Plate i in print

The Smoke

the factory whose smoke dirties a stranger's wash: the cost that falls outside the bargain, the gap between private and social cost, and the too-much of every harm the price ignores.

Beside the costs a firm pays and the gains it keeps lie others it neither pays nor keeps — economies and diseconomies that fall upon its neighbors, and that no account of its own will ever show.

— the concept of this plate, after Alfred Marshall, 1890

The second of the failures begins with a factory and the wash on a line. The factory makes its goods and sells them at a price that covers what it spent — the wages, the coal, the iron. Downwind, a household's laundry grays with the factory's smoke, and the household bears a cost — in soap, in labor, in lungs — that it never agreed to and the factory never paid. That cost is as real as any on the factory's books. It simply is not on them.

The phenomenon is old in observation and was named in theory by the economists who first noticed that a firm's fortunes depend on more than its own dealings. Alfred Marshall spoke of external economies and diseconomies — the effects, good and bad, that one firm's activity visits on others outside any contract between them: the cluster of trades that makes skilled labor cheap for all, or the crowding and fouling that the growth of industry inflicts on a town. The defining mark of such an effect is that it travels outside the market, touching parties who are not party to the transaction that produced it, and so entering the price of nothing. It is a cost or a benefit without a bill.1

1. Alfred Marshall (Principles, 1890) introduced external economies and diseconomies — effects of one firm's activity on others outside any market transaction between them. The defining feature of an externality: it falls on parties not party to the trade, and so is reflected in no price. Arthur Pigou (1920) supplied the welfare analysis that follows.

Arthur Pigou gave the matter its decisive form, in the distinction between what an action costs the one who takes it and what it costs society entire. The factory's private cost is what it pays: its inputs. The social cost is that plus what it imposes on others: the smoke's damage to the households. When the two diverge — when the social cost exceeds the private — the factory, weighing only its private cost against the price it can charge, will produce wherever price covers private cost, and so will produce past the point where the goods are worth their true, social cost. It makes more of the smoking thing than it should, because a part of what that thing costs is borne by people whose suffering never enters its arithmetic. The divergence of private and social cost is the analytic heart of the externality, and the overproduction of the harmful is its first consequence.2

2. Pigou's divergence: private cost is what the actor bears; social cost is private cost plus the external cost imposed on others. When social cost exceeds private cost, the actor (equating price to private cost) produces beyond the efficient quantity — the overproduction of an activity with a negative externality. The gap is a deadweight loss.
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The argument runs exactly in reverse for benefits as for harms, and the symmetry matters, for the externality is not only a tale of pollution. When an action confers a benefit on bystanders — a benefit the actor cannot capture in any price — the actor, reckoning only the private benefit he can keep, does too little of it. The man who vaccinates himself protects not only himself but everyone he might have infected; yet he weighs only his own protection, not theirs, and so, left to the private calculus, too few are vaccinated. The orchard in bloom feeds the neighboring beekeeper's hives; the inventor's idea, once loose, enriches a world that never paid him; the educated citizen makes his neighbors freer and more prosperous. In each, a benefit escapes the price by flowing to those outside the deal, and because the actor cannot bill for it, he supplies less of the good than, all benefits counted, the world would want. Too much of what harms, too little of what helps: the externality cuts both ways, and the price misleads in both.3

3. Positive externalities mirror negative ones: when an action benefits bystanders in ways uncapturable in price — vaccination's herd immunity, Meade's classic orchard and bees, knowledge spillovers, education — the actor supplies too little, weighing only private benefit. The same private/social divergence yields under-provision. See The Vaccine, The Patent, The Network.

It is worth being precise about the failure, for it is not a failure of anyone's virtue. The factory owner is not a villain; he responds, sensibly, to the prices he faces, and those prices do not charge him for the smoke. The buyer is not a villain; he pays the price asked, which does not include the damage. No party to the transaction does anything but act on the costs it actually bears — and yet the outcome is one that no one would choose if all the costs were counted: more smoke, and more of the smoking goods, than the harm is worth; fewer vaccines than the protection is worth. Value is destroyed — the households' losses exceed the buyers' gains on the last units made — and destroyed not by malice but by the silence of the price, which omits the costs that fall outside the deal and so lets the market act as though they were not there. This is the externality as a market failure: an inefficiency produced by correct private behavior steering off a social cliff the price does not show.4

4. The externality is a failure of the price, not of virtue: each party acts correctly on the costs it bears, yet the outcome is inefficient because uncounted external costs are omitted. The deadweight loss is value destroyed — marginal external harm exceeding marginal private gain — arising from the price's silence, not from malice. This distinguishes it from a moral wrong.

If the price is silent because the cost falls outside it, the cure must somehow bring the outside cost in — must make the factory feel the smoke, or the vaccinator reap the protection he confers. How to do this is the matter of the plates that follow, and the great division of the field. One school, after Pigou, would mend the price by law — tax the smoke, subsidize the vaccine — so that private cost is forced to equal social cost and the market, its arithmetic corrected, chooses rightly of its own accord. Another, after Coase, would deny that the smoke has a culprit, and ask instead who holds the right to the air, and whether the parties might simply bargain. Between them lies the volume's argument, and beneath both lies its question, the plainest in the family and the one the flagship must answer: who pays for the smoke, when the price of the goods does not?5

5. The remedy must internalize the external cost — make the actor bear it. Two approaches contend: Pigou's corrective tax and subsidy (The Levy) force private cost to equal social cost by law; Coase's analysis (The Neighbor) reframes the harm as reciprocal and asks about property rights and bargaining. The volume's question — who bears the uncounted cost — is answered in the flagship, The Boundary.

The smoke, then, is the externality in its plainest dress: a cost as real as any, borne by those outside the bargain, and therefore counted by no one and priced into nothing — so that the market, steering by a price that does not include it, makes too much of the harm and, in the mirror case, too little of the good. It is the second of the failures because it is the most visible: one need not understand a market to see the soot on the wash. The plates that follow take up the cures — the tax that would price the harm, the bargain that would trade it, the market in permits that would own it — before the flagship returns to ask what, at bottom, an externality is, and finds that it is nothing but the world the price has been left to ignore. The next plate begins with the boldest cure: to mend the price by main force, taxing the harm until the factory feels in its purse what its smoke costs the world.