The problem of external effects

From the innocent parable of the bees to the poisonous gas clouds of Bhopal, environmental external effects are evidence of the price system's inability to signal the true significance of the interdependence of human activities undertaken within a common environment. They are the ex-post measures of the environmental effects of activities launched in a state of deliberate or accidental blindness as to their consequences. Although external effects are all-pervasive, it is by no means universally accepted that they constitute a significant “problem” for economic theory. Like the social costs of racism or sexism, external effects are not susceptible to exact estimation precisely because they are outside the price system, and whether one believes them to be significant is often argued to depend on one's ideological predisposition. This book seeks to demonstrate that environmental external effects represent fundamental flaws in the axiomatic structure of the dominant models of the economic system, and that the adoption of an appropriate axiomatic structure changes the properties of those models in an important way. More particularly, it alters both the conceptualization of the environmental management problem and the criteria for developing strategies to deal with it.

The modern theory of external effects stems from two seminal articles in the early 1950s by Meade (1952) and Scitovsky (1954). These articles established that the basis of external effects is the nonindependence of the preference and production functions of economic agents who operate within a common environment, but who do not meet in the marketplace.