An externality is when a transaction between two people—call them Art and Betty—has

an effect on a third person, Carl, without Carl’s permission.

Suppose Art sells Betty some potato chips. Now Betty really likes potato chips. She opens

the bag; she’s looking forward to eating the chips. As she eats them, she makes “yum,

yum, yum” sounds. Just look at her. She loves it.

But no matter how loud she is, there is no externality unless someone, like Carl, is

there to hear it. Obviously Art benefits from selling the product, and Betty benefits from

buying the product since this exchange was voluntary.

But Carl’s affected by a negative externality. He’s harmed. He didn’t get anything, but

he has to listen to all that crunching and yum-yumming. It really annoys him. So it takes

three to have an externality: a seller, a buyer, and at least one additional person

who is not voluntarily a participant in the transaction.

In a previous video, I claimed that prices can tell people the right thing to do. But

if there are externalities, do prices tell us everything we need to know? The answer

must be no, because with externalities, the price of something and its actual cost are

different. The price is the amount Betty paid to Art, but the cost is the amount Betty paid

to Art plus the cost to Carl of having Betty munch potato chips in his ear during class.

The problem with externalities is that prices do not capture all of the costs of the transaction.

Instead, some of the costs are borne by people who never gave their permission. It seems

like the solution would be to try to adjust price so that it coincides with the total

cost. For many people that means “fix it with

taxes.” In other words, impose a tax equal to the difference between the market price

and the true cost to force the buyer and the seller to bear the full cost of their transaction.

This is what economists call internalizing the cost.

We may not need to resort to government action, of course. One way we solve externality problems

is called manners. If Carl tells Betty her crunching is bothering him, she’ll probably

apologize and stop. Then there’s bargaining, a solution proposed

by R. H. Coase. If Carl complains, Betty might make a side payment sharing her chips with

Carl. Once Carl’s crunching too, there are no externalities, only chips.

Even if these solutions don’t work, it may not be easy to fix it with taxes through state

action. Remember, the problem is information. Prices don’t contain the full information

about cost. But where can accurate information be attained? How can the state be expected

to acquire more accurate information and then act on it effectively?

The most interesting answer to these questions came from the original scholar who proposed

fixing it with taxes, A. C. Pigou. Pigou was a really smart guy and understood that guessing

at the correct tax would be very difficult. Back in 1920, Pigou said, “It is not sufficient

to contrast the imperfect adjustments of unfettered enterprise with the best adjustment that economists

in their studies can imagine, for we cannot expect that any state authority will attain

or even wholeheartedly seek that ideal. Such authorities are liable alike to ignorance,

to sectional pressure, and to personal corruption by private interests. A loud-voiced part of

their constituents, if organized for votes, may easily outweigh the whole.”

The “fix it with taxes” solution often has unintended, bad consequences. The government

has a knowledge problem just like everybody else. Every economics student learns about

externalities and Pigouvian taxes, but professors rarely mention how hard Pigou himself thought

it would be to get those taxes exactly right.