Free Markets and Externalties; J. R. Edwards

THEFREEMAN IDEASON LIBERTY Free Markets and Externalities: The Symmetry of Unintended Effects by James Rolph Edwards S omeone once said that the world is not only a stranger place than we know, it is a stranger place than we can know. Whether that is true or not, upon close examination it often turns out to be quite different in crucial respects than we had previously believed. Consider the theory of externali ties, in which a distinction is made between the social costs and private costs of human actions and transactions. Normally, the vol untary trades that characterize production and exchange activities in market econo mies are mutually beneficial to the parties involved a priori because each exchanges something they want comparatively less for something they want comparatively more. Each bears the private costs of his actions generated by alternate uses forgone in the decision to use the resources employed in the way that they were. A meaningful dif ference between the social costs generated by these actions and the private costs exists, however, when unintended costs (often termed external costs) are imposed on third parties. In such cases, too many resources will be employed in the industry or activity involved, because only the private costs and benefits are being considered by the parties James Rolph Edwards is Associate Professor of Economics at Montana State University-North ern.

generating the externalities, and the private costs are by definition less than the true social costs. The quintessential examples are air and water pollution, which affect the environ ment adversely and often pose human health hazards. It has come to be accepted by many economists that in such cases the govern ment is justified in imposing some sort of coercive regulatory policy to reduce the external costs generated and to obtain a more correct resource use. Other observ ers-including many leaders of the environ mental movement-extend this logic to a more radical conclusion. They believe that pollution and waste are so pervasive and threatening that government must either socialize the economy, taking full control of industry to end pollution, or force an end to industrial/technological market society it self in order to save the human race. A variety of arguments can be marshaled in opposition to these views. First, solutions more consistent with the maintenance of a free society, such as specification of private property rights (since externalities are a common-property problem) and tort law (in which those harmed sue for compensa tion) can often be applied to solve or reduce externality problems.

Second, industry and technology-in the 421 422 THE FREEMAN • AUGUST 1994 forms of such things as medicine and sew age, and water treatment-have often been intentionally employed to improve human health. 1 Indeed, as measured by mean life expectancy-the single best summary indi cator of environmental risks faced by human beings-people face fewer such risks now than ever before in human history, and do so as a direct result of technical and economic progress in the market economy. Third, the whole externality effects of industrial market society are being mischar acterized. As industry and technology de velop, some forms of pollution are gener ated and others are eliminated. The electric stove largely ended the breathing of wood smoke in the home. The automobile ended the scourge of horse manure in cities, which would otherwise constitute a terrible source of pollution and a public health threat. As an inherent element of technological develop ment, firms have progressively discovered and employed more and more efficient sources of fuel and power generation in order to reduce costs under competitive market pressures. This caused pollution per unit of output generated to decline steadily long before the EPA and the 1970 Clean Air Act were created. Indeed, according to economist Paul MacAvoy, there is no evi dence that those regulatory mechanisms improved on that record. 2 A closely related point constitutes the central argument of this paper. While it is true that market activities often generate externalities, and new technologies often have unintended side effects, nobody has ever offered a convincing reason why such external effects should more frequently be detrimental than beneficial. Creation of the automobile generated traffic and mobility problems that Henry Ford and other devel opers of the technology never foresaw, but it also eliminated local monopolies and mo nopsonies by integrating markets (as well as eliminating horse manure pollution), which was also no part of their intent. Environ mental ideology, however, and the regula tory policy it drives, are biased toward findingthe detrimental side effects of market industrial activity, and ignoring or mischaracterizing the beneficial effects. The exam ple of industrial CO2 emission is striking.

Carbon dioxide is quantitatively the larg est single emission of free market industrial! technological society, and over time these emissions have begun to add substantially to atmospheric CO2 concentration. Auto mobiles contribute heavily by emitting car bon monoxide, which is unstable and quickly mixes with atmospheric oxygen to form carbon dioxide. Most economists and all environmentalists treat CO2 as an un qualified pollutant; that is, a substance which generates only external costs. As one of the primary greenhouse gases, industrial CO2 emission is accused of being a primary factor generating global warming, that is, raising lower atmospheric temperatures over time. Such rising temperatures are asserted to be eventually capable of melting the ice caps and causing deserts to expand, threatening disastrous loss of land area and increasing famine. Consequently, the argu ment goes, massive government controls and interventions must be employed to re duce industrial CO2 emission.

Actually, the evidence that global warm ing is even occurring, much less that human CO2 emission is generating such warming, is very weak. Most ground station atmo spheric temperature time series show no warming in the last forty or fifty years, though one data series does show a very slight temperature rise.3 Tyros N satellites, in orbit since 1979,may eventually settle the matter. They use an extremely sensitive system of microwave· radiometers to mea sure lower atmospheric temperature. The satellite observations cover a large area at a time (a circular "footprint" 110 km in di ameter) and are not restricted to land, as are most surface based temperature recording systems. Over this period in which, by globalwarmingtheory, temperatures should have risen more rapidly than ever before in human history, since industrial CO2 emis sion has been larger than ever before, the satellite data show no upward trend in global temperature at all.4 If the effect of industrial CO2 emission on lower atmospheric temperature is obscure FREE MARKETS AND EXTERNALITIES 423 and debatable, however, certain other ef fects are not, or at least should not be. CO2 is the primary nutrient that plants use in transforming sunlight into plant matter (car bohydrates) through photosynthesis. That is, plants grow by transforming CO2, other nutrients, and sunlightinto plant matter. For various natural reasons, many of which are unknown, atmospheric CO2 concentration has varied widely over the earth's history.

The last Ice Age seems to have reduced the CO2 level far below concentrations existing in earlier historic periods. Indeed, it may have reached a level within 100 parts per million(PPM)of being too low to sustain life on earth. 5 The significance of this is that industrial CO2 emission is correcting what is, in terms of the Earth's geological and ecological history, an imbalance of atmospheric CO2 on the low side. In particular, as Sylvan Wittwer, Professor Emeritus of Horticul ture at Michigan State University explains, at current atmospheric concentrations (about 365 PPM), CO2 is the limiting nutri ent in plant growth, the one plants cannot obtain in adequate amounts. Increasing at mospheric CO2 concentration increases plant growth. Wittwer explains that it also makes plants healthier and tends to benefit common food plants more than it does common weeds.6 The beneficial effects of CO2 are well established in the scientific literature, and the knowledge is so common in some circles that nursery owners have been deliberately enriching the CO2 content of the atmospheres in greenhouses to as much as 1,000 PPM for decades.

In economic terminology, the point is that, at current atmospheric concentrations, industrial enrichment of atmospheric CO2 has a positive marginal product for plant growth. Many hundreds of scientific exper iments have been conducted to determine CO2 productivity effects on particular plants, which often yield startling results. Recently, for example, Sherwood Idso, a well known soil physicist at the u.s. Water Conservation Laboratory in Phoenix, Ari zona, planted two groups of orange trees in the ground in identical soil and climate conditions. In similar experiments the plants are usually grown in laboratory pots, so Idso's experiment more closely approx imated real world conditions. Then he en riched the atmospheric CO2 content around the second group of trees by 75 percent and observed the two groups over time. Trees in the CO2 enriched group bore fruit a year earlier than the control group, and after three years were 2.8 times as large on average. Their fruit yields were enormously larger, and by every measure of plant vital ity they exceeded the control group.7 A Greener World?

Evidence is accumulating that industrial CO2 emission is increasing plant growth around the world. For example, scientists at the Finnish Research Institute, in a recent study of European forests, discovered that there had been a 25 to 30 percent increase in the growth and growing stock of those forests between 1971 and 1990, which they attribute at least partly to the increase in atmospheric CO2 over the period.8 They strongly hinted that this process is probably operating world wide. Other data indicate so. At Mauna Loa recording station in Hawaii, scientists measure the amplitude of the oscillation in atmospheric CO2 concen tration between summer, after spring plant growth has reduced the concentration, and winter, after much vegetation has died and returned CO2 to the atmosphere. The sci entists report that this oscillation, which is known as the' 'breath of the biosphere, " has increased by 15 percent since 1959, indicat ing that plant sequestration of CO2 has risen that much in the northern hemisphere over this period.9 If so, this CO2 "fertilization"

effect must be more than offsetting defores tation in the tropics. Indeed, it may auto matically compensate as rain forest trees are cut and stop sequestering atmospheric car bon through growth, leaving more in the atmosphere to generate and be removed by plant growth elsewhere. The world is actually getting greener, then, due to the beneficial effects of indus trial CO2 emission, contrary to the dismal 424 THE FREEMAN • AUGUST 1994 projections of the environmental apocalyp tics. On the basis of the Mauna Loa data, Patrick Michaels computes that the proba bility that the world is not getting greener is only 3 percent. Consumers driving their automobiles, instead of feeling guilty for using depletable fossil fuels, as environmen tal apocalyptics so ardently wish them to, mightjustifiably take satisfaction in helping to feed the world's billions, since that is exactly what they are doing. It is safe to say that economic models which exclude such a systematic, beneficial externality, cannot generate accurate estimates of the costs or benefits of CO2 emission abatement, and must systematically overstate the amounts of such emission abatement that is econom ically justified. They may even get the jus tified direction of change wrong.

Blinded by Ideology How can economists studying environ mental issues and other effects of technical change and industrial development miss all this? It seems odd that they would, since the theory of externalities makes specific refer ence not just to external costs but also to external benefits possibly resulting from human actions. Environmental ideology seems to blind most analysts to those ben efits. In a recent paper on the issue of global warming policy, William Nordhouse makes the following amazing admission in a dis cussion of the costs and benefits of CO2 emission abatement: In contrast to the cost function, we know little about the shape of the damage func tion . . . We suspect that higher levels of greenhouse gases will hurt the global economy, but because of the fertilization effect of CO2 or the attractiveness of warm climates, the greenhouse effect might on balance actually be economi cally advantageous. to Later in that paper, followinga discussion of the various factors that must be considered in assessing the impacts of CO2 emission and of emission abatement on the global economy, Nordhouse adds the following: These remarks lead to a surprising con clusion. Climate change is likely to pro duce a combination of gains and losses with no strong presumption of substantial net economic damages. This is not an argument in favor of climate change, or a laissez-faire attitude to the greenhouse effect. Rather, it suggests that a careful weighing of costs and damages will be necessary if a sensible strategy is to be devised. tt Unfortunately, though Nordhouse is among the fairest and most moderate of modern economic analysts dealing with such issues, these observations appear to be unrepresentative of his general philosophy.

In an even more recent paper on the same subject, Nordhouse not only completely fails to mention the "fertilization effect" of CO2, but expresses a highly pessimistic perspective on the risks associated with human industrial activity. That paper begins with a statement, phrased in the best apoc alyptic style, that mankind is playing dice with the natural environment through a multitude of interventions. The usual bleak list follows, with none of the potential ben eficial effects or side effects of scientific/ industrial progress mentioned. This attitude carries through to the last section of Nordhouse's paper, titled, symp tomatically, Uncertainties and Anxieties. He remarks on the relatively small amount of coercive governmental controls for emis sion abatement his and other economic models justify, with some apparent disap pointment, which becomes clear as he then writes the following: Yet, even for those who downplay the urgency of the most likely scenarios for climate change, a deeper anxiety remains about future uncertainties and surprises.

Scientists raise the specter of shifting currents turning Europe into Alaska, of mid-continental drying transforming grain belts into deserts, of great rivers drying up as snow packs disappear, of severe storms wiping out whole populations of lowlying regions, of surging ice sheets raising ocean levels by 20 to 50 feet, of FREE MARKETS AND EXTERNALITIES 425 northward migration of old or new tropi cal pests and diseases decimating the temperature (sic) regions, of environmen tally induced migration overrunning bor ders in search of livable land. Given the potential for catastrophic surprises, per haps we should conclude that the major concern lies in the uncertainties and im ponderable impacts of climate change rather than in the smooth changes fore seen by the global models. 12 Nordhouse clearly reads different scien tists than I do. Most of the elements in this list of potential disasters seem highly un likely. But notice his uniform concentration on catastrophic surprises, with no hint that beneficial surprises might be equally possi ble. Nordhouse goes on to point out that society often has to make decisions in the absence of complete information, and that a reasoned decision process lists events that may occur, assigns them probabilities, and weighs the expected values of costs and benefits under alternate courses of action in such a way as to maximize the expected value or utility of the outcome. This stan dard neoclassical economic argument is dif ficult to deny. But any society whose intel lectual opinion makers and governmental decision makers-like Nordhouse-only presume disasters to be likely, and never beneficial surprises, would arrive at incor rect and harmful policy decisions with un necessary frequency. Indeed, the progres sive extension of controls such myopic disaster prevention policies entail would eventually end the very freedom that has been a precondition of modern human wellbeing. D 1. See Steven Gold, "The Rise of Markets and the Fall of Infectious Disease," The Freeman, November 1992, pp. 412 415.

2. Paul W. MacAvoy, Industry Regulation and the Per formance of the American Economy (New York: W. W. Norton & Company, 1992), pp. 96-103. 3. The data and surrounding issues are discussed clearly and exhaustively in Patrick J. Michaels, Sound and Fury: The Science and Politics of Global Warming (Washington, D.C.: The Cato Institute, 1992). Michaels was Virginia State Clima tologist for several years, and was President of the American Association of State Climatologists, 1987-1988. 4. See Roy W. Spencer and John R. Christy, "Precise Monitoring of Global Temperature Trends from Satellites," Science 247, March 30, 1990, pp. 1558-1562. 5. Michaels, Sound and Fury, p. 10. 6. Sylvan Wittwer, "Flower Power," Policy Review, Fall 1992, pp. 4-9. 7. Idso's experiment is reported both in Michaels, Sound and Fury, pp. 109-110, and Wittwer, "Flower Power," p. 7. 8. Pekka E. Kauppi, et aI., "Biomass and Carbon Budget of European Forests, 1971 to 1990," Science 256, April 3, 1992, pp.70-74.

9. Michaels, Sound and Fury, p. 12. 10. William Nordhouse, "To Slow or Not to Slow: The Economics of the Greenhouse Effect, " The Economic Journal 101, July 1991, pp. 920-937. The quotation is from page 933. 11. Nordhouse, ~'To Slow or Not to Slow," p. 933. 12. William Nordhouse, "Reflections on the Economics of Climate Change," Journal of Economic Perspectives 77, Fall 1993, pp. 11-26. The quotation is from page 23. THEFREEMAN IDEASON UBERTY NoW', a better value than ever! SPECIALOFFER! Begin or renew your subscription to The Freeman by August 31,1994, and receive absolutely free: American Unionism-Fallacies and Follies 237 pages, paperback, a $14.95 value Just mention this ad to receive twelve great issues of The Freeman and American Unionism. A donation of $25 or more is all it takes. Call today with your Visa or MasterCard order: Tel. (800) 452-3518; Fax: (914) 591-8910. For addresses outside the U.S., please remit $40 to cover shipping costs.