The Online Library of Liberty

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• Associate Editors
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• II: Political Analysis
• Society, State, and Right In Proudhon
• Human Rights and Political Change
• Carter's Human Rights Policy
• Locke's Tolerance: Prudence Or Right?
• Political Intolerance
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• Croce's Hegemony: How to Win Minds
• III: War and the State
• Just War and Rights
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• Walzer & Just War
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• IV: Political Economy and Theory
• Three Kinds of “capitalism”
• Adam Smith: Economic Utilitarian
• Roepke: Laissez Faire and Social Order
• Government-induced Boom & Bust
• Austrian Vs. Neoclassical Methodology
• Professor Friedman's Instrumentalism
• Milton Friedman's Critics
• Entrepreneurship and Justice
• Externalities & Government Intervention

Externalities & Government Intervention

Carl J. Dahlman

• University of Wisconsin

“The Problem of Externality.” The Journal of Law and Economics 23(April 1979):141–162.

The concept of an “externality” has gained increased prominence as modern technology produces an ever-lengthening catalog of unwanted side effects. Dahlman's essay deals with the theoretical analysis of the sources and remedies for externalities. When an externality is present, there are interactions among individuals that ought to be taken into account, but are not. Since it is believed that market forces cannot cope with these interactions, it is supposed that such situations justify government intervention. Dahlman critically examines the underpinnings for the standard analyses of externalities and questions this justification for government action.

Externalities exist because it is too costly for interacting parties to transact on the market. Benefits cannot be fully captured in the market place nor harm fully compensated. Dahlman patiently leads the reader through a typology of transactions costs. He concludes that all transactions costs ultimately are costs due to incomplete information. Those who assert that markets fail to take account of externalities are implicitly asserting that they know better than markets what to do. They are postulating rather than proving that a “better way” of organizing economic activities exists. Although government is typically alleged to be that better way, this conviction is not a scientific conclusion but a normative judgment.

Standard general equilibrium theory cannot demonstrate that externalities, which should be eliminated, in fact exist. Standard economic analysis can only show that people do the best that they can, given their information. “Whatever is, is optimal.”

Dahlman argues that Ronald Codge's alternative tradition to that of general equilibrium economics would allow possible changes in institutional arrangements that would lower transaction costs and make market transactions easier. Such changes might also involve government intervention.

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