A Market for Externalities

Externalities are costs or benefits that are not represented by market prices. They are ‘hidden’ from the market — the long-term health benefits of exercise, or the health costs of smoking, for example. When you use a gym, you pay for your membership, but the gym does NOT get extra cash for having kept you healthy! Conversely, cigarette companies do not need to pay extra for the harm their products cause. Those impacts are external to the products’ sale, and these externalities are a huge problem: the market does not value what it cannot price.

The Multiplier Effect:

Many positive externalities are provided at a cost that is much lower than the value that they create. For instance, the World Economic Forum notes that “every dollar spent on treating TB would generate $43 in returns” for the local economy. Meanwhile, negative externalities are often pursued by companies and individuals whose profits are much smaller than the harm they caused. Paper mills often dumped mercury into local water supplies, which caused immense harm for generations, in return for slim profit margins. These are examples where externalities have a high multiple; a dollar spent on positive externalities generates MANY dollars of benefit, and a dollar of profit from negative externalities generates MANY dollars of cost.

Externalities suffer from an additional problem: most of the external impact is felt by people who did not even use the product! Locals living down-river from the paper mill may not have purchased the paper products that it made, but they are the ones harmed by its mercury pollution.

And, like the case of TB treatment, the benefits of positive externalities are felt by people at large (the over-all impact on economic activity) or people at random (who contracted tuberculosis) — a business would not know who to charge a fee, those people may be unable to afford treatment on their own, or the value to each person is so small that a business could not extract a profit if it was required to manage each transaction. So, externalities stay external to pricing.

Not External Forever…

This is where government comes in! Governments are, fundamentally, a way to internalize externalities. We each benefit from mutual defense, from enforcement of contracts, and from public education and health care. No business could handle these needs. Defense is such an irregular, strategic need, that no one would be expected to pay for it, until it was too late! Enforcement of contracts could not be left to private businesses; they would be able to extract larger profits by selective enforcement than they could from fair and just arbitration. And the immense economic benefits of a healthy and educated population are felt by all, while a business would be hard-pressed to ask all to pay for services which only a few use directly.

Yet, modern governments are bloated by social services which pay-out more to their employees than to their beneficiaries. And legislators regularly divert public money to ‘pork’ projects that serve local contractors and lobbyists. The ‘cure’ offered in response: privatize! By letting businesses accept government contracts for those services, the businesses will be encouraged to provide those services at a lower cost — because that leaves a larger profit margin for them. Unfortunately, if a privatized industry receives a government contract, they are incentivized to lower costs for themselves, but they are NOT incentivized to lower costs to the people. Enron did that. And, lowering costs by lowering quality of service is still a path to profits, because political lobbyists protect these contractors from being fined, or even having the quality of their service measured at all! Privatization doesn’t work, as a result.

So, what could we do, instead?

Ideally, a business would not need to win a government contract, for their services to be included as a positive externality. Instead, the government would be responsible for measuring the value of the actual benefits of that service, and the business would be paid accordingly. (No payments to contractors who failed to provide real benefits!) That same accrediting and regulatory body would be responsible for measuring any harm that a business causes, and levying fines accordingly. (No profits for polluting paper mills! No waiting for a class action lawsuit!) And, those fines would go toward remunerations for those harmed, to pay for the costs of operating the regulatory agency, and to pay other businesses for the positive externalities that they provide. Any additional positive externalities would be paid from a broad tax base.

In such a system, we would need experimentation. Some businesses might want to sell a product that would also provide health benefits, for example. They would need to sell their product to many people, for their claim of benefit to be verified and measured. Someone must take an entrepreneurial risk, to provide that business with its initial capital. If that business does produce health benefits, it should be paid accordingly, and some of that payment should go back to its investors. That is the Market for Externalities.

An Alternative to the Bloated Government:

Imagine a country where the government consisted of an accrediting and regulatory body, and tax collectors. Nothing else. Instead of government-run services, and businesses operating on a government contract, the government would ONLY extract fines, levy taxes, and make payments to businesses. Those businesses are closely monitored by the accrediting and regulatory body, and they are only paid when they produce measurable benefits. The payments would be a fixed percent of the ascribed value generated; not 100%. (Say, just 25%?) These payments would be made from a pool, which is filled first by any fines levied against businesses and individuals who created measurable negative externalities, and second, by a variable tax rate. Yes, taxes would vary from year to year, and you would only be taxed for the amount that was not covered by fines!

A market would handle business proposals. Any proposal in this Market for Externalities could receive investment, which buys the investor a share of that proposal’s dividend. When the proposal receives its budget from investors, it goes into action, and so too does the government’s regulatory body. When enough data has been collected, to assess the real value of the proposal, that business is paid a percentage of that value. Its costs are covered, first, and the remainder is given as dividend to its investors. No profits are retained.

Who would buy that?

The Market for Externalities takes the profit motive, and plugs it into the public good. And, the public good is a much better investment than MOST businesses! Consider the tuberculosis example: a dollar spent fighting TB will add $43 to the local economy. So, a proposal can be placed on the Market for Externalities, to fight TB. At a return of 25%, a business enacting such a proposal would receive $10.75 gross profits, for every $1 in expenses. That is a larger multiple on capital than Apple! If investors could get that kind of return from any for-profit business today, they would rush to it. But, no business is fighting TB, because the $43 gains are spread out over the entire population. You would need a tax base, to extract a portion of that price from everyone. That requires a government.

Yes, a Market for Externalities would not be perfect. Regulators would still need to be regulated by citizens and journalists. Market actors could still squander investors’ cash, and attempt to fudge data to get more than their share of payments. However, it would be superior to BOTH government-run services AND privatization. Government, by restricting itself to only accrediting and regulating, would be simpler, and easier for the people to monitor and hold accountable. Each proposal, being visible on the Market for Externalities, would be priced by the accumulated foresight of all market investors, instead of hidden behind privatization contracts wrought by lobbyists. It wouldn’t be socialism. And, it wouldn’t be traditional capitalism. It would be a Market for Externalities. How does that sound, to you?

Written by

Easily distracted mathematician

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