Thom Lambert Has Never Heard of Positive Externalities

This is for the non-lawyers and non-economists … which, I imagine, leaves very little audience left for this blog, but what the hell.

Thom Lambert writes:

The upshot of today’s editorial, Let Them Go Green, is that the federal government should “throw its weight behind” (i.e., subsidize) private efforts to develop alternative energy technologies. Specifically, Washington should use “loans, grants, or targeted tax breaks” to encourage companies to develop alternative fuels.
Why? As the Times observes, this sort of investment is already occurring at an unprecedented rate. Goldman Sachs, the Times notes, has recently invested over $1 billion in alternative fuels, and it is not alone: “Goldman is only one of a growing number of investment and manufacturing enterprises chasing emerging technologies that could help provide the alternative energy sources that politicians from President Bush on down say they want and that the country will certainly need in years to come.” Indeed, the Wall Street Journal recently reported that venture capital is pouring into alternative energy technologies.

This is happening, of course, because of high and rising oil prices. That’s the way markets work. When the price of a commodity rises enough, enterprising entrepreneurs scramble to develop a cheaper substitute for that technology, and investors provide them the capital to do so. Thus, high energy prices will lead to increased investment in alternative technologies without government intervention. The Times complains that “a tax credit to encourage wind power is set to expire next year, at a time when high energy prices are raising interest in that clean technology,” but isn’t that as it should be? If high energy prices are pushing entrepreneurs into new technologies, why should the government try to do so?

Well, actually, Thom has got the facts wrong. Goldman isn’t investing in alternative technologies because of rising oil prices. It’s investing in them because it predicts that governments will enact regulations requiring greener technology, and the companies that get in early will do better in the long run under a system of regulation.

Leaving that point aside, as any first-year law student learns in his tort class, the theory goes that a rational market actor will be profit-maximizing. He or she will adopt just as many good and safe improvements to his business as will increase profits relative to costs — and then stop. So, for example, if I make widgets, I will improve my widgets to the point where my profits increase as a result of increased sales, but if an improvement is so expensive that I have to increase costs beyond what people are willing to pay, I won’t adopt that improvement.

In a perfectly functioning market, that’s a good thing. People are willing to pay, the theory goes, exactly what a product is worth; if they won’t pay above a certain amount, then the “improvement” contemplated by the manufacturer just isn’t worth the cost. Therefore, through supply and demand, the purchasing public will make clear exactly what does and does not have value; the manufacturer will respond accordingly, and a widget will be produced that perfectly matches improvements relative to cost.

Except, even the theory recognizes a hitch: Positive externalities — or, more commonly, collective action problems. The simple model assumes that for every improvement the manufacturer makes, he or she is rewarded with increased sales, up to the point where society no longer values the improvement. That kind of feedback tells the manufacturer when to stop making improvements.

But sometimes a manufacturer, who is the only one making the decision about what to improve, does not reap all of the benefits of the improvement. If people other than the manufacturer, and the purchaser, reap benefits, then the manufacturer does not get the feedback he needs to determine when sufficient improvements have been made.

So, for example, I might manufacture cars and I have to decide what kind of safety devices to install. And the perfectly rational buyer who doesn’t actually care about his own pain and suffering may calculate to the penny exactly the point when it’s worth it to him, personally, to risk injury rather than pay for additional safety. But neither one of them is taking into account the fact that when drivers, en masse, drive in unsafe cars, society as a whole bears the costs in terms of ambulances and public hospitals, traffic snarls, etc. Those costs, which can be alleviated by additional safety measures, are not considered in the calculus of either manufacturer or purchaser. So, the manufacturer does not have sufficient information or incentive to determine the perfect point at which the cost of additional safety devices outweighs the benefits.

In legal parlance, this is called a “positive externality.” Positive means there’s additional “good” that comes of the improvement, and it’s “external” to either manufacturer or purchaser. Society benefits as a whole if we all spend a little extra money to improve safety, but any one person who decides to make the improvement, by himself, suffers additional costs without reaping the full benefit.

The same situation exists when it comes to the environment. An individual buyer and manufacturer will not, by themselves, do very much to help the environment no matter what kind of improvements they make, and whatever good they do manage to do benefits society as a whole and not them personally. Perfectly rational actors will figure that it’s not worth it to bear the full costs of an improvement while not reaping the full benefits — the full benefits, of course, go to society as a whole — and they’ll skip it.

Tragedy of the commons, in a way.

Environmental issues are, for this reason, exactly the kind of thing that government needs to regulate. It’s not about oil prices; it’s about global warming and whether we can breathe in 50 years. And Goldman, an individual company, does not have the same incentive to see that the entire planet is able to keep breathing that, well, the entire planet has. That means that Goldman will not invest the same amount of money that the entire planet would invest, and that means that government needs to step in to correct the imbalance.

Of course, all of the foregoing is bullshit, because people aren’t rational actors, and they don’t have perfect information, and why on Earth would an executive invest in a technology that reaps benefits in 50 years when he personally will retire on his back-dated stock options …. but as long as we’re in a fantasy life….