# Differentiate a positive externality and the absence of a negative externality. Tax or subsidize?

I hope this isn't overly semantic, but I'd like to gain some clarification on the use positive (or negative) externality.

I usually shoot down suggestions for examples of positive externalities like organic agriculture. We can grant that organic agriculture is better than conventional, but that doesn't mean it is producing additional external benefits. Instead, organic agriculture might feature fewer negative externalities compared to the status quo.

I've even seen examples like smoking being a positive externality because smokers die sooner and save governments money on Social Security (perhaps that accounting might be questionable, but let's grant it for the sake of argument). Again, my semantic preference would be to label this as the absence of status quo negative externality.

If the semantics aren't interesting, might there still be something interesting on the tax vs. subsidize side? Returning to the agriculture example, taxing the negative externalities associated with conventional agriculture seems smarter than subsidizing organic. This seems like a case where it's more efficient to regulate the end and not the means. But what market characteristics might make subsidizing specific not-negative-externality-producing things more efficient?

• My professor, Walter Block, actually loves to go into the semantics of externalities. Other professors joke that he argues away market failures by saying, "These aren't externalities you're looking for." I'll try and return with a competent answer incorporating his work. – rosenjcb Nov 18 '14 at 22:13
• It'd be helpful if you briefly indicated what the negative externalities associated with regular agriculture actually are (you mean like fertilizer runoff?) just so we're all on the same page... – Steve S Nov 18 '14 at 23:09
• What is "more efficient" in your terminology? Bang for your buck? Effectiveness of purpose? Something else? – Brythan Nov 18 '14 at 23:23
• @SteveS The externalities don't need to be explicitly named. I'm charitably granting that conventional is bad (producing pollutants or other external costs). Brythan, efficiency is measured by comparing total welfare in each case, or seeing when DWL is lower. So we care about consumer surplus, producer surplus, external costs, and external benefits. – Pburg Nov 18 '14 at 23:52
• @Pburg: Yeah, I know you're referring to Externalities in general, I just thought that it might add a little bit of context (you know, for posterity). – Steve S Nov 19 '14 at 0:30

A negative externality arises when the private net marginal benefit (i.e. the marginal benefit minus the marginal cost) of an activity exceeds the net social benefit. In such cases, the self-interested private decision maker will increase their participation in the activity even though it is socially inefficient for them to do so.

A positive externality arises when the private net marginal benefit (i.e. the marginal benefit minus the marginal cost) of an activity are smaller than the net social benefit. In such cases, the self-interested private decision maker will not increase their participation in the activity even though it is socially efficient for them to do so.

This is a semantic distinction to the extend that if one thinks activity $A$ has a negative externality then one can define a new activity $B$, which is simply the "act of not doing $A$" so that $B$ has a positive externality. On this basis, one can argue that every externality is positive or that every externality is negative. For example, many people think that education has a positive externality because educated people make better citizens (e.g they make more informed voting decisions that benefit others). As a matter of semantics, one could argue that this is, in fact, not a positive externality and that what is really going on is that people who do not educate themselves are exerting a negative externality on those who do by virtue of their ignorance.

Whilst there is some merit to this reasoning, I do not find it helpful. Often, when we study the effects of behaviour, we are interested in comparing those effects to some baseline or benchmark in which the behaviour is absent. When communicating economics to others, it is usually the case that some benchmarks are more intuitive that others. We could, for example, rewrite all of consumer theory in terms of "the dis-utility people experience from not having goods" and look at the "problem of non-consumption dis-utility minimisation". Doing so would be formally equivalent to the more conventional approach of consumption utility maximisation (only the language changed), but would probably be less intuitive for people trying to understand the economics.(*) At least to me, it is more intuitive to think that people actively choose to undetake some level of education and exert a positive externality on others than to think that everyone receives infinite education by default and the choice of abstaining results in a negative externality.

Besides education, another example that I think fits most intuitively into the positive externalities box is network effects. If I buy a telephone then all of my phone-owning friends are made better off because now they can use their telephone to call one more person that they couldn't reach before. It seems weird to think of the negative externality of not owning a phone.

In terms of taxes versus subsidies: to get to the socially optimal intensity we need to ensure that the private net marginal benefit is zero precisely when the social net marginal benefit is zero. In the case of a negative externality this can be done either by increasing the private marginal cost (via a tax) for the activity or by increasing the private marginal benefit of not participating in the activity via a subsidy. For example, we could either subsidize low carbon firms or tax heavy polluters. As far as aligning incentives are concerned, the two are equivalent. In most practical cases, the more important consideration is likely to be that of budget constraints and politics:

• In the case of a tax: can the person you are taxing afford to pay the tax and can the tax be levied without seeming vindictive (for example, I think that taxing people without a university degree would be a no-no on these grounds).
• In the case of a subsidy: can the government raise enough popular support and funding for a subsidy without leaving people with the impression the some parties are receiving unfair government hand-outs?

In most cases, thinking about these political and financial constraints makes it clear whether a subsidy should be used. Sometimes a combination of both is used. For example, in the UK the government both taxes petroleum consumption and subsidises electric car ownership.

(*) Nevertheless, economists do often find it useful to convert the utility maximisation problems into their dual expenditure minimisation problems, which is somehow similar. This technique, though, is usually reserved for more advanced students who already have a well-developed intuition for the economics.

A possible pair of definitions is this:

Definition. A negative externality of a good is any cost suffered by a party other than the buyer or the seller of the good, relative to a situation where the good is not traded at all.

Definition. A positive externality of a good is any benefit enjoyed suffered by a party other than the buyer or the seller of the good, relative to a situation where the good is not traded at all.

As in mathematics, it all follows from the definitions. One can certainly disagree with my definitions. But if one agrees, then, applying them to your examples:

• Organic agriculture could be generating fewer negative externalities than traditional agriculture: e.g. The latter uses pesticides and thus damages third parties (perhaps by contaminating the water supply). The former doesn't use pesticides and so doesn't damage third parties (at least in this specific regard). So the former results in fewer negative externalities (at least in this specific regard).

• It could also be generating more positive externalities: e.g. roses always give off a fragrant smell and thus generate a positive externality for passers-by. But maybe organic roses give off a stronger fragrance, so organic roses generate a larger positive externality.

Most likely when people think of the benefits of organic agriculture, they are thinking of the reduction in negative externalities. I say this only because I found it much harder to think of examples of positive externalities.

• Smoking in your context is both reducing negative externalities and also generating positive externalities. By dying off more quickly, we reduce the costs to other taxpayers of having to treat lung cancer (reduction in negative externalities). By dying off more quickly, we increase the benefits to other taxpayers of not having to support smokers in their old age--the logic here is that everyone needs to be supported by taxpayers in old age, but by dying off more quickly, smokers reduce the need for such support.

Your question about taxing negative externalities vs subsidizing positive externalities is much trickier and I don't think can be answered in the SE format.

• Semantics again, but not having to support another person is the avoidance of a cost imposed by others. So what are you pointing out as the positive externality? Is there an assumption that there is a fixed pool of benefits split by society? That seems like a transfer more than an externality. – Pburg Nov 18 '14 at 23:56