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To start us off, here’s Tim Harford on some of the negative side effects of automobile use:

Washington DC, London, Tokyo, Atlanta, Los Angeles, and Bangkok, and indeed any of the world’s great cities, are full of cars, buses, and trucks. Those vehicles seriously damage the happiness of innocent bystanders. They cause severe air pollution. Admittedly, London’s current air pollution is not as severe as the “Great Stink” of the 1850s, in which tens of thousands died of cholera. But still, air pollution from traffic is not trivial: many thousands of people die because other people want to drive. Around seven thousand people a year die prematurely because of traffic pollution in Britain, a little more than one in ten thousand. In the United States, the Environmental Protection Agency estimates that fifteen thousand people die prematurely because of the particulate matter produced from sources such as diesel engines. Within urban areas like London, the cost of delays from congestion are even worse, if you consider the number of hours spent sitting in traffic as being in any way a significant loss of productive or enjoyable life. Then there is the noise, the accidents and the “barrier effect,” which discourages people, and particularly children, from walking to school, the local stores, or even to meet their neighbors across the street.

People are not fools: it’s almost certainly true that anyone taking a trip in a car is benefiting from driving. But they are doing so at the expense of everyone else around them—the other drivers stuck in traffic, the parents who dare not let their children walk to school, the pedestrians who risk their lives dashing across the street because they are tired of waiting for the light to change, the office workers who even in the sweltering summer cannot open their windows because of the roar of the traffic.

Because each driver who gets into his car is creating misery for other people, the free market cannot deliver a solution to the problem of traffic. The external effects of congestion and pollution are important departures from the [ideal of a perfectly efficient market]. In [such a market,] every act of selfish behavior is turned to the common good. I selfishly buy underwear because I want it, but in doing so channel resources into the hands of underwear manufacturers, and do nobody any harm. Textile workers in China, where the underwear is made, selfishly look for the best job, while manufacturers selfishly look for the most capable employees. All of this works to everyone’s benefit: goods are manufactured only if people want them, and they are manufactured only by the most appropriate people to do the job. Self-centered motives are put to work for everybody.

Drivers are in a different situation. They do not offer compensation for the cost they inflict on other people. When I buy underwear, the money I spend is compensation for all of the costs incurred in making it and selling it to me. When I take the car for a drive then I do not even need to think about the costs incurred by the rest of society as I avail myself of the free roads.

In other words, whenever there’s a transaction that only involves two parties – just a buyer and a seller – the free market is an excellent mechanism for helping them coordinate and set prices at a level that makes them both better off. But in cases where a transaction has secondary effects that extend beyond just the two parties directly engaging in it, the standard market pricing mechanism often fails to account for all the relevant costs (sometimes dramatically so). The negative side effects, instead of being factored into the costs of the transaction, are simply externalized onto outside third parties – hence why they’re known as “external costs” or “externalities.” But the affected third parties never get any say in the decision-making process themselves – they never give their consent to bear any of these external costs, nor do they receive any compensation for doing so; they’re just forced to unwillingly bear someone else’s costs themselves. The “market price” in such a transaction, then, no longer serves as an accurate reflection of the true cost; it’s an unjust distortion. And so imposing a tax that makes it so all the costs actually are accounted for and all the affected parties can be properly compensated makes sense – not only in terms of justice and fairness, but also in terms of overall economic efficiency and market functioning. Anti-government critics will often argue that all taxes are bad because they can only ever impose new costs on taxpayers; but unlike many other taxes, taxes on externalities – known as Pigovian taxes (after the economist Arthur Cecil Pigou) – don’t unduly impose new costs on anyone, so much as they simply recognize the costs that already exist and are being unduly forced onto innocent bystanders, and re-assign those costs to the people who are actually responsible for producing them — something which proper market functioning demands. Again, as with land value taxes, this is one case where if you care about keeping the market efficient, and you care about protecting people’s rights and respecting their consent, you should want there to be some kind of government intervention in the market (whether it be a tax or a regulation or some other such measure) – because without one, the distortionary effects of these externalities would persist unabated. And this is something that even such ardent defenders of the market economy as Milton Friedman and Thomas Sowell fully acknowledge. As Sowell writes:

Economic decisions made through the marketplace are not always better than decisions that governments can make. Much depends on whether those market transactions accurately reflect both the costs and the benefits that result. Under some conditions, they do not.

When someone buys a table or a tractor, the question as to whether it is worth what it cost is answered by the actions of the purchaser who made the decision to buy it. However, when an electric utility company buys coal to burn to generate electricity, a significant part of the cost of the electricity-generating process is paid by people who breathe the smoke that results from the burning of the coal and whose homes and cars are dirtied by the soot. Cleaning, repainting and medical costs paid by these people are not taken into account in the marketplace, because these people do not participate in the transactions between the coal producer and the utility company.

Such costs are called “external costs” by economists because such costs fall outside the parties to the transaction which creates these costs. External costs are therefore not taken into account in the marketplace, even when these are very substantial costs, which can extend beyond monetary losses to include bad health and premature death. While there are many decisions that can be made more efficiently through the marketplace than by government, this is one of those decisions that can be made more efficiently by government than by the marketplace. Even such a champion of free markets as Milton Friedman acknowledged that there are “effects on third parties for which it is not feasible to charge or recompense them.”

Clean air laws can reduce harmful emissions by legislation and regulations. Clean water laws and laws against disposing of toxic wastes where they will harm people can likewise force decisions to be made in ways that take into account the external costs that would otherwise be ignored by those transacting in the marketplace.

Of course, he also adds this caveat:

While externalities are a serious consideration in determining the role of government, they do not simply provide a blanket justification or a magic word which automatically allows economics to be ignored and politically attractive goals to be pursued without further ado. Both the incentives of the market and the incentives of politics must be weighed when choosing between them on any particular issue.

And this is a fair point. When trying to figure out how to best handle a negative externality, it’s often tempting not only to tax it, but to immediately jump to the most extreme solution of just banning it outright. And to be sure, in some cases, this actually is the best approach. In many cases, though, it can make more sense to allow the externality to continue but levy a charge for it – i.e. a Pigovian tax – or to take some similarly lighter-handed approach. As Timothy Taylor explains, there are a number of different options that might be appropriate depending on the situation:

The central economic concept here is an “externality,” which occurs when a party other than the immediate buyer and seller is directly affected by a transaction. The idea of a free market is based in part on the notion that buyers and sellers will act in their own best interests. However, when a market transaction adversely affects a third party—one who didn’t choose to be involved in the transaction—the argument that free markets will benefit all parties does not hold as well.

Externalities can be positive or negative. As an example, imagine your next-door neighbor is throwing a party and hires a really loud band. Your neighbor is happy to have music; the band is happy to be hired. You, as the external party, could go either way. If you like the music, great! Free concert! If you don’t like the music, not so great. You’ll have to suffer through it (or call the police). Either way, the deal between your neighbor and the band didn’t take you into account.

Pollution is the most important example of a negative externality. In an unfettered market transaction, the firm looks only at the private costs of production of a good. Social costs, the costs of production that the firm doesn’t pay for, don’t figure into the calculation. If a firm doesn’t have to pay anything to dump its garbage, it’s likely to generate a lot of garbage. But if firms have to pay for garbage disposal, you can be sure they’ll find ways to reduce their waste. Similarly, public policies concerning pollution seek to make those who create pollution face its costs and take them into account.

“Command and control” is the name economists give to the kind of regulatory policies that specify a maximum amount of pollution that can legally be emitted. Early environmental regulation in the United States in the 1970s took this approach with the passage of the original Clean Air Act and Clean Water Act, and they were effective. According to U.S. Environmental Protection Agency statistics, between 1970 and 2001, the level of particulates in the air fell by 76 percent, sulfur dioxide by 44 percent, volatile organic compounds by 38 percent, and carbon monoxide by 19 percent. The level of lead in the air—which is particularly harmful to growing children—fell by 98 percent, mainly from the use of unleaded gasoline. It’s harder to measure water quality consistently, but the widespread construction of better sewage treatment plants and better provisions for disposing of wastewater has made a huge difference over the past four decades.

Despite this good news, command-and-control environmental regulations have some prominent weaknesses. One obvious weakness of any regulatory system is that the regulators may start acting in the interests of industry—[a phenomenon known as] regulatory capture. […] In addition, command-and-control regulatory standards are typically inflexible. They often specify exactly what technology must be used to reduce a certain kind of pollution. Command-and-control regulation doesn’t reward innovative ways of avoiding pollution in the first place or reducing pollution below the legal standard.

The alternative to command-and-control regulation marches under the broad heading of market-oriented environmental policies. These policies seek to work with market incentives, rather than ordering firms to take certain actions. These policies come in several flavors. One is a pollution tax imposed on producers per unit of pollution. For those allergic to the word “tax,” it can instead be called a pollution “charge.” Such a charge creates an obvious incentive to reduce pollution, and unlike in a command-and-control system, it encourages firms to keep seeking ways to reduce pollution—rather than cutting pollution to just a hair below the legal limit. A pollution charge is also highly flexible, allowing producers to determine the best way to clean up their act.

Another market-oriented environmental policy is a marketable permit system. Marketable permits give polluters the legal right to emit a certain amount of pollution; often the permissible levels are set to decline over time. If the polluter can reduce pollution by more than the amount of the permit, then the permit can be sold to someone else—hence the word “marketable.” If a new producer wants to enter the market, it has to purchase a pollution permit from some existing firm. The United States has had some success with marketable permits—to reduce lead in gasoline, for example. Permits provide the same reason to reduce pollution and create cleaner technology as the pollution tax, but instead of reducing a tax, cleaning up their act enables producers to make a profit. In recent years, the European Union has sought to use marketable permits as a way of reducing carbon emissions into the atmosphere, and the U.S. Congress has debated similar measures.

Yet another alternative for [applying] market-oriented environmentalism is the use of property rights as an incentive. Think about the problem of protecting elephants or rhinoceroses in Africa. If no one owns the animals, they are vulnerable to poachers and a shrinking habitat. But if you declare their habitat a protected park, and everyone who lives around the park has an economic incentive from tourism to protect the park, then the people surrounding the animals have a sound economic reason to protect them.

Over the past twenty to thirty years, environmental policy has moved away from pure command and control and toward market-oriented mechanisms. In general, economists have tended to favor these mechanisms.

One of the biggest environmental issues of our time is the threat of global warming due to emissions of carbon dioxide and other gases. It’s a controversial topic, to say the least, from both economic and policy standpoints. Here’s my take, as an economist who has no claim to any specialized knowledge about climate science. A number of prominent climate scientists clearly believe that our present level of carbon emissions raises a risk of severe worldwide environmental damage. The probability and size of this risk is hard to measure, but when faced with a real possibility of a severe risk, it’s often worth taking out some insurance. In this case, one form of “insurance” would mean finding ways to limit the amount of carbon in the atmosphere. We could have command-and-control rules, for example, about maximum carbon emissions and minimum gas mileages for all cars. We could pass rules about carbon emissions from factories and other pollution sources. We could, alternatively or in addition, institute a carbon tax. We could issue marketable permits for carbon emissions to factories, refineries, automobile manufacturers, and the like. We could invest in research and development for technologies that remove carbon from the air or to spur development of energy sources that don’t emit carbon. It’s no challenge to come up with ways to reduce carbon emissions; the real trick is to do it in a market-oriented and flexible way that limits carbon emissions at the lowest possible economic cost.

For many environmentalists, all these ways to address pollution miss the point because they don’t lead to zero pollution. Wearing my hardheaded economist hat, I have to declare that zero pollution is not a realistic or a useful policy goal. Zero pollution would mean shutting down most industry and most of the economy. All our policy options—both command-and-control and market-oriented environmental policies—involve allowing some pollution. The argument for absolutely zero pollution is neither viable nor intellectually serious. The reasonable policy goal is to balance the benefits of production with the costs of pollution, or, to put it another way, bring the social costs and social benefits of production into line with each other.

Charles Wheelan sums it up this way:

The activities that create comfort and prosperity—such as manufacturing and transportation and heating our homes—will always have some environmental costs. The most logical way to balance growth and environmental responsibility is to build the price of pollution into the activities that cause it. Rational people respond to prices, and rational prices should reflect the true “social cost” of any activity. Coal is not a “cheap” source of energy when its environmental impacts are taken into account.

Pollution taxes, particularly a tax on carbon emissions, would encourage cost-effective conservation; consumers and companies can respond in whatever ways make the most economic sense to them. Any tax on pollution would also make cleaner sources of energy more economically viable. The market is a remarkably powerful phenomenon for creating sane environmental policies—if we give participants the right price signals, which we have failed to do so far.

Again, this point about making sure that prices accurately reflect costs – not just the immediate costs to buyers and sellers, but all relevant costs – is the key here. It’s true that under Pigovian taxes, prices for certain goods would be higher than they would otherwise be – but that’s the entire point; without the tax, the prices of those goods wouldn’t be high enough to reflect their true costs. The private cost of the goods wouldn’t be in line with their social cost. The Pigovian tax resolves this disparity and un-distorts the price. As Joseph Heath explains:

[The argument that] taxes always distort incentives in undesirable ways […] is not actually true of all taxes. […] Pigovian taxes […] are taxes that are imposed upon goods that are associated with significant negative externalities (a bit like so-called sin taxes on tobacco and alcohol). In this case, the incentive effects of the tax are themselves desirable from an efficiency perspective. Take, for example, the gasoline tax. The general problem with gasoline is that the market price is too low—the purchaser does not fully compensate those who are inconvenienced by her consumption. In particular, those who suffer as a result of the atmospheric pollution generated are not compensated. As a result, the price of gasoline is much lower than it would be in an ideal market economy (in which we all lived in bubbles and were able to charge other people for introducing foul emissions into our airspace).

The result, among other things, is that too much gasoline will be consumed. When the state imposes a tax upon gasoline, the incentive effect of the tax is to discourage gasoline consumption, and therefore to bring total consumption down closer to what it should be (closer to the point where the social cost is warranted by the private benefit). Thus the tax itself can be efficiency-promoting. (I say “can” because of the Second Best Theorem, which shows that, in an economy with multiple price distortions, fixing one price will not necessarily lead to a more efficient outcome; the argument must be made on a case-by-case basis.) Most important, the beneficial effects of the tax can be achieved regardless of what the government does with the revenue raised (even if it were to stuff it in bottles and bury them in abandoned mines). Indeed, many people think the government should impose a range of Pigovian taxes, then just turn around and give the money back to people. One sophisticated strategy is to push for the introduction of “green taxes” on a revenue-neutral basis, by matching them with cuts in the income tax. The general slogan: “Tax bads, not goods!”

And among economists – even conservative economists – this is an uncontroversial idea. As Wheelan notes:

Basic economics—the same study of markets that conservatives typically extol—tells us that most environmental problems are “market failures,” meaning that producers and consumers do not take the cost of pollution into account when they are making private decisions. This is one of those relatively rare circumstances in which markets do not align private behavior in ways that are consistent with what is good for society overall. As a result, economists across the political spectrum have embraced pollution taxes, such as a carbon tax, as a better way to raise government revenue than taxing productive activities like work, savings, and investment.

Gary Becker—a Nobel Prize winner from the University of Chicago, a disciple of Milton Friedman, and one of the most articulate contemporary proponents of free markets—is on record as favoring a carbon tax. So is former Federal Reserve chairman Alan Greenspan (who was a close friend of Ayn Rand while she was alive). Another persistent and persuasive advocate for some kind of carbon tax is Harvard economist Gregory Mankiw, who is the author of one of the most popular economics textbooks in America. More important in this context, Mankiw was the chair of the Council of Economic Advisers under George W. Bush.

The Booth School of Business at the University of Chicago polled an ideologically diverse group of prominent economists about their views on a carbon tax; 96 percent of the economists polled answered either “agree” or “strongly agree” that a twenty-dollar-per-ton tax on carbon emissions would be better for the U.S. economy than an income tax increase that raised the same amount of revenue.

It’s not often that an economic policy idea produces such a strong consensus; usually, the debate is firmly split into the pro-government side on the one hand, which supports intervention in the market, and the pro-market side on the other, which opposes anything that might make the market less efficient. In the case of Pigovian taxes, though, it’s no surprise that there’s no such split – because in this case, the two sides are actually one and the same. When it comes to negative externalities, intervening in the market is the very thing that helps keep the market efficient in the first place.

It’s the same sort of dynamic that we saw with land value taxation; by imposing a tax on a particular economic activity, we aren’t unduly violating people’s consent and thereby decreasing efficiency – we’re correcting for violations of consent and thereby preserving efficiency. We’re ensuring that the market is properly pricing in all the relevant costs, so that prices are actually accurate. And so in this context, government intervention – the act of taxing and redistributing money – isn’t some kind of outside force that can only ever get in the way of the proper functioning of the market; it’s an integral part of a well-functioning market. The government itself is simply an actor within the market economy, just like any other – it’s just that instead of only comprising one person or company, it comprises the entire populace. And when it collects taxes (assuming it’s actually collecting only the amount of tax that it’s justly entitled to, and not unduly imposing excessive taxes), it’s doing nothing more than receiving the payments that are rightly owed to its citizens for everything they’ve given up to the people being taxed – their land, their clean air and water, etc.

In a sense, we might regard the government as basically just a giant real estate company, which is collectively owned by the entire population. It rents out the land that naturally belongs to it (i.e. the commons, which belong to everyone), and in exchange for doing so, it receives rent from the people who move onto that land and assume the exclusive right to use it (i.e. also everyone). In turn, it provides them with services like roads, police, education, and so on, in the same way that the owner of an apartment building provides residents with housing, access to utilities, and amenities like a pool, a fitness center, etc. There isn’t really some fundamental economic difference between what the government does here and what private companies do; the same kind of transaction is occurring in both cases. In the end, whether we call it the “public sector” or the “private sector” is largely irrelevant; at the most basic level, it’s all just people acting in groups to achieve their economic goals. As Heath writes:

[There is] a surprisingly pervasive error that I refer to as the “government as consumer” fallacy.

The picture underlying this fallacy is relatively straightforward. Government services, such as health care, education, national defense, and so on, “cost” us as a society. We are able to pay for them only because of all the wealth that we generate in the private sector, which we transfer to the government in the form of taxes. A government that taxes the economy too heavily stands accused of “killing the goose that lays the golden eggs” by disrupting the mechanism that generates the wealth that it itself relies upon in order to provides its services.

Thus the government gets treated as a consumer of wealth, while the private sector is regarded as a producer. This is totally confused. The state in fact produces exactly the same amount of wealth as the market, which is to say, it produces none at all. People produce wealth, and people consume wealth. Institutions, such as the state or the market, neither produce nor consume anything. They simply constitute mechanisms through which people coordinate their production and consumption of wealth. Furthermore, the value of what a person produces has nothing to do with who pays his salary. The services of a security guard make the same contribution to the real wealth of the nation regardless of whether he is called a “police officer” and works for the state or is called a “rent-a-cop” and works for a private security firm.

At the end of the day, the fact that we call some of our economic activities “government” doesn’t change the fact that they’re still occurring within a market economy, and are therefore inescapably a part of the market themselves. (It’s a bit like how we refer to human civilization and technology as being “artificial” instead of “natural,” even though we humans are ourselves a product of nature, so by extension, everything we do is “natural” in a sense.) Anarchists and libertarians will often try to come up with ways of conducting certain economic activities (like addressing externalities) without government – but the best solutions they come up with will typically turn out to functionally just be small-scale “governments” of a sort themselves, just without the explicit “government” label. And again, there’s a reason for that; the label itself is fundamentally an artificial one. The fact that the “market mechanisms” they come up with are functionally just mini-governments is not a coincidence, because government itself – the thing they think they’re trying to avoid – is just such a market mechanism in its own right. If you’re going to have a well-functioning market economy that does things like account for externalities, some kind of government (whether you use that label for it or not) will just inextricably be a part of it. As Alexander writes:

Suppose […] that I sell my house to an amateur wasp farmer. Only he’s not a very good wasp farmer, so his wasps usually get loose and sting people all over the neighborhood every couple of days.

This trade between the wasp farmer and myself has benefited both of us, but it’s harmed people who weren’t consulted; namely, my neighbors, who are now locked indoors clutching cans of industrial-strength insect repellent. Although the trade was voluntary for both the wasp farmer and myself, it wasn’t voluntary for my neighbors.

[Are] there are libertarian ways to solve externalities [like this one] that don’t involve the use of force?

To some degree, yes. You can, for example, refuse to move into any neighborhood unless everyone in town has signed a contract agreeing not to raise wasps on their property.

But getting every single person in a town of thousands of people to sign a contract every time you think of something else you want banned might be a little difficult. More likely, you would want everyone in town to unanimously agree to a contract saying that certain things, which could be decided by some procedure requiring less than unanimity, could be banned from the neighborhood – sort of like the existing concept of neighborhood associations.

But convincing every single person in a town of thousands to join the neighborhood association would be near impossible, and all it would take would be a single holdout who starts raising wasps and all your work is useless. Better, perhaps, to start a new town on your own land with a pre-existing agreement that before you’re allowed to move in you must belong to the association and follow its rules. You could even collect dues from the members of this agreement to help pay for the people you’d need to enforce it.

But in this case, you’re not coming up with a clever libertarian way around government, you’re just reinventing the concept of government. There’s no difference between a town where to live there you have to agree to follow certain terms decided by association members following some procedure, pay dues, and suffer the consequences if you break the rules – and a regular town with a regular civic government.

As far as I know there is no loophole-free way to protect a community against externalities besides government and things that are functionally identical to it.

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