The argument of the volume
A price, the first family insisted, is never the innocent measure it appears; but it is at least, we assume, a measure of the thing's whole cost — pay it, and you have paid for everything the thing took to make. The externality is the discovery that this is false. The price a factory charges covers what the factory pays — its labor, its materials, its fuel — but not what its smoke costs the households downwind, who pay in soot and sickness and were never asked. That cost is real, but it falls outside the transaction, on parties who are not party to it, and so enters no one's reckoning: not the factory's, which does not bear it, nor the buyer's, who is not charged for it. The price is silent about it, and because the price is silent, the market behaves as though the cost did not exist — and makes more of the smoking thing than, all costs counted, it should.
The point is perfectly general, and runs in both directions. Wherever an action visits a cost on a bystander — the smoke, the noise, the congestion, the carbon — the actor, bearing only his private share, does too much of it, for the part of the cost that falls on others does not stay his hand. And wherever an action confers a benefit on a bystander — the vaccine that protects the unvaccinated, the orchard that feeds the neighbor's bees, the research whose fruit the whole world reaps — the actor, capturing only his private share, does too little of it, for the part of the benefit that flows to others does not fill his purse. In each case the divergence between what the act costs or yields the actor and what it costs or yields society is the measure of the failure, and the market, steering by private reckoning alone, steers wide of the social optimum: too much of what harms, too little of what helps, and a price that, either way, does not tell the truth about the whole.
That a price can be wrong in this way invites the question of how to make it right, and a century of argument has turned on two answers. The first, Pigou's, is to mend the price by force of law: tax the harm by exactly its cost to others, subsidize the good by exactly its worth to them, and the corrected price will at last carry the whole social cost, leading the market, by its own logic, to the right amount. The second, Coase's, is more unsettling, for it denies that the harm has a culprit at all: the smoke harms the laundry only because the two are neighbors, and the harm is the joint product of both their activities; assign a clear right to one or the other, Coase showed, and — could they but bargain freely — they will reach the same efficient outcome whichever way the right was assigned, with no tax required. Between the tax that prices the harm and the bargain that trades it lies the whole modern science of the externality, and beneath both lies the deeper discovery this volume builds toward: that the very line between what the price counts and what it omits is not fixed by nature but drawn by property, and moves as the law moves it.
The argument remains open. What follows is an attempt to fix its exact edges.
The twelve plates of this volume
- i The Smokein print 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. Read the plate →
- ii The Vaccinein print positive externalities and the good the market makes too little of; herd immunity, the subsidy, and the spillovers of knowledge and health. Read the plate →
- iii The Levyin print Pigou's remedy: a tax set equal to the harm, a subsidy equal to the good, so that the price at last tells the whole cost and the market, corrected, wants the right amount. Read the plate →
- iv The Neighborin print Coase's reply: that the harm is reciprocal and has no villain, and that neighbors with clear rights and a way to bargain will reach the same efficient end whoever the law first favors. Read the plate →
- v The Permitin print the missing market made: property in the right to pollute, a cap, and a price found by trading it — the externality internalized not by the state's tax but by a market in the harm itself. Read the plate →
- vi The Holdoutin print the limits of the bargain; transaction costs, holdouts, and the free rider, and why the multitude that a harm touches can rarely negotiate at all. Read the plate →
- vii The Highwayin print congestion as an externality; the road, the bridge, the crowded network, and the toll that Vickrey would set to price the delay each adds to all. Read the plate →
- viii The Boundaryin print the deepest turn: that what counts as 'external' is set by where the law draws property, a line that moves as it becomes worth moving — so the price omits not what cannot be priced, but only what no one yet owns. Read the plate →
- ix The Patentin print the spillover of ideas, and the patent that fences them; the appropriability problem, and the trade between the spur to invent and the freedom to use. Read the plate →
- x The Networkin print Arthur; increasing returns to adoption, the paths history selects, and the alternatives a network can close off. Read the plate →
- xi The Contagionin print systemic externalities; the risk one firm's gamble visits on the whole, financial contagion, and the case for taxing fragility. Read the plate →
- xii The Atmospherein print the great externality: a harm spread across every border and every generation, the global commons, and the boundary no single nation can draw. Read the plate →
In closing
This volume took up the second way a market fails: not in the gap between what one party knows and another cannot, but in the gap between what a transaction costs its parties and what it costs the world. The externality is the cost or benefit that escapes the price by falling on a stranger to the deal — and because it escapes the price, the market, which steers by price alone, ignores it, making too much of every uncounted harm and too little of every uncounted good.
The diagnosis, the volume showed, is the divergence of private from social cost: the factory weighs the smoke's cost to itself, which is nothing, not its cost to the neighbors, which is real, and so it smokes too much. Against this the age has set two remedies. Pigou would have the state mend the price directly — a tax equal to the harm, a subsidy equal to the good — so that the private reckoning is forced to carry the social cost, and the market, its arithmetic corrected, chooses the right amount of its own accord. Coase replied that the harm has no villain, being the joint creation of both neighbors, and that where rights are clear and bargaining is cheap the parties will trade their way to the efficient outcome with no tax at all — so that the externality is less a wrong to be punished than a sign of a missing market, and the cure may be to supply the market, by defining the right and letting it be traded, as the permit schemes do for pollution.
And then the volume turned on the ledger itself, and found the deepest thing there. We speak of costs that 'escape' the price, as though the price were a net with holes; but Coase's and Demsetz's turn is that the price has no holes — it counts, exactly and only, what is owned, and is silent about exactly and only what is not. What we call an externality is simply the world that lies outside the current boundary of property; and that boundary is not given by nature but drawn by law, and redrawn whenever the gain from drawing it at last exceeds the cost. The smoke is an externality only because no one owns the air; grant someone the right to it, and the smoke acquires a price like any other. So the question of who pays for the smoke has, at bottom, a legal answer and not a natural one: the smoke is paid for by whoever the law has declined to give the right — and that, the volume's subject reveals, is a choice, not a fact. The first family found that a price conceals a contest over who gets what. The failures family finds that the price is partial as well as unfair: the asymmetry showed it cannot convey what is hidden; the externality shows it cannot count what is unowned; and the commons, the family's last, will show it cannot defend what is shared. The price, for all its genius, keeps only one ledger — the ledger of the owned — and the world it leaves out is exactly as large as the world we have declined to enclose.
If the price omits not what cannot be priced but only what no one yet owns, then every externality is a question the law has left unanswered — and the choice of what to leave outside the price is the choice of who shall bear it. Who, then, should own the smoke?