No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Thirteen: Market “Failure” and the Role of the Government 304 considered. Many activities have both parties immediately involved in consenting to the exchange (such as gambling, prostitution, and drug use), and yet we typically make them illegal because of perceived negative impacts to a community as well as the loss of dignity and harm to the people involved. As another common example, when a production process results in air and/or water pollution, the fact that the producer and the purchaser of his or her product believe they will both be improved by the trade doesn’t mean that we’re socially better off; we need to consider the effects of the pollution on others. The effects of pollution (or gambling, prostitution, drugs, etc.) on the broader community are called negative externalities. The presence of negative externalities from market transactions calls into question the efficiency of market results, since not all costs are included in the production decision. While we have no way to measure any sort of “social” welfare (or utility), we intuitively know that there is such a concept—the well-being of the broader society. Let’s go back to the music example. We know the guy blasting his deep bass in the car next to me is experiencing an increase in personal utility, or he wouldn’t do it. There may be other cars nearby with passengers that actually enjoy the song as well; they have a positive increase in personal utility. Then there is me; I definitely have a huge decrease in utility, and of course there may be additional old fuddy duddies like me that don’t like it. If there were some way to objectively measure our individual utilities, we could add them up to arrive at an amount of social utility and determine if, on net, an action was welfare enhancing (positive social utility) or welfare decreasing (negative social utility). Recall that utility is an ordinal concept, not a cardinal concept. This means we can rank order our individual preferences (ordinal), but we cannot objectively measure an amount (cardinal) of utility. Let’s consider this example. Say the kid blasting his stereo in the car next to me gets 10 utils (our imaginary objective utility standard) by playing his stereo loudly at intersections. Then there is my car, where I have -8 utils of lost personal utility. If we were the only ones at the intersection, the social utility would simply be the sum, which in this case would be +2 utils. We would conclude that him playing the stereo very loudly is welfare enhancing from a social perspective, despite my objections, since he enjoyed the benefits of his stereo more than I suffered. If there were two other cars, with drivers who likewise shared my displeasure with the music at -6 and -9 utils, then we would have 10 – 8 – 6 – 9, or -13 utils—a welfare decreasing action socially. But of course, we cannot perform any such calculation because utility is a subjectively valued concept, and cannot be interpersonally compared. Therefore, economics doesn’t really have anything to say regarding whether any action is welfare enhancing or decreasing socially. We may have our personal preferences, but it cannot be an objective analysis. The fact that we can’t say how much social utility may increase or decrease by an action does not mean that we don’t know anything. Imagine a producer of steel (Stinky Steel) that dumps toxins in the river that runs past the factory. Let’s further assume that there is no one downstream of the factory who enjoys the toxins, while at least some find