(This is Part 8 of a series. Go back to Part 7.)
3. Externalities (the third source)
An externality is an effect created when a person or an organization takes an action but does not bear the full cost of that action.
A classic example of an externality is the tragedy of the commons (described by Garrett Hardin in 1968), where an external cost is borne by a public resource.
His example was of an English commons, used by all
the livestock farmers in a village to graze their livestock.
Each farmer had an incentive to graze as many animals as possible, since the extra grazing cost him nothing.
But as each farmer acted in the same way, the commons became overgrazed. Eventually, as overgrazing depleted the soil, the commons became no longer usable and the village perished.
Thus, externalities can create suffering and "evil" even when no-one is specifically intending an "evil" act, but simply acting in their own self-interest.
In our time, the tragedy of the commons increasingly applies to the environment. From the countless examples available, we might mention overfishing of the oceans, overlogging of forests. pollution of air and water, the diminishment of species, etc.
For instance, cod fishermen off the east coast of Canada overfished for decades. The enormous stocks of cod—which had supported cod fishermen for 500 years—kept declining under the withering impact of the overfishing, but no fisherman would stop because it was not in their personal interest to do so.
Finally, in 1992 the Canadian government stepped in and stopped all cod fishing off its coast, but by then it was too late. The tremendous schools of cod had totally vanished, resulting in a depleted coast and 40,000 fishermen thrown permanently out of work.
Similarly, companies and farmers in the jungles of Brazil have an incentive to clear-cut as much land as possible for farming, but the net result is the gradual deforestation of the crucial Amazon jungle.
In the same vein, driving a large gas-guzzling vehicle seems like a personal matter, but in total it contributes decisively to air pollution, global warming, oil depletion and so on.
In all of these cases, the decision is made individually or corporately but most of the cost is borne by the common resource, whether it be the earths's air, water, schools of fish, forests or whole ecosystems.
Until very recently, the solution to the tragedy of the commons was assumed to be a command-and-control, top-down sort of thing. A welter of edicts, mandates and regulations would be issued, accompanied by a small army of bureaucrats and enforcement agents.
This had some effect, but clearly not enough. The world's atmosphere, species, forests, oceans, etc. are all still in decline. The central defect of this command-and-control paradigm is that it does not make use of the enormous power of markets.
This is changing. The cap-and-trade paradigm, discussed at more length elsewhere, is a third-way solution that combines the strengths of government with the strengths of the free markets.
Applied to fishing, for instance, it means that a fisherman must buy permits to allow him or her to catch a certain quantity of fish. The government or other agency sets the overall quantity of fish to be caught, and offers to sell an amount of permits corresponding to that limit. Then the fishermen, buying and selling permits in an open market, determine the varying price of the permits.
In this elegant process each fisherman, in calculating his or her own economic self-interest, automatically assists in maintaining the overall fishing cap in the most efficient way possible.
All of this is to the good. Using cap-and-trade schemes is a powerful way to avoid the "evil" that can result from the tragedy of the commons. It brings the immense power of free markets to bear in allocating costs and risks, so that the most cost-effective means can be used in preserving the various "commons" of nature, including the air, water, oceans, soil, forests and species.
The way free markets work their magic is through the price mechanism. Through the process of price discovery,
a free market brings together supply and demand in the most efficient way possible.
However, a free market must itself function within an overall context of limits if abuses are not to occur. For example, as said before, while free-market capitalism is the most efficient means of producing wealth in a society, it also has a tendency to create monopolies and exploit the disadvantaged. Laws that countermand excesses can help to prevent and/or ameliorate such tendencies.
Such approaches, which pursue a creative and flexible middle way while avoiding the extremes of unrestricted license or heavy-handed control, will tend to produce the most efficient and sustainable results while preserving a high degree of individual freedom.
(This is the end of Part 8. Go to Part 9.)
—jim sloman, 4.23.05
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