If you want an economist to support a government intervention, then there are two major sets of logic that they generally find attractive.

The first concerns rate of return and attracts narrower support. If the government can invest in a project in a way that the private sector couldn’t/wouldn’t and the payoff is bigger than the investment by enough, then the project should be built. 

The second set of logic is more accepted more broadly. If there is an externality, and the administration costs are small relative to the change in the externality, then the project should be pursued in order to increase total welfare.

I’m going to criticize and refine the second argument.  I was inspired by a student who wrote about education creating positive externalities for “all”. They kept using the word “all”. And I notated each time “not *all*”. While we might refer to something called ‘social’ cost and value, the existence of externalities does not imply that everyone is affected by the them identically. That’s a representative agent fallacy. The externalized costs and benefits are often irregularly distributed among 3^rd parties. This is important because government intervention can impose its own externalities depending on how the administrative costs funded.

I’ll elaborate with two examples that illustrate when an irregular distribution of externalities is a problem and when it isn’t a problem.

Electric Plant Pollution

The first example illustrates how resolving an irregular distribution of externalities can be resolved without issue. Consider a coal-powered electric plant that serves a metropolitan area and creates pollution. That pollution drifts east and passively harms residents in the form of asthma exacerbation and long-term ill health. The residents to the west are unaffected by the pollution, thanks to favorable weather patterns. Obviously, one would rather live on the west side, all else constant (importantly, all else it not always constant and there is a case to be made that there is no externality here).

To resolve the externality, the government imposes a tax per particle on the power plant at a low administrative cost. That’s nice and efficient – we won’t waste our time with means-oriented regulations. In turn, the cost of electricity increases for all metropolitan residents, both those in the east and in the west. Why is this appropriate? Prior to the intervention, the electricity users in the west were enjoying electricity at a low price, failing to pay for the harm done by their consumption. For that matter, the residents to the east are also paying the higher rates, but now they enjoy better health.

In the end, the externality is resolved by imposing a cost on all consumers of the good – which happens to be everyone. This circumstance is not pareto efficient, but it is Kaldor-Hicks efficient. Everyone now considers the costs that they were previously able to impose on others and ignore.

That’s the best case scenario.

Continue reading →