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Published online by Cambridge University Press:  24 June 2009

A. H. Barnett
Economics, American University of Sharjah
Bruce Yandle
Economics, Clemson University


In the early 1970s, we and others in the economics profession became enamored with the notion of externalties—a cost or benefit imposed on or provided to others but not taken into account by the economic agents who generate the effect. We, and others, seemed to see external effects everywhere. There was polluted water and air, noise, urban blight, traffic congestion, and other features of modern life that seemed to call out for some form of corrective action. As the externalities revolution unfolded, economists and other social scientists overlooked the importance of evolved legal and other institutions that formally and informally establish property and liability rules that cause decision makers to face the cost of their actions, including what otherwise could be external costs imposed on unwilling third parties.

While markets seemed always to fail, political institutions were seen systematically as without blemish, or so it seemed. It was this two-pronged failure, 1) a failure to consider and state assumptions about background institutional arrangements and 2) a disregard for special interest politics, that became the Achilles Heel of the otherwise elegant externality arguments. Eventually, it was the modern institutionalists, scholars who focused on laws, regulation, and rules of the marketplace, who attempted to close the lid and drive the nails on the externality coffin.

In this paper, we reach back to 1920 and trace the rise and decline of the policy importance of externalities theory. Beginning with A. C. Pigou and Alfred Marshall, our story includes some of the great figures in economic history of thought. But while theory was being built, institutions were overlooked. Pigou continues to be a dominant player in the story until the 1960s and 1970s when externalities theory was challenged by James M. Buchanan, Ronald Coase and other scholars. It is here in the twilight years of the externalities revolution that the prospects of government failure are raised as being more daunting than the likelihood of market failure. Finally, in the late 1970s and beyond, the externalities revolution is replaced by a property rights revolution.

Research Article
Copyright © Social Philosophy and Policy Foundation 2009

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1 Cheung, Steven N. S., “The Structure of a Contract and the Theory of a Non-Exclusive Resource,” Journal of Law and Economics 13 (1970): 4970Google Scholar.

2 Prominent among the institutionalists are Ronald H. Coase, Terry L. Anderson, Donald R. Leal, Steven N. S. Cheung, Fred S. McChesney, and Elinor Ostrom. For related literature, see Coase, Ronald H., “The Problem of Social Cost,” Journal of Law and Economics 3 (1960): 144CrossRefGoogle Scholar; Anderson, Terry L. and Leal, Donald R., Free Market Environmentalism (New York: Palgrave, 2001)CrossRefGoogle Scholar; Cheung, “The Structure of a Contract”; Anderson, Terry L. and McChesney, Fred S., eds., Property Rights: Cooperation, Conflict, and Law (Princeton, NJ: Princeton University Press, 2003)Google Scholar; and Ostrom, Elinor, Governing the Commons (New York: Cambridge University Press, 1990)CrossRefGoogle Scholar.

3 See Coase, “The Problem of Social Cost”; Buchanan, James M. and Tullock, Gordon, The Calculus of Consent (Ann Arbor: University of Michigan Press, 1965)Google Scholar; and Buchanan, James M. and Stubblebine, William C., “Externality,” Economica 29 (1962): 371–84CrossRefGoogle Scholar.

4 Pigou, A. C., The Economics of Welfare, 1st ed. (London: Macmillan Publishing, 1920)Google Scholar.

6 Coase, “The Problem of Social Cost.”

7 On this, see Raymond, Leigh, Private Rights in Public Resources (Washington, DC: Resources for the Future, 2003)Google Scholar.

8 In spite of his recognizing the possibility of legislative anti-efficiency effects, Pigou apparently gave no consideration to the operation of private law in imposing cost on negligent producers of externalities. Pigou, it seems, embraced the system of property rights described by David Hume. (On this, see Raymond, Private Rights in Public Resources.) For Hume, property rights and their articulation were created and modified by government, not by market forces and private law. To Pigou, property rights are endogenous to the political process. We note that when politicians and government become endogenous to the story, the simple analytics of welfare economics get complicated.

9 Buchanan and Tullock, The Calculus of Consent.

10 See Marshall, Alfred, Principles of Economics (London: Macmillan and Co., 1920)Google Scholar; Pigou, The Economics of Welfare; Knight, Frank H., “Some Fallacies in the Interpretation of Social Cost,” Quarterly Journal of Economics 37 (1924): 582606CrossRefGoogle Scholar; Young, Allyn A., “Increasing Returns and Economic Progress,” Economic Journal 38 (1928): 527–42CrossRefGoogle Scholar; Sraffa, Piero, “The Laws of Returns under Competitive Conditions,” Economic Journal 36 (1926): 535–50CrossRefGoogle Scholar; Clapham, J. H., “Of Empty Economic Boxes,” Economic Journal 32 (1922): 305–14CrossRefGoogle Scholar; Graham, Frank D., “Some Fallacies in the Interpretation of Social Costs,” Quarterly Journal of Economics 39 (1925): 324–30CrossRefGoogle Scholar; Robertson, D. H., “Those Empty Boxes,” Economic Journal 34 (1924): 1630Google Scholar; Shove, G. F., “Varying Costs and Marginal Net Product,” Economic Journal 38 (1928): 258–66CrossRefGoogle Scholar; Robbins, Lionel, “The Representative Firm,” Economic Journal 38 (1928): 387404CrossRefGoogle Scholar; Harrod, R. F., “Notes on Supply,” Economic Journal 40 (1930): 232–41CrossRefGoogle Scholar; and Viner, Jacob, “Cost Curves and Supply Curves,” Zietschrift fur Nationalokonomic 3 (1931): 2346CrossRefGoogle Scholar.

11 Buchanan and Stubblebine, “Externality.”

12 Ibid., 371. We note that the concept of Pareto-optimality is used by most neoclassical economists to address the issue of efficient use of resources. In brief, a state of the world, with its associated allocation of resources, is considered efficient if there is no reallocation of resources that could make at least one person better off (relative to the initial allocation) while leaving no one worse off. When a reallocation could make at least one person better off, while leaving all others no worse off, an inefficiency exists and a so-called Pareto-improvement is possible. A Pareto-relevant externality is an externality that produces an allocation of resources that is inefficient, so that a Pareto-improvement is possible. A Pareto-irrelevant externality is an externality that does not yield a potential Pareto-improvement. In other words, Pareto-irrelevant externalities do not cause inefficiency; thus, no policy for improvement is appropriate.

13 Kapp, William, “On the Nature and Significance of Social Costs,” Kyklos 32 (1969): 334–47CrossRefGoogle Scholar.

14 Ibid., 335.

15 The “empty boxes” debate takes its name from a 1922 article by J. H. Clapham (see note 10 above). The debate revolved around whether inefficiencies (Pareto-relevant externalities) existed with increasing-cost and decreasing-cost competitive industries. Assuming that inefficiencies existed, it would then seem appropriate for analysts to identify industries that are characterized by increasing or decreasing costs. Clapham, using an analogy of a shop with boxes on the shelf, suggested that analysts place industries in conceptual boxes labeled increasing-, decreasing-, or constant-cost industries. Clapham argued that the distinction was not useful—that the conceptual boxes were, in effect, empty. The subsequent debate, with its related spin-off issues, is referred to as the “empty boxes” debate.

16 Pigou, The Economics of Welfare, 223.

17 Clapham, “Of Empty Economic Boxes.”

18 Ibid., 312 (emphasis added).

19 See Young, “Increasing Returns and Economic Progress”; and Knight, “Some Fallacies in the Interpretation of Social Cost.”

20 The only thing of conceptual value that survives from the empty boxes debate is the distinction that is drawn between pecuniary and nonpecuniary externalities. See Ellis, Howard and Fellner, William, “External Economies and Diseconomies,” American Economic Review 33 (1943): 493511Google Scholar.

21 Marshall, Alfred, Principles of Economics (London: Macmillan and Co., 1920), 225Google Scholar.

22 Interestingly, given the Pigouvian tax tradition, Pigou did not limit acceptable government interventions for equating social and private net product to taxes and subsidies. He also speaks very favorably of a wide variety of regulations and legal constraints.

23 We take some liberties in characterizing this as a debate, for there were few protagonists before Coase, chiefly Pigou and Knight, and Pigou appears either to have conceded (though not explicitly) the point without much debate or to have simply ignored the issue raised by Knight.

24 Knight, “Some Fallacies in the Interpretation of Social Cost.”

25 Pigou, A. C., The Economics of Welfare, 4th ed. (London: Macmillan and Co., 1932), 182203Google Scholar.

26 Pigou attributes this example to Henry Sidgwick.

27 Ibid., 183–85.

28 On this point, Pigou laments in a footnote: “In Germany the town-planning schemes of most cities render anti-social action of this kind impossible; but in America individual site-owners appear to be entirely free, and in England to be largely free, to do what they will with their land.” Pigou's view that the freedom of site-owners is the source of “anti-social action” may offer some insight into his mind-set regarding external effects. (See ibid., 186.)

29 See ibid., 134, 186–87, and 196–203.

30 Ibid., 129–30.

31 Ibid., 192 (emphasis added).

32 Coase, “The Problem of Social Cost,” 35.

33 See Meade, James E., “External Economies and Diseconomies in a Competitive Situation,” Economic Journal 62 (1952): 5467CrossRefGoogle Scholar. It is telling that Meade's essay is remembered almost exclusively for one of his examples, the famous beekeeper and apple farmer example, rather than for a basic insight contained in the distinction he makes.

34 See Baumol, William J., “On Taxation and the Control of Externalities,” American Economic Review 62 (1972): 307–22Google Scholar; and Baumol, William J. and Oates, Wallace, The Theory of Environmental Policy (Englewood Cliffs, NJ: Prentice Hall, 1975)Google Scholar. Meade's discussion, however, had one advantage over the later discussion by Baumol and Oates. Specifically, Meade implies that it is the depletability of the asset whose use gives rise to external effects, not the depletability of the externality itself, which is significant. This is a subtle but potentially important distinction.

35 See Yandle, Bruce, “Environmental Turning Points,” Independent Review 9 (2004): 211–26Google Scholar.

36 See Anderson and Leal, Free Market Environmentalism; and Yandle, Bruce, “Coase, Pigou, and Environmental Rights,” in Hill, Peter J. and Meiners, Roger E., eds., Who Owns the Environment? (Lanham, MD: Rowman and Littlefield, 1998), 119–52Google Scholar.

37 Central to this point are Coase, “The Problem of Social Cost”; Buchanan and Stubblebine, “Externality”; Ralph Turvey, “On Divergences between Social Cost and Private Cost,” Economica 30, no. 119 (1963): 309–13CrossRefGoogle Scholar; and Baumol, “On Taxation and the Control of Externalities.”

38 For example, see Meiners, Roger E. and Yandle, Bruce, “Common Law and the Conceit of Modern Environmental Policy,” George Mason University Law Review 7 (1999): 923–63Google Scholar.

39 On this, see Coase, “The Problem of Social Cost”; and Browning, Edgar L., “External Diseconomies, Compensation, and the Measure of Damage,” Southern Economic Journal 43 (1977): 1279–87CrossRefGoogle Scholar.

40 See Buchanan and Stubblebine, “Externality.”

41 Baumol and Oates, The Theory of Environmental Policy.

43 Pigou, The Economics of Welfare, 4th ed., 195.

44 Ibid., 332.

45 Buchanan, James M., “Public Choice: The Origins and Development of a Research Program,” in Eberling, Richard M., ed., Champions of Freedom, vol. 31 (Hillsdale, MI: Hillsdale College, 2004), 25Google Scholar (emphasis in the original).

46 Buchanan and Tullock, The Calculus of Consent.

47 Ibid., 189–90.