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I recently read an excellent paper on the causes of high urban real estate prices in the United States, Why is Manhattan so expensive? Regulation and the rise in house prices (GLAESER, GYOURKO, and SAKS (2005)). In trying to understand if Manhattan’s regulatory tax can be justified they lay out three potential justifications for such a regulatory tax.

In this section, we ask whether there is likely to be any negative externality large enough to warrant a regulatory tax of the magnitude we found in Manhattan. ...

In a big city such as Manhattan, an optimal zoning tax should incorporate at least three elements in order to reflect the marginal social cost of a new resident to the community. First, the zoning tax should reflect the fact that a new apartment may eliminate views from existing apartments. Indeed, most current height restrictions exist for exactly that reason. Second, the new development should be taxed to the extent there are negative externalities created by extra crowding. Pure wage effects (that is, the fact that more workers can depress wages) are pecuniary, not real, externalities, so the usual economic logic suggests that these effects should not be part of the development tax. Third, the tax should reflect the fiscal burden of the new resident. This fiscal burden should be defined as the difference between government expenditures on the new resident and the taxes that the resident will pay.

My question concerns the part in bold, that new construction obstructs the view of old construction and therefor is an externality that should be regulated. Is this an externality?

If this cannot be answered generally, imagine specific case. A simple world where all building is as of by right. I have an empty lot. I am entitled to build and do build a ten story building which obscures your view out of your 9 story apartment building. This right to build is not in dispute by and common knowledge to both parties. Your building happens to be on the market at the time. You got an early offer for \$10 million but when I announced my construction they withdraw the bid and submit a new one for \$9 million which you accept. Was that million dollar difference an negative externality on you?

Maybe this seems obvious, I did something, you suffered, you had no say in it, ergo, an externality. But I'm not so sure. By construction, in the example, I had a property right to block your view. That made my property more valuable and the expectation that your property might one day have obstructed views should have held down the value of yours. Since the right to develop was priced the basic condition of an externality is not satisfied. Like in Coase's setup, if I own the right to pollute there is no externality to polluting. If I own the right to obstruct what's the externality to obstructing?

How should we think about more complex and general urban settings?

______________________ Update __________________________________

Mas Collel Winston Green (1995) defines an externality as follows:

Definition 11.B.1: An externality is present whenever the well-being of a consumer or the production possibilities of a firm are directly affected by the actions or another agent in the economy

They then continue:

Simple as Definition 11.B.1 sounds, it contains a subtle point that has been a source or some confusion. When we say "directly," we mean to exclude any effects that are mediated by prices. That is, an externality is present if, say, a fishery's productivity is affected by the emissions from a nearby oil refinery, but not simply the fishery's profitability is affected by the price of Oil (Which, in turn, is to some degree affected by the Oil refinery's output Of oil). The latter type of effect (referred to as a pecuniary externality by Viner (1931)) is present in any competitive market but. as we saw in Chapter 10, creates no inefficiency. Indeed, With price-taking behavior, the market is precisely the mechanism that guarantees a Pareto optimal outcome. This suggests that the presence of an externality is not merely a technological phenomenon but also a function of the set of markets in existence.

So there is a two-part test for an externality:

  1. Is A harmed by the actions of B?
  2. Does B's action happen through the price mechanism or not?

In the example in the question above, as in the problem of the price change of the oranges in the comment on @EnergyNumbers's answer, test 1 is satisfied. The question remaining is is test 2 also satisfied.

The price of the land under the new building is priced to include development rights. The price of the existing building is lower because of those development rights. But, you say, the price dropped when you actually built it!

Is that enough? That's also exactly what you would expect to happen if the purchase price included a bet on when the other building would be built. If construction is increasing in rents, then should we view the construction as simply a pecuniary externality no different than if lower rents had decreased the value of the existing structure?

What's also tricky about views is that they aren't destroyed so much as transferred by the new construction. So it isn't as though , in MWG's example like the pollution kills the fish, it is more like one group of fishermen decide to fish upstream from another group of fishermen. That certainly isn't good for the latter group but makes it seem much more like a pecuniary externality where another worker takes your job by being willing to work for less or another buyer takes your orange by being willing to pay more for it.

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In general, yes it's an externality: it's a cost borne by others. How do we know it's a cost with real economic value? Because in general, properties with good light and better views tend to attract higher purchase prices and higher market rents.

And there's a difference between "view/light might be obscured some time in the future" versus "they are obscured now" - in sufficiently sophisticated and liquid markets, that would be captured by the price of an option.

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  • $\begingroup$ I agree that a view has value, the question is if obstructing it is necessarily an externality. Oranges have value. If you buy oranges regularly and their price goes up are you the victim of a negative externality? After all, you are worse off through no fault of your own. No, this is not an externality because you have no right to the oranges at the old price. If you enjoy a view but don't own that view, I don't see how that is an externality when you later no longer enjoy it. $\endgroup$ – BKay Jan 22 '16 at 17:15
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    $\begingroup$ But the new construction would decrease the value of property already owned: so it's infringing their existing property rights. That's not the case in your example. $\endgroup$ – EnergyNumbers Jan 22 '16 at 17:17
  • $\begingroup$ I agree it's a negative externality if it decreases the value of the property already owned and the value of the view was reflected in the price paid. Otherwise, you could suppose the view was a positive externality if the view was only created after the purchase. Then, the obstruction simply eliminates a positive externality instead of creating a negative. $\endgroup$ – Pburg Jan 23 '16 at 14:28
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An externality is a cost on a third party resulting from an economic transaction, that isn't captured by the buyer(s) and/or seller(s) of the initial transaction.

So if the price of oranges goes up, as in BKay's comment, it may or may not be an externality on orange buyers. If I decided to buy the right to burn a bunch of oranges from the government (I'm a real rebel), and that caused a supply shortage, then that does end up being an externality on orange buyers, since they had no input on my transaction, but they are bearing the cost.

In this simple housing example in BKay's example, if I simply have the right to build (I "buy" the right to do so from a non-existent "seller" and/or government), then imposing on your view is a negative externality for you, since you bear the cost of the lost view, and not me or the "seller". Whether or not you expected me to build there does not particularly matter.

In short, think of my building as a sort of pollution, the archetypal negative externality. This requires market correction.

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