Front Page Titles (by Subject) A Closer Look - Cost and Choice: An Inquiry in Economic Theory, Vol. 6 of the Collected Works
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A Closer Look - James M. Buchanan, Cost and Choice: An Inquiry in Economic Theory, Vol. 6 of the Collected Works 
The Collected Works of James M. Buchanan, Foreword by Geoffrey Brennan, Hartmut Kliemt, and Robert D. Tollison, 20 vols. (Indianapolis: Liberty Fund, 1999-2002). Vol. 6 Cost and Choice: An Inquiry in Economic Theory.
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A Closer Look
According to the Pigovian theory, the change in “costs” which results from an explicitly recommended levy of a tax modifies the behavior of the acting person so that “efficiency” results. But what is meant by “costs” here? This Pigovian framework provides us with perhaps the best single example of confusion between classically derived objective cost concepts and the subjective cost concepts that influence individual choice.
Consider, first, the determination of the amount of the corrective tax that is to be imposed. This amount should equal the external costs that others than the decision-maker suffer as a consequence of decision. These costs are experienced by persons who may evaluate their own resultant utility losses: they may well speculate on what “might have been” in the absence of the external diseconomy that they suffer. In order to estimate the size of the corrective tax, however, some objective measurement must be placed on these external costs. But the analyst has no benchmark from which plausible estimates can be made. Since the persons who bear these “costs”—those who are externally affected—do not participate in the choice that generates the “costs,” there is simply no means of determining, even indirectly, the value that they place on the utility loss that might be avoided. In the classic example, how much would the housewife whose laundry is fouled give to have the smoke removed from the air? Until and unless she is actually confronted with this choice, any estimate must remain almost wholly arbitrary. Smoke damage cannot be even remotely approximated by the estimated outlays that would be necessary to produce air “cleanliness.” “Clean air” can, of course, be physically defined; the difficulty does not lie in the impossibility of defining units in a physically descriptive sense. Regardless of definition, however, “clean air” cannot be exchanged or traded among separate persons. Each person must simply adjust to the degree of air cleanliness that exists in his environment. There is no possibility of marginal adjustments over quantities of the “good” so as to produce an equilibrium that ensures against interpersonal differences in relative evaluations.
Figure 1 illustrates my argument. There is no way in which the analyst can objectively determine whether the housewife is at position A, B, or C on the diagram, yet it is clear that the utility loss, both at the margin and in total, may be significantly different in the three cases. There is no behavioral basis for observing evaluations here. Figure 1 also suggests that if individual preference functions have the standard properties, the valuations of separate persons probably vary directly with private-goods income. The affluent housewife will value clean air more highly than the poverty-stricken. The reason is obvious. The external diseconomy, “smoke damage,” cannot be “retraded” among persons. If it could be, the poverty-stricken housewife might be quite willing to take on an extra share of the damage in exchange for some monetary payment from her affluent neighbor. But since such a trade cannot take place, she must simply adjust to the degree of “bads” in her environment.
Objective measurement of externally imposed costs seems more feasible in cases where the removal of the damaging agent results in changes in the production function of firms. If the damaged units should be producing firms, not individuals, there would seem to be no need to get into the complications of evaluating utility losses. A change in the rate of “pollution” can be observed to change the rate of outlay required for producing marketable goods and services. Since these goods and services command prices in markets, objective measurement of their value can be made.3
If a corrective tax, equal to the costs that are imposed externally upon others (which we shall now assume to be objectively measurable despite the problems noted above), is to generate the behavioral changes predicted by the Pigovian analysis, the internal costs as faced by the decision-maker must also be objectively measurable, at least indirectly. The analysis assumes implicitly that, in the absence of the corrective tax, choices are informed by money outlays made in purchasing inputs in ordinary market transactions. As an earlier discussion has shown, however, there is no logical support for this presumption in the general case. Observed money outlays need not reflect choice-influencing costs, the genuine opportunity costs that the decision-maker considers.
There is an obvious inconsistency. The Pigovian norm aims at bringing marginal private costs, as these influence choice, into line with social costs, as these are objectively measured. Only with objective measurability can the proper corrective devices be introduced. But under what conditions can objectively measurable costs, external and internal, be taken to reflect, with even reasonable accuracy, the costs that the effective decision-maker may take into account. In conditions of ideal competitive equilibrium, the costs that can be measured by the observer provide a reasonable proxy for the subjective evaluations of decision-makers. However, almost by definition, external effects are not imposed in such a setting.
[3. ]It seems likely that this helps to explain the source of the confusion. Marshall and Pigou developed the externality notion within the context of interfirm models, implicitly assuming competitive structures. As we shall see, the relevance of objectively measurable costs is limited even in this model, but the errors are of a different order of magnitude from those that arise when the externalities refer to an interpersonal interaction or to an interfirm interaction where utility functions are employed. The possibility of objectively measuring external costs does not, of course, ensure that the policy of levying a corrective tax is desirable. Under competition, this policy can be plausibly defended within certain limits. In noncompetitive structures, by contrast, the attempt to levy corrective taxes on an externality-generating firm may do more harm than good. On this elementary point, see my “External Diseconomies, Corrective Taxes, and Market Structure,” American Economic Review, LIX (March 1969), 174-77.