Which Externalities Should Be Internalized?

Robert Frank's NY Times column on using Pigovian taxes as an "efficient" way to deal with the negative externalities of gas consumption has generated some interesting comments in the blogosphere. The article also points to an important question that has been bugging me for some time. But first, the interesting comments. First up is Gabriel Mihalache who points out an important assumption in Frank's analysis:

...A Pareto improvement [from imposing a Pigovian tax on gas consumption] means that afterwards, everyone is at least as well off (subjectively) as before and some are better off. But how can that be the case when we’re talking about taxing externalities, given that some people’s income is tightly tied with those activities?

The implicit, unstated, assumption of Frank’s article is that we could compensate the losers from the new energy policy from the gains of others. By the logic of what a Pareto improvement means, the gain to some is larger than the loss of others, so there exist potential transfers to compensate the losers and still leave the winners better off.

When supporters of free trade point out that the net losers from the full opening of borders could be compensated, with transfers from the net winners, the common criticism is that those transfers are both politically and institutionally unfeasible. There’s no mechanism we can trust that would identify the correct transfers (from whom, to whom, how much?) and make it in a way that’s politically acceptable.

I will unashamedly yield the same critique against Frank. He wants to seduce us with Pareto improvements but he only tells us half the story, less that half really… he mentions introducing the carbon tax but he remains strangely silent on the ways he’d use to compensate the losers.

Gabriel suggests we avoid resorting to the Pareto efficiency argument and say up front there may be net losers. Josh Hendrickson, meanwhile, also questions the usefulness of invoking Pareto efficiency and goes on to stress that the proper use of a Pigouvian tax requires a Herculean ability to properly assess social costs:

The problem inherent in any such analysis is the view of societal benefit and societal loss that is assumed to be easily calculated and dealt with through Pigouvian taxation. The ability to identify the social cost of a particular action is extremely difficult as each individual has his or her own subjective valuation. The problem is communicating each of these preferences in aggregate form to some central authority. This is a distinct problem in terms of both Hayekian knowledge and a neoclassical framework (Arrow’s Impossibility Theorem). In the absence of this ability, setting the tax rate is extremely difficult.

In short, both of these commentators suggest we should be more humble about our ability to (1) rigorously justify and (2) precisely implement a carbon tax. As noted above, Frank's column also points to another important question that I have been wrestling with for some time: exactly which externalities should be internalized? There are so many negative externalities in society so why stop at those created by gas consumption? Frank alludes to this in his article:

Gasoline is one of a host of goods whose production or consumption generates costs that fall on outsiders. Noisy goods, like leaf blowers, for example, can jolt whole neighborhoods from calm. And goods that don’t biodegrade readily, like many plastic bags, can generate costly waste streams. The list goes on.

Okay, then, why not tax noisy leaf blowers (noise pollution) or billboards along the highway (sight pollution) or rancorous, smelly, ugly people (noise, sight, and smell pollution)? Conversely, should we subsidize quiet neighbors, firms that do not advertise on highway billboards, and beautiful, well-kept people?

Now I am not advocating we tax or subsidize the above items. However, this list does illustrate the fact that society does choose to correct only certain externalities. So what is the decision criteria used in this process? Presumably it involves equating some margins; I am just not sure which one they are though. Any thoughts?

In closing, let me refer you to Peter Klein who, in the context of applying a Pigouvian tax to negative externalities, makes the following statement:

But my main beef with today’s Pigouvians is that they cherry-pick a case here and there — taxes on gasoline, primarily — without fully pursuing the implications of the analysis. If increasing gasoline taxes is efficient, why stop there? What other market failures should the state be empowered to remedy? Here’s my question, specifically:

Please name the activities you believe deserve Pigouvian subsidies. For each activity provide the efficient subsidy amount, explain how this was calculated, and say how the revenues should be raised.

Update: Mark Thoma and others provide answers here.

Does My Apartment Manager Understand Externalities?

I have been out of Texas for a couple of weeks and returned yesterday. Upon my return, I got a surprise notice from my apartment manager. Before I tell you what was in that notice, let me give you some background.

As noted before in this blog, I moved my family this past summer from Michigan to Texas. We moved into an apartment while we waited to sell our home in Michigan. Our home finally sold so now we are waiting out our one-year apartment lease and getting to know the area better. (I am also hopping the Nouriel Roubinis of the world are right when they say the housing recession has yet to hit bottom--I am ready to pick up a home at a bargain price this summer.) I am currently in a nice apartment complex that allows pets. The complex has pet waste collection stations place throughout the complex. There are also warning signs about being fined for not collecting and properly disposing of your pet's poop. Unfortunately, many pet owners are negligent in this area. As a result, most of the grassy areas in the complex are often not safe for walking. This development has become particularly frustrating for me since I have children who inevitably find their way into the grassy areas. The management has sent out many notices, but to no avail. Apparently, the marginal cost of collecting and disposing of pet waste exceeds any marginal benefit for many pet owners here.

In economics, the standard solution for correcting a negative externality like this is to somehow force the pet owners to internalize the cost they are imposing on me and other tenants. My solution for management was as follows:

(1) Every month, at some unannounced time, count the amount of poop. If it is too costly to go over the entire complex, then randomly pick representative locations throughout the complex.

(2) If the poop count exceeds a certain threshold--one must allow for the occasional pet pooping without the owner knowing--then all of the pet owners should be charged a higher rent. The greater the poop count the greater the excess rent.

I had been meaning to submit my idea to the complex, but never got around to it. The surprise notice I got upon my return, however, stated that going forward into 2008 pet owners will now be charged extra when there are excessive amounts of poop. The excess poop charge is probably not large enough, but management is on the right track and effectively forcing the pet owners to internalize the external costs they are creating. It is as if my apartment manager understood the concept of externalities.

A bigger point I take away from this experience is that best place to experience market failure is in your own backyard.