribus. If people are not compensated for doing so, they will tend not to bother, or so the argument goes. In the case of negative externalities, if people are not forced to internalize those costs they will tend to over-produce those goods. That's bad for society as well.

To see where this can go wrong, let's take an extreme example. Bill Gates has been the world's richest man, although he's currently #2 behind Carlos Slim. What's more, no one believes that Gates has secured his wealth illegitimately. However, the benefits to the economy of Microsoft's products have not all been captured by Gates. As intermediate goods, Microsoft products allow people to produce other products, and to do so more efficiently than they otherwise might. Though I can't find the study now, a few years back someone estimated that Microsoft had generated hundreds of billions of surplus value to the economy, mostly by reducing transaction costs, improving efficiency in a number of business environments, and generating network externalities. These innovations have literally benefitted hundreds of millions, if not billions, of people all over the world.

You can probably see where I'm going with this. The fact that Gates has not been able to internalize all of the benefits from his products has not stopped him from creating and distributing them. On the contrary: in order for Gates to be as wealthy as he is he has to make sure his products are broadly dispersed, which is why he gives some of them away for free. He has been rewarded very well, but no utilitarian calculus that I'm aware of would suggest that we should redistribute away from ordinary people who have benefitted from Microsoft to Gates. He has more than enough. So we should modify the common claim at the beginning: internalizing (positive) externalities only needs to be done when we're operating near the margin where innovators might choose not to innovate without more compensation. And if we think in those terms, it isn't immediately obvious that we're usually operating at that margin. It is well-known, for example, that popular live music events are generally "inefficient" in that they usually sell out quickly, which indicates that there is quite a lot of surplus that is being captured by consumers rather than producers (or other consumers, who might be willing to pay more for a ticket in an auction setting). Economists generally think this is puzzling, but from a utilitarian perspective it's arguably a very good thing.

How about negative externalities? Arguably this is a more difficult case, but if we keep using the same utilitarian logic I've presented it isn't hard to argue that poorer people should be given some license to push negative externalities onto richer people. People have used this sort of argument to suggest that developing countries should not have to adhere to the same climate change restrictions that richer countries should adhere to. The question is where the margin that tips over into inefficiency lies. I admit that these cases will be much more in the eye of the beholder than the case in which Gates' positive externalities are broadly shared, but there isn't any ex ante reason to discard the idea.

*You don't have to be a believer in strong-form trickle down economics to generally accept this point.