Pecuniary externalities

by on August 23, 2010 at 7:08 am in Economics, Philosophy | Permalink

Samson, a loyal MR reader, requests:

Tyler,
What do you think about pecuniary externalities? What would be a good definition of such externalities, if you find them to be plausible? Without the fiction of an infinite number of buyers and sellers, why isn't it the case that any transaction through the price system, through an impact on price, causes an externality, and might one call such an externality a pecuniary externality? I cannot find much on this subject.
Thanks!

Economists try to make a distinction between pecuniary externalities — changes in price which merely redistribute wealth — and non-pecuniary externalities, which involve a real good or service being provided or denied at the margin.  If the price of wheat rises, wheat consumers suffer a pecuniary externality.  If you dump garbage on my lawn, that's a non-pecuniary externality, although it may be accompanied by a pecuniary externality, namely a decline in the value of the house.  In the meantime, the lawn stinks.

The distinction is often a tricky one, especially in the absence of perfect markets.  A lot of the complaints about health care markets are actually complaints about pecuniary externalities, namely that some people get priced out of the market.  Alternatively, the risk of facing high prices for cancer treatment may make people nervous and insecure.  The notion of "risk" often bundles together pecuniary and non-pecuniary externalities in a not-too-easy-to-separate form.

Efficiency and distribution are not always possible to separate, no matter what the first and second welfare theorems seem to imply. 

What about people near subsistence?  Say you redistribute $500 from a poor Haitian to a somewhat less poor Mexican, and the Haitian dies and the Mexican buys a used motorbike.  Is that "just a transfer"?  Or is it "a real resource loss"?  I say it's the latter, but then virtually any redistribution will destroy some complementary value from the portfolio of the individual losing the money.  What is then left to count as a pure transfer?

There is also no such thing as a pure lump-sum transfer when population is endogenous, either through child-bearing decisions or through taking risks with one's life.

The distinction between pecuniary and non-pecuniary externalities is useful, and hard to do without, but its foundations are shaky.  In practical terms the weakness of the foundations matters most when we are doing health care economics or analyzing food subsidies (or comparable forms of aid) in poor countries.  The richer and healthier the people are, the more likely the distinction can be invoked without much trouble.

And Samson is correct to think that large numbers of transactions involve pecuniary externalities, at least whenever the particular actions of a buyer or seller influence market price.

Leigh Caldwell August 23, 2010 at 8:14 am

Very interesting area. Two modelling innovations may help to provide tools to better analyse the continuum between these two types of externality.

One is the incorporation of cognitive costs into economic models. These are typically ignored (after all, they are hard or impossible to directly measure) but they are real. Arguably, they account for nominal stickiness as well as for a large proportion of economic transaction costs.

The other (which is a special case of the first) is to model economic relationships which have an existence over time, rather than just individual atomic exchanges. If agents have some kind of endowment effect in a continuing series of economic exchanges (informally, if they are invested in the existence of an economic relationship), they have a reason to care about stability of price levels, and about the effects of exchanges made by third parties.

Another way to look at this is that things traditionally viewed as purely nominal (prices, lump-sum redistribution) actually have a real effect – not least because our brains, which mediate between different nominal concepts, are real objects which have real running costs.

John Goodman August 23, 2010 at 8:47 am

I’ve always thought the relevant distinction was: is the effect “external” to the market? A rise in the price of wheat is “internal” to the market, and therefore I would not count it as an externality.

Mike August 23, 2010 at 10:32 am

Put simply, a pecuniary externality acts through the price mechanism, while a non-pecuniary externality does not. We have a tendency to also claim that these are equivalent to, respectively, welfare-neutral and non welfare-neutral externalities, but this is misleading and confusing, since it is easy to create examples of pecuniary externalities that have first-order welfare consequences and non-pecuniary externalities that are welfare neutral.

I believe the general Pigovian principle is that externalities have real efficiency consequences in any model in which economic actors are equating anything other than marginal social cost and marginal social benefit.

Welfare-neutral pecuniary externality:
In a perfectly competitive economy, price equates social marginal benefit (so that the sellers’ problem coincides with the social planner’s problem) and social marginal cost (so that the buyers’ problem also coincides with the social planner’s problem). Any tiny change in the price level has only second-order effects on the equilibrium allocation and is thus what we would call “welfare neutral.”

Non welfare-neutral pecuniary externality:
Suppose sellers have market power. Buyers buy if their marginal benefit exceeds the price. Market power implies that the price does not equal social marginal cost (and in fact exceeds it), so we can have some potential buyer for whom price exceeds marginal benefit (so that he doesn’t buy the good), but his marginal benefit exceeds the social marginal cost (so that he should). In this world, the marginal consumer is not equating social marginal benefit to social marginal cost. A small increase in the price level would lead to first-order welfare losses, since the marginal unit purchased would yield a strictly positive welfare gain but is precluded by the increase in price.

Non-welfare neutral non-pecuniary externality:
In Tyler’s trash example, suppose the cost of getting rid of (or living with) trash is lower for you than for Tyler. If you dump trash on his lawn, unless you do so taking into account his cost of removing it (or of living with it), then you are not equating marginal social benefit to marginal social cost. Reducing your behavior would lead to first-order welfare gains.

Welfare-neutral non-pecuniary externality:
In a static world with no income effects, in which cars are worth the same to everyone, if you steal Tyler’s car, then he loses the same amount you gain. You do not internalize the externality you impose on Tyler. However, this is welfare-neutral, because the social marginal cost and social marginal benefits of reallocating a car from one person to another are both zero. This, of course, goes away in an economy in which Tyler can expend resources to preventing you from stealing his car. It also goes away if you value his car less than he values his car (which is presumably the case if he has made any complementary investments).

Jobu August 23, 2010 at 1:12 pm

Interesting!

But I do not get your first example.
According to the definition, an externility is a cost incurred by a party who did not agree to the action causing the cost or benefit (third party).
If consumers are responsible for the rising wheat prices (because of increasing demand) they aren’t a third party…So there cannot be an externality, right?

libert August 23, 2010 at 2:34 pm

Six Ounces said “The emotions attached to being priced out of a market may be real, but the economic concept is vacuous.”

Huh? That is certainly an economic concept. Prices go up, the consumer’s budget constraint tightens, and his utility decreases.

Anyway, here’s a concrete example of a pecuniary externality. Say I like oranges, and I am lactose-intolerant (or just plain don’t like dairy). Thus, I buy a lot of oranges, but can’t eat ice cream. Now, someone comes along and invents a delicious orange flavored ice cream. Well demand for oranges goes up, increasing the price of oranges. I don’t benefit at all from the invention because I can’t eat ice cream, but I end up paying more for oranges, meaning I have less money for other things. And I’m paying more for oranges because other people (i.e. not me) are buying orange ice cream. Thus, the actions of other people (ice cream consumers) make me worse off (I face higher orange prices).

In terms of efficiency, welfare would generally be deemed to have gone up on a societal level (assuming our social welfare function doesn’t strongly favor the lactose-intolerant orange lovers for some reason), since people are willing to pay more for oranges for the new delicious ice cream. But that doesn’t mean that some people are hurt in the process, namely the the lactose-intolerant orange lovers.

In short, if we’re committed to utilitarianism, then the new orange flavored ice cream is a great thing. But if we’re committed to the libertarian principle of “do no harm to others,” then the new ice cream flavor is a bad thing, since it redistributes wealth away from the lactose-intolerant to the ice cream lovers.

Sunset Shazz August 23, 2010 at 4:09 pm

My undergraduate public policy prof said that economists say “that’s not an externality, it’s merely pecuniary” the way one would say “that’s not pate, it’s spam…”

vt August 23, 2010 at 4:15 pm

Given that everybody’s budget is finite, any change in the price for x will influence that person’s demand for at least one other product or service. But if any price change on a market (for whatever reason) counts as a “pecuniary externality” than the concept is indeed vacuous because it fails to draw a distinction between different classes of changes.

So, can we have an example of a price change that is not a “pecuniary externality”?

mulp August 24, 2010 at 5:48 am

The only real externalities are:
- God or gods
- system factors excluded, incorrectly believing them to insignificant to matter
- and the factors economists don’t want to admit to because their economic models become as hard to comprehend as quantum mechanics and gravity.

Most of economics theory works only when millions of acres of land are available for free and half the world lives off the farm they live on. Like it was when Adam Smith and John Locke were defining today’s political economy.

Pacer August 25, 2010 at 10:42 am

howard: “Can we make the argument that poverty itself is a market failure (or result of a market failure)?”

Lots of ways to make that argument, Howard. In a world of essential but finite resources, it would be a market failure for the population (or any autonomous unit of the population, e.g. a nation or a family) to increase its demand–through reproduction–beyond the resources available. One result is mass deprivation, but a more likely result is that some will get enough and others will be onerously deprived. Put too many astronauts in a spaceship, and they won’t have enough air, water, food to survive the trip. Malthus talks about this, and the essential failure is one of timing–demand can be created long before the supply crunch is apparent.

Another possible market failure leading to poverty is the destruction of supply. Tragedy of the commons is probably the most frequent example, such as the salient issue with unregulated utilization of groundwater. Not everyone can afford to drill their wells ever deeper, and not everyone can do with less water–those on the wrong end of those equations will become impoverished unless they can relocate or create value without the intensive use of water.

Lastly, and this is the one everyone talks about, is market failures that allow hoarding by certain actors. Capitalism is all about hoarding–accumulating wealth. Since wealth is not infinitely obtainable (by definition it cannot be), accumulation by some can create poverty in others. So while accumulation/concentration of wealth is not a market failure, the causes that give rise to accumulation can be (capture of government by special interests, use of private force, monopolization of critical economic factors, or a combination thereof). In the world today I think we see lots of these market failures, whereas tribal societies would perceive and refuse to tolerate them (though they might as we do tolerate the ascension of a gilded class if achieved fairly and squarely). The problem is the rule of 150, which means that larger groups lose the power to effectively police their own institutions. In this sense, localization–bugaboo of modern economics–is the only sustainable solution to poverty.

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