External Diseconomies Do Not Exist

[Market Economy Op-Ed]

Producers inevitably reflect external costs in the process of profit maximization

The story of a dye factory upstream and a brewery downstream is a classic example used to discuss negative externalities. If pollutants discharged by the dye factory flow into the river, they impose costs on the brewery that makes beer using river water. Yet the dye factory does not pay the brewery for these costs. When someone causes harm to others without paying the corresponding cost, this is called a “negative externality.” The output of goods associated with negative externalities exceeds the socially optimal level of production that takes those externalities into account. That is because the producer maximizes profit without considering the external costs imposed on other members of society.

In mainstream economics, the market-based way to solve a negative externality is to assign property rights over the river. According to the Coase theorem, regardless of who holds the property rights to the river, the socially optimal level of production will be achieved through monetary negotiation. However, the mainstream economic conclusion is that the state must intervene because there are transaction costs associated with negotiation, and because income distribution varies depending on who holds the property rights and bargaining power. Economics textbooks accordingly present various policies, such as direct regulation of emissions or the imposition of environmental taxes.

What is overlooked in the above example is an analysis of where demand for each good comes from. In a two-good, two-producer model like the one above, it is naturally a reasonable assumption that the demander of dye is the beer producer, and the demander of beer is the dye producer. If so, the costs borne by the beer producer as a result of pollution emissions will be reflected in its demand for dye. In the end, the dye producer will inevitably reflect the costs it imposes on the beer producer in the process of profit maximization.

A similar principle can apply even if the demander is a third party. The beer producer will reflect in its own costs the costs resulting from pollution emissions. As a result, the third party in the beer market will face a higher beer price. This will reduce demand for dye, and once again, in the process of profit maximization, the dye producer will have no choice but to reflect the external costs it causes.

The only assumption that can avoid this line of reasoning is that demanders of dye and demanders of beer are completely separate. But making such an assumption is as unrealistic and irresponsible as an economist stranded on a deserted island with only canned food and no can opener saying, “Let us assume there is a can opener.” Moreover, even in this case, if we assume there is a transactional relationship between demanders of dye and demanders of beer, the same logic holds. That is because the higher price faced by beer demanders will reduce demand for the goods produced by dye demanders, thereby reducing the income of dye demanders. In the end, demand for dye will decline, and dye demanders will reflect the external cost in the process of profit maximization.

If one follows the argument through, negative externalities become an illusion that does not exist. In any transactional relationship, the beer producer indirectly pays the costs it causes, which directly contradicts the definition of a negative externality as a case in which the cost is not paid. In economics, cost is not an “explicit cost,” but a subjective disutility concept of “opportunity cost,” so the counterargument that the beer producer does not fully reflect all pollution-related costs does not hold. Not reflecting something in cost means that, to that extent, it is not a cost to the beer producer.

Jinwoo Park, Intern Researcher, Center for Free Enterprise (CFE)

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Original title: 외부 불경제란 존재하지 않는다

Author: Jin-woo Park

Date: 2020-04-03

Source: https://www.cfe.org/bbs/bbsDetail.php?cid=press&pn=21&idx=22538