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More precisely, is there any practical way to operate a free market so that external costs, namely negative social and environmental impacts, become naturally (intrinsically) covered (paid for or mitigated) by the market itself?

History suggests that capitalism inherently incentives production processes which externalize as much of the cost of production as possible.

This economic tendency to externalize costs wasn't a big problem in a world of seemingly infinite resources. More recently, however, globalization appears to both intensify and conceal the externalization tendency, as large international corporations seek to increase profits and/or stockholder earnings through any available means, including unethical and/or illegal means which remain concealed by the sheer size and complexity of the global marketplace.

[The next two paragraphs are probably not necessary for the question, and may be inflammatory.]

But the damage being done by externalized costs is also global, and is apparent to us all. We call them "wicked problems". We are becoming like the laboratory rats that, under conditions of severe crowding, go crazy and start eating their young. For all of its incredible efficiency and historical success -- creating a huge increase in global wealth -- free market capitalism in its current form is like a cancer, sacrificing the host in its pursuit of unlimited growth, both environmentally (e.g. global warming) and socially (e.g. the middle class shrinks while the financial sector expands).

There is hope, and there is still time. Perhaps all that is needed is a tweak to our economic system. At the local level externalized costs can be identified, controlled and mitigated by government regulation. But at the national level, regulatory mechanisms are expensive and inefficient, and regulators will always be playing catch up to corporate ingenuity. The regulatory challenge is even greater at the global level.

It would be far more efficient and sustainable if the tendency to externalize costs were managed by market mechanisms that, ideally, were built into the economic system, rather than imposed from the outside.

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  • $\begingroup$ Is this a question, or a political statement disguised by a short question at the beginning? $\endgroup$ – Giskard Jan 24 '17 at 8:13
  • $\begingroup$ @denesp It's meant to be a sincere economics question. Unfortunately, factual questions (and answers) about environmental and social conditions and trends have been politicized (perhaps because of the immense social costs and social dislocations that current science projects are being created by the status quo). If it helps, just ignore paragraphs 4 and 5. Perhaps the magnitudes and consequences of externalities aren't relevant to the issue of efficiently managing external social costs created (but not recognized) by the marketplace. $\endgroup$ – J Conklin Jan 25 '17 at 1:14
  • $\begingroup$ When you say "paid for by the market itself", are you also ruling-out systems like carbon trading, where a market mechanism is used to eliminate the externality? $\endgroup$ – Ubiquitous Jan 25 '17 at 7:52
  • $\begingroup$ @Ubiquitous Great question. I'm struggling to understand the boundaries of the economic "system". If there are non-trivial externalities then it's obviously not a closed system (and treating it like one seems intellectually dishonest). But, as EnergyNumbers says, the use of pollution taxes or pollution credit trading systems has done a good job of managing targeted externalities. But, such mechanisms are not so much built into the market as bolted onto it, and as such they, like a body of regulations, require a (functioning democratic) authority to create, launch, and maintain them. $\endgroup$ – J Conklin Jan 25 '17 at 19:23
  • $\begingroup$ Here's an answer to another question that explains how market mechanisms can be used to fix externalities provided people are able to trade without frictions (as implemented in the intellectual foundation of the carbon tax). economics.stackexchange.com/a/365/108 Such a solution is still "bolted on", but it at least functions through a self-regulating market mechanism rather than requiring ongoing external intervention as with taxes or regulations. $\endgroup$ – Ubiquitous Jan 25 '17 at 20:47
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As far as we can tell, no, there is no way to do it using only a free market.

Coase postulated that within a free market, agents would negotiate private contracts to internalise the externalities.

In reality, this didn't happen. It turned out that humans aren't perfectly informed hyper-rational beings. And as Coase himself had inferred, the transaction costs are typically too high.

There are well-documented ways in which markets have been adjusted for externalities: sometimes taxes or subsidies are sufficient; other times, prescription or proscription has been necessary.

There are even well-documented ways in which the commons have been protected, meaning that the destruction of them is no inevitable tragedy: Elinor Ostrom won the Nobel Economics Prize for her work showing how empowered stewardship by a group of custodians had repeatedly protected the custodians' commons.

So the relative efficiency of market mechanism versus planned mechanism is nowhere near clear enough to claim that "It would be far more efficient and sustainable if the tendency to externalize costs were managed by market mechanisms ... ". Each of the alternatives has inherent inefficiences: planned mechanisms have dead-weight costs. market-mechanisms have transaction costs and failures due to imperfect information and bounded rationality. There's a lot of evidence, particularly when it comes to the wicked problems you describe, that the market inefficiencies are far worse than the planning inefficiencies.

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  • $\begingroup$ Thank you! That strikes me as an excellent brief but complete answer to my question. Perhaps I should ask this as a top level question, but I'd be grateful for your opinion ... How is the conflict between planned mechanisms and market mechanisms to address wicked problems playing out in the field of economics? Is it, as in politics, just another (theoretical) food fight? Are there emerging theories or notations that give exponentially increasing externalities a more central role in understanding free market economics? Something more structural than band-aid? $\endgroup$ – J Conklin Jan 25 '17 at 19:44
  • $\begingroup$ For example, perhaps a marriage of Coase and Ostrom that subsidizes custodial stewardship of the commons? $\endgroup$ – J Conklin Jan 25 '17 at 19:55
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    $\begingroup$ My own angle is that the market is a good servant but a poor master, when it comes wicked problems such as climate change. That seems consistent with how the literature is panning out. There's a largely fruitless discussion about regulating quantity vs regulating price. But the Ostrom line seems to be playing out - the UNFCCC is a group of empowered custodians seeking to protect the commons. Ostrom's custodians don't make Coasian contracts between them; instead, they form a body that plans and governs. $\endgroup$ – EnergyNumbers Jan 25 '17 at 21:59
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We could create new institutions, combine them with free market and maybe account better for social and ecological costs. For example, when every commodity gets a CO2 impact label and every person will have an personal budget of CO2 tickets, which is limited to a sustainable level, a new market for such tickets is created. To put such an label on every commodity and to account the personal budgets are costly tasks, but it would not be impossible today. Informing customers about environmental impact is a strong signal for an ecology conscious business and could make this idea interesting for trading companies, even if it will limit the consumption.
Another way already exists are rating agencies for goods and services. It is realized as an smart phone app. A customer scans a bar code and augment the product packaging with information about negative or positive effects caused by producing the product.
These are only two simple ideas, which both partly exists today.
Processes like these will lead to more conscious producers. Consumers alone can't change the economic world, but we can help to make it more social and environmental friendly.

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    $\begingroup$ I think you underestimate the economic impossibility of forcing companies to track one of their key cost centres. It will ruin them, and result in gross inefficiency across cities, nations and the world. Moreover, consumers will just make stupid decisions if fully informed (unless the subject is what they will do with the proceeds of a tax reduction on their income or consumption, in which case they always make superior decisions). $\endgroup$ – nathanwww Jul 16 '18 at 16:11

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