'Exceptional and Unimportant'? The Rise, Fall, and Rebirth of Externalities in Economic Analysis

Abstract

Economists typically locate the origins of the theory of externalities in A.C. Pigou’s The Economics of Welfare (1920, 1932), where Pigou suggested that activities which generate uncompensated benefits or costs—e.g., pollution, lighthouses, scientific research—represent instances of market failure requiring government corrective action. According to this history, Pigou’s effort gave rise to an unbroken Pigovian tradition in externality theory that continues to exert a substantial presence in the literature to this day, even with the stiff criticisms of it laid down by Ronald Coase (1960) and others beginning in the 1960s. This paper challenges that view. It demonstrates that, almost immediately after the publication of The Economics of Welfare, economists largely stopped writing about externalities. On the rare occasions when externalities were mentioned, it was in the context of whether a competitive equilibrium could produce an efficient allocation of resources and to note that externalities were an impediment to the attainment of the optimum. When economists once again began to take up the subject of externalities in a serious way, the very real externality phenomena—pollution, etc.—that had concerned Pigou were not in evidence. Instead, the analysis was targeted at identifying how and why externalities violated the necessary conditions for an optimal allocation of resources in a competitive system. In short, externalities were conceived very differently in the welfare theory of the 1950s than they had been in Pigou’s treatise. It was only when economists began to turn their attention to environmental and urban problems that we see a return to a conception of externalities as real, policy-relevant phenomena—that is, to the type of externality analysis that had preoccupied Pigou and that characterizes the economic analysis of externalities today. Even then, however, the approach to externality policy was anything but straightforwardly Pigovian in nature. The history of externality theory is therefore not a history of a continuous tradition but of changing conceptions of externalities, framed by changing ideas about what economic theory is attempting to achieve.

Keywords: Externalities, Social Cost, PIgou, Coase, Competitive Equilibrium

JEL Classification: B2, D62, H23