Michael Lissack economists in formulating their recommendations for economic policy. In particular, the existence of what they call “externalities” does not imply that there is a prima facie case for governmental intervention. Assume that A, in manufacturing a product, emits smoke (which A has a right to do), harm- ing B with whom A has no contractual relations and of whose existence he may even be unaware. The smoke (or more properly the harm the smoke is doing) is an “externality.” Assume that the government is able and well motivated. What should it do? Consider the case in which the amount which B would pay to avoid the harm is less than the additional cost that would have to be borne by A to eliminate it. In these circumstances, the perfect government, anxious to maximize the national well being, would do nothing, neither through taxation of A nor by direct regulation, to prevent the smoke emission. The “externality” would continue to exist and would not call for governmental intervention. Now consider the case in which B would pay more to avoid the harm than the additional cost that would have to be incurred by A to eliminate it. We must first enquire why B has not made a bargain with A to end the emis- sion of smoke, since a bargain would appear to be possible on terms which would be profitable to both A and B. The answer must be that the costs of making the transaction were such as to offset the gain that the transaction would bring. If this is the situation, what should this perfect government do? Just as A and B would take into account the costs of carrying out their transaction, so a perfect government would take into account its costs of discovering what B would pay to avoid the harm and the costs that A would have to incur in order to eliminate it, as well as the government’s costs in administering whatever scheme is adopted. If the costs of investigation and administration are sufficiently high and/or the results obtained are sufficiently uncertain, with the consequence that the expected gains from governmental intervention are less than the costs involved, such a government would neither place a tax on A nor impose regulations which would eliminate the smoke. Another possibility would be to change the law to make A liable for the damage caused.
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