Hi, everybody. Welcome back. In this lecture, I'd like to introduce a concept that will concern us over the next several lectures and one that's really central to the entire field of economics and law and that concept's externality. We'll talk about externality in the context of an extended example involving a steel plant which tosses pollution into the air. And that's why I've chosen this particular picture with which to open our talk today. But in fact, the idea of externality is one that incorporates and uses many of the ideas that we've been talking about up to this point in the course. Externality in this sense is a kind of unifying concept that relates transactions cost to property rights and to the achievement of efficient allocation which you'll recall, means a situation in which all property rights are held by their highest valuing owner. So, let me take a couple of cracks at defining externality in the context of what I'll call and indeed what economists call, external costs. And I'll, in fact, attempt two different definitions, each in the same direction, but each emphasizing slightly different aspects of the relationship between externality transactions cost and property rights. So, here's a first crack at defining externality. The first clause of the definition of externality, like the first clause of the definition of the co-styrum, has to do with the condition. When property rights are not defined or respected or when high transaction costs block existing rights from reaching their highest valuing owners through free exchange, some costs or benefits will remain external to the system of free exchange which means that markets will fail to allocate resources efficiently. Let me unpack this definition and talk about each of the separate elements of it. Property rights, as we have seen, are sometimes controversial and they're sometimes unclear. It's not always clear who owns a particular right. And when it isn't clear who owns a right, it's never certain who has to negotiate with whom. And this uncertainty makes it very difficult, indeed, impossible for negotiations to take place for the transfer of the property right. We have to know, before a transfer and negotiation can take place, who owns the right initially and therefore, who has the owness of purchasing it from the other person. It's also, obviously, the case often that property rights are not respected. Even when it's clear who the owner of a particular property right is, there are, as luck put it, unreasoning people in the world. There are thieves who would in fact steal other people's property rights. So, when property rights are not defined or respected or when high transactions cost block existing rights from reaching their highest valuing owners through free exchange, that is, when the sorts of things that we've associated with frictions in transacting. Discovering what it is that you want, seeking out potential trading partners, negotiating terms of trade and physically consummating the transfer of goods in the exchange, all of these are fraught with costs. When those costs are sufficiently high, as we've seen in Posner's corollary, they may block property rights from reaching their highest valuing owners by blocking the exchanges which are necessary to move the right from lower valuing to higher valuing owners. When either of these things happens, when property rights are not defined or respected or when high transactions cost block rights from reaching their highest valuing owners from exchange, then, the cost that use of those property rights imposes upon other people remain external to the system of free exchange. Typically, when the system of exchange is working well and I surrender a property right to you, I'm compensated for the cost that I bear in surrendering that property right by the mutually agreed upon compensation that you pay me for the property right. When such a transaction has occurred, I bear costs from losing the property right that I transfer, but I'm made whole, as it were, compensated by the payment from you that we've agreed upon for the transfer of the property right. Given such a circumstance, the costs of my losing the property right to me are internalized in the exchange system through the exchange that results in the payment of compensation to me. But costs remain external when the second half of that exchange is left uncompleted. A cost remains external when I lose a property right and thereby, suffer the cost of losing that property right, but the person who takes the property right does not pay compensation to me. An external cost is, thus, an uncompensated cost. Uncompensated in terms of what the individual who has the lost the right receives, but also uncompensated because the person who has taken the right, gets to use the right for free without having to pay compensation. And the result of my losing the property right with compensation, so that somebody else can use the property right without paying me for it is an inefficient allocation of rights, typically, an inefficient allocation of rights. Such external costs will generally keep property rights from gravitating to their highest valuing owners. We could try another crack at the definition of exernality, which is the same definition, but emphasizes slightly different aspects of the definition. Externality implies that costs, that is, disutility suffered by people who have lost something at the hands of someone else. Externality implies that costs that should, for efficiency's sake, be incorporated into market prices are not incorporated into market prices due to the absence of property rights or high transactions costs. And when this occurs, first, the costs that are borne by some people in order to produce value for other people, are not compensated. And here, I'll introduce a new word, an awkward word, retributed. That is to say, compensation in this sense for the loss of a property right is much like retribution, a concept that we use typically to talk about offenders convicted of crimes who are now asked to pay a cost, to go to jail as it were, for their crimes. And the justification for requiring convicted offenders to undergo a costly act, a costly incarceration, costly for them, is retribution that they are, in a sense, being paid back for the costs that they have imposed upon others. In a situation of externality, the cost that are imposed by some on others are not compensated, so that the user of a property right pays no retribution for the cost that, that use of the property right has imposed. And when that happens, there are inefficienlty high levels of the cost imposing activity. And that's because the person who is taking the property right doesn't have to pay for it. And because he or she doesn't have to pay for it, they are likely, almost certain to use more of it than they would have used if they'd actually had to pay for it. One of the functions of having to pay for something. One of the functions of prices is to keep people from consuming everything in sight and to force them to order their consumption priorities. To choose what's more important for them. And then, to allocate their limited income to meeting what they perceive to be the greatest of their needs. Obviously, in such a formulation, people want as much as they can get of most of the goods that are out there, but they're constrained in how much of the goods they can take by requirement that they can't take them unless they pay the cost of producing those goods, a point that we'll return to later in the course. And so, if in an externality situation, somebody is able to impose costs upon other people by taking their property rights without compensating them, they are likely to take more of those property rights than they would take if they had to pay that compensation and that will lead to an inefficient level of cost imposing activity. That is to say, more cost imposing activity will take place. Then, can actually pay for itself in terms of the willingness of the cost imposer to bear the costs of the cost imposing activity. There's one important qualification to this definition of externality that is crucial to keep in mind in all of the discussions that we'll be having till the end of the course. And that is that not every situation in which somebody imposes costs upon other people and doesn't pay them compensation for that imposition, not every such situation rises to the level of an externality. That's the importance of property rights. Whether costs are deemed external or not, depends on what the law says about the initial placement of property rights. That is, what costs are deemed external depends on the law's assignment of rights. On the social decision as to what costs people must bear on their own without compensation and alternatively, what costs they have a right to be free of. In ordinary life, people do all sorts of things that impose costs upon other people. But in only some of those cases does the law forbids them from doing that, so that they will have to pay some sort of punishment for compensation for having committed the activity. In some cases, people are allowed to impose costs upon other people even if the cost barers don't like it and wouldn't suffer those costs voluntarily because the law has made a decision that it is socially beneficial to allow people to impose such uncompensated costs. Let me close this lecture by giving you an example of the importance of the law's position in defining whether an externality actually exists or not. Suppose I have a mouse trap factory and I've been happily building mouse traps and selling them in a particular way for the past 20 years. But now, I suppose, a competitor has taken an action which has completely destroyed the value of my business and the competitor proposes to destroy the value of my business for his own purposes without paying me compensation. So, the question before the floor is can my competitor destroy my mousetrap business for his own benefit without paying compensation to me? Ordinarily, our instinctive response might be, well, of course, he can't destroy your business for his own purposes without compensating you. He will have taken something of value away from you and justice would seem to require that he pay you compensation for the loss that his activity has imposed upon you. But in fact, the law takes a subtler position than this. And the law argues that you can destroy my mousetrap business for your own benefit without compensating me if you do it in a certain way. But you may not destroy my business if you do it in another way. So, for example, one way that my competitor could completely destroy the value of my business is to plant a bomb on my factory floor in the middle of the night, explode the bomb and destroy the factory building. If such a thing happens, then in fact, my business has been destroyed completely, but the perpetrator of this crime will not, we hope, get away with it. The law does not allow one person in pursuit of his own interests to destroy the business of another person by planting a bomb on the factory floor. The reasons for this might seem obvious. It's dangerous to plant bombs, it's, it can destroy all sorts of things in addition to the value of the business and, indeed, as everybody knows, it's just a horrible thing to do. It's a nasty thing to do, to plant a bomb and destroy a competitor's factory in this particular way. But on the other hand, suppose my competitor, instead of planting a bomb on my factory floor, figures out a way to produce mousetraps that are identical to mine and are sold more cheaply than mine or he's figured out a way to produce a better mousetrap than mine that he's able to sell for the same price as my mousetrap. In either of these two cases, pretty soon my business is likely to be completely destroyed. If my competitor sells identical mousetraps to mine for half the price, nobody will buy my mousetraps instead of his. Or, alternatively, if my competitor produces a better mousetrap than mine and sells it at the same price that I'm selling my inferior mousetrap, the world will, again, beat a path to his door and abandon me and destroy my business. From where I sit, my business is as much destroyed by the competition of my competitor as it would have been destroyed by the bomb. But, of course, the law does not prohibit my competitor from willfully destroying my business for his own benefit by producing better or cheaper mousetraps than I am able to produce. In both cases, the bomb or the better mousetrap, my business is destroyed at the hands of another competitor who's done so purposefully for his own benefit and has not compensated me for the loss that I've suffered as a result of his activity. But in one case, the law says, my competitor cannot do this to me without paying compensation. That's the case of the bomb, and therefore, if he bombs my factory, he will have imposed an external cost on me, until I'm able, if possible, to receive some sort of compensation from him at, At a later date. But if my factory has been destroyed, the value of my business has been destroyed because my competitor has made a better mousetrap than I, then I've suffered a cost but the law does not recognize this as an externality and it does not recognize a right on my part to being compensated by the competitor or anyone else for the cost that aren't suffered. This, of course, represents a social justice, a social judgement that destroying mousetrap factories by producing better mousetraps is a socially beneficial activity on net, that is when all things are considered and that it's worth the societies bearing the cost of losing factories like mine and my bearing the cost of losing my business in order to allow a system of competition, of competition that enables people to produce better or cheaper mousetraps and make them available to the public. And so, we've reached the conclusion that before there can be externality, the law must first declare that people have a right to be free of the uncompensated imposition of the cost that are suggested as an externality, if the law does not make this declaration first, then, the costs are costs, but they're not external. They become external only when they represent the taking of somebody's property rights, when the law has thrown its weight behind somebody's claim to be free of the sorts of costs that they are bearing without being compensated by the cost imposer. So, with that definition of externality under our belts, we'll now move to talk about an extended example of externality, our steel plant example.
