Economics in Two Lessons, Chapter 10

by John Q on May 16, 2018

Thanks to everyone who commented on the first nine chapters of my book-in-progress, Economics in Two Lessons.

Here’s a draft of Chapter 10: Market failure -Externalities and pollution. Comments, criticism and praise are welcome.

The book so far is available
Table of Contents
Chapter 1: What is opportunity cost?
Chapter 2: Markets, opportunity cost and equilibrium
Chapter 3:Time, information and uncertainty
Chapter 4:Lesson 1: Applications.
Chapter 5: Lesson 1 and economic policy.
Chapter 6: The opportunity cost of destruction
Chapter 7: Property rights, and income distribution
Chapter 8:Unemployment
Chapter 9: Market Failure

Feel free to make further comments on these chapters if you wish.



Anarcho 05.17.18 at 10:17 am

Of course, from the perspective of neo-classical and Austrian economics, the fundamental problem is that breathable air is a free good, so inherently economically irrational. People are not able to put a price on air — so the destruction of the environment is actually economically rational for it will allow the atmosphere to be enclosed (air will be supplied on the market by companies) and so will allow consumers to rationally decide if they “value” breathing more than eating, and adjust their utility-maximising activity appropriately….

More seriously, the environment does seem to bring out the inherent contradictions of propertarianism like few others (E.4 Can laissez-faire capitalism protect the environment?).


Peter T 05.17.18 at 10:41 am

Minor point:

“The best estimates are that, if the concentration of CO2 and other greenhouse gases can be held below 450 parts per million (ppm) the mean global temperature will ultimately rise by 2 degrees Celsius or less.”

I think this need re-phrasing. It’s the current conservative estimate, and it’s looking likely to be overtaken (for the worse).

Larger point:

Not in all, but in many areas, externalities are where the logic of economics breaks down, and it might be simpler for the reader to acknowledge this. Where there is no cost that can be measured in money, no compensation that can be given (or would be taken) in money, no calculation at the individual level, then there is no solution within the bounds of economics as currently practiced. There is no price – no point at which one can buy or sell, no sale in fact at all. One moves from money to broader, inevitably more subjective measures of value, and from individual calculation to collective purposes. I’ll reiterate that this does not apply to all externalities, but it applies to many, and to many of the most important ones (there can be no price on the survival of humanity, in the case of extreme climate change – who would it be paid to?). We banned CFCs – we did not negotiate a price at which the costs of producing them equated to the harm done.

Neither one or two lesson economics can tell you to value the future prospects of other unknown people above one’s present wealth. It’s not market failure, it’s not a market at all. May be easier to just say so.


cervantes 05.17.18 at 2:20 pm

Externalities are not exceptions. They are ubiquitous. It is difficult to imagine a transaction that doesn’t entail externalities. Every time I go to the grocery store I contribute to greenhouse gases and NOx and particulate pollution, and traffic congestion; my groceries obviously generated immense externalities in growing, processing and shipping; and of course a lot of it will end up as trash, methane and sewage. It is fundamentally wrong to treat this as a special case. Market failure happens virtually 100% of the time. Markets always fail, in this sense. It is a fundamental property of markets.


RichieRich 05.17.18 at 4:00 pm

A little behind the curve, here are some comments on the “Introduction”!​​​​


I find “Introductory” a slightly odd title​ and ​prefer “Introduction”.

I think it’s ​a little odd to have​ a​ “Preface” as a sub-section of an introduction.

In the first para after the quote, I think “in the quote above” is unnecessary. To use “third” in the third question ​strikes me as a little odd, when “first” and “second” haven’t made an appearance.

In the second para you write​​​

​Readers have embraced the message that all economic problems have a simple​ answer, and one that matches their own preconceptions.​

​​But surely not all readers’ preconceptions will match th​ose​ of Hazlitt​?​ Yours certainly don’t!​


In the third para you write​

​The central question, which will be the main focus of this book, is whether the prices of goods and services reflect all the costs involved for a society in providing those goods and services, summed up in the concept of ‘opportunity costs’. ​

​Here, “opportunity cost” seems to ​be ​defined as “all the costs involved for a society in providing those goods and services”. Let’s call this definition D1.

On p3, the opportunity cost of a choice is defined as the value of what’s given up in order to make that choice (D2). Presumably, D1 and D2 must be equivalent, but it’s not obvious to me – a​s​ someone who studied​ a very little economics a very long time ago – that they are​. A​nd I wonder whether it will be to the uninformed reader.


In the first para you write​

​ Hazlitt assumes that market prices always reflect opportunity cost, and this assumption drives all his conclusions.

​My memory of the little economics I studied a long time ago is that D2 is the standard definition of opportunity cost. If so, then I wonder whether the uninformed reader will be able to make sense of the idea of price reflecting opportunity cost. The idea that the price of a widget reflects the value of what’s given up in order to produce that widget is not (IMHO) intuitively obvious.

The second question on p1 is “Why two lessons instead of one?” Your answer to this question in the fourth para on p3 is “we need Economics in two lessons”! From the previous para, I think what you mean is we need a second lesson to discuss the important limitations of the market.

On p2 you restate Hazlitt’s lesson as​ ​​

​Once all the consequences of any act or policy are taken into account, the opportunity costs of government action to change economic outcomes always exceed the benefits​.​​

​Then on p3 you say​

​The first lesson, implicit in Hazlitt’s is:

Market prices reflect and determine opportunity costs faced by consumers and producers.

​In other words, on p3 you’re saying that there’s a first lesson implicit in Hazlitt’s restated first lesson! This strikes me as ​all ​getting ​a little complicated​!​ Are you making a distinction here between your first lesson and Hazlitt’s?

Also, at the top of p3 you talk of prices reflecting opportunity costs, whereas in ​the Lesson 1 summary ​on p3, prices both reflect and determine opportunity costs.


In para 2 you talk of “social opportunity costs”? Is this the same as “opportunity costs”? If so, why complicate matters with two terms? If not, this needs explaining to the reader.​​


In para 2, prices are no longer reflecting, or reflecting and determining, but, instead, are determining opportunity costs!​​


Robert 05.17.18 at 6:37 pm

As usual, I am commenting without having done the reading.

In thinking about cost and benefits of natural resources, lack of pollution, etc., economists can quantify such costs as decreased income acquired from tourism, hunting and fishing, etc., Not all costs and benefits can be internalized in a market.

Those advocating a deep ecology perspective might argue that unquantifiable benefits might exist in keeping some areas “forever wild”, a phrase that is used in New York State sometimes in discussing the Adirondacks. The idea is that there is a value to maintaining some ecosystems of sufficient size, even if they are inaccessible to human visitors, outside the price system.

I am probably expressing that badly. Perhaps Michael Sandel has something to say along these lines in his book, “What Money Can’t Buy”, which I only know through reviews.


Robert 05.18.18 at 11:52 am

My name links to a defense of David Suzuki on externalities.


John Quiggin 05.18.18 at 3:20 pm

@6 I’ve been underwhelmed by Suzuki ever since I attended a public lecture in which he recapitulated Malthus at some length and followed up with “Of course, no economist would ever think of this”. Based on a quick reading, the linked article is more of the same.

I’m much more sympathetic to Sandel: I don’t think everything in the world should be viewed through the lens of economics.


John Quiggin 05.18.18 at 3:24 pm

@1 “the environment does seem to bring out the inherent contradictions of propertarianism like few others” Agreed! I’ll try to say more on this

@2, @3 I hope to bring some of this out in Part IV, when I talk about policy responses

@4 Thanks! I’ll post a further revised version, taking account of at least some of these comments.


Mike Huben 05.18.18 at 4:09 pm

‘external’ economies of scale is not defined well or in an appropriate location.

“with effects that aren’t mediated by markets.” will not b e clear to most people. Better to say “that affect other people (not participating in that market.)”

Positive externalities are given short shrift here. You neglect zoning, auto safety regulation, law enforcement and military defense.

“Externalities may arise between production and consumption activities, or between producers, consumers and households …”
This sentence assumes people already know a great deal. It doesn’t clarify anything. What do you mean by “between”? Perhaps you mean: “All activities (production, consumption, household, etc.) can cause externalities for others.

“The key feature of an externality is that the person who is affected has no say in the matter, and therefore cannot demand a price to offset the negative effects of the actions of others.”
This could be better written as “is affected without consent”, because often the affected party later has a say in court or in the legislature.

“More complex cases arise with congestion “: you need examples, such as traffic jams and greater communication opportunity with more participants that leads to monopolies in telephones, facebook, etc..

“As Pigou observed,”
rational individual economic behavior is to privatize profit, socialize costs. That’s a simple but clear way to put it, that you might want to include.

pure public goods and club goods and inbetween
The Theory of Externalities, Public Goods, and Club Goods
Do you REALLY want to talk about pure public goods, when almost all the examples you can name are really club goods? Libertarians routinely point out that pretty much everything is excludable. Defense excludes outsiders by definition, and insiders could be expelled. Roads are rivalrous when congested. Etc.

You seem to miss clearly stating the important point that public goods and club goods will be UNDERPRODUCED by markets because of lesson 2.

The example of the advertising model for TV programming is also important: as a way of increasing production but also as a mispricing. The cost to viewers (displeasure and time wasted by advertising) is MUCH higher than the cost of production of the TV shows. US television revenues are on the order of 50 billion. Does that mean that
we’re paying roughly $200/year per capita to watch shows with commercials?
Doesn’t that mean we could pay less than a dollar a day and get entertainment
without commercials? How much is your time worth? Why are we not demanding direct pay for our eyeballs?

“Water pollution was as bad or worse.“ You might want to list sewage, and industrial contamination with heavy metals, acids, dioxins, petrochemicals, etc.

“Pollution is part of the social opportunity cost of production.” People will say “so what” unless you tell them the really big numbers involved. Get some ecosystem services numbers. Get some numbers from expected costs of rising sea levels and disruption of agriculture.

Another example of auto pollution was lead emissions. Likewise lead paint. Estimate some costs there also, in terms of stunted intelligence and greater crime rates.

Where do you clearly say that people do not pay for releasing CO2 and methane, and thus lesson 2?

You might want to point out that acid rain and CFC pollution were solved by government action, because markets couldn’t solve it due to lesson 2.

“the work of Ronald Coase,” required clearly defined property and legal protection, which does not exist for the atmosphere internationally.

Footnote 8 is about climate change, but the sentence it footnotes is about tobacco. Some of the same players were involved, but they are different.

Another major problem is time shifted opportunity costs not reflected in prices (or discounted), such as later disease and lower salaries from cigarette smoking or CO2 now affecting climate in the future.

10.5: ah! There’s the description of externalities of scale.

Further Reading:
Needs The Theory of Externalities, Public Goods, and Club Goods, Cornes, Richard, and Todd Sandler

Once again, every paragraph should be checked to see whether it relates clearly and directly to lesson 2 TO A NON_ECONOMIST READER.

Also, you may want to point out in a final chapter that there are OTHER lessons besides 1 and 2, and list a few of them.


Kenny Easwaran 05.18.18 at 5:07 pm

At the end of 10.1 you say “There are, however, good reasons for expecting negative externalities, such as pollution, to predominate.” What does this mean? Is it just that positive externalities tend to be undersupplied while negative externalities are oversupplied, so the negative ones dominate? Or is there some reason to believe that two-party transactions are more likely to cause negative impacts to third-parties than positive impacts to them?

At the end of 10.2 I was confused by this sentence: “If the price is equal to the benefit received by the provider, it will be below the benefit for society as a whole.” I see now that part of my confusion was that I was thinking of the “provider” of a public good as someone other than the beneficiaries, but now I see that you mean that a person who wants to invest in producing the good for themselves will create much more good for others than the good they will be able to earn. In any case, it might be confusing to some readers to see why it’s a problem that the price of a public good is less than the benefit it provides. It might be helpful to be explicit that some goods (like a park, a neighborhood cleanup, or the creation of an educated middle class) might be too expensive for any one person or institution to want to invest in by themselves, but might be much less costly if provided communally than the total benefits that would accrue to all, and thus they are unlikely to be produced even though they are quite beneficial.


John Quiggin 05.18.18 at 6:54 pm

@10 Is it just that positive externalities tend to be undersupplied while negative externalities are oversupplied, so the negative ones dominate?

Yes, that’s it. I’ll look to see if I can write more clearly.

“Provider”: I think actually the confusion was mine, and your explanation is a good one. Public goods can be provided by the state. But where the beneficiaries collectively produce it, “contributor” is the better term.


John Quiggin 05.18.18 at 6:56 pm

@9 Thanks, Mike. Helpful and insightful comments, as always


Philip 05.19.18 at 8:16 am

I felt the section on public goods broke up the discussion of externalities and didn’t really lead anywhere. I think Mike Huberon’s suggestion to state the problems more explicitly is a good one. I’d talk more about positive externalities too, especially stating that education and healthcare would be under provided by the market. Are you avoiding bringing up healthcare to avoid the US debate.


John Quiggin 05.20.18 at 11:16 am

@13 I have some draft material on health and education, but I’m thinking about omitting it for space reasons and to get the book done.


Robert 05.20.18 at 2:05 pm

Sraffa (1926) argues that that increasing returns are compatible with the supply curve in a partial equilibrium model if they are internal to the industry, but external to the firm. I don’t know if you need to bring up this question of what an externality is external to.

Paul Romer (1990) has a discussion of non-rival and non-excludable goods that makes these properties seem a lot less binary.

Maybe you might say something about joint production. If one creates a market in pollution, those who produce the pollution will be jointly producing the product with some other good. A standard example of joint products is wool and mutton. Joint products present difficulties in accounting in allocating costs, particularly overhead costs. Does the literature on externalities adequately treat this issue? Is this a serious practical difficulty? I don’t know what economists think the answer to these questions are.

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