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?
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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:
- Is A harmed by the actions of B?
- 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.