Tuesday, December 8, 2009

Why Externalities Are Bad

Here's another story which, like the one about the hurricane and the ice sellers, belongs in an introductory microeconomics class.

After gold was discovered at Sutter's Mill in Coloma, California, we all know that there was an influx of prospectors to the foothills of the Sierra Nevada mountains. The popular image is of solitary, rough-edged men kneeling in the shallows of mountain streams and panning for gold. There actually were many prospectors who fit this description, especially in the early days of the rush. However, once it became better established that there actually were large quantities of gold dispersed in the alluvium of the rivers, mining companies with the ability to outfit custom excavators and extractors moved into the gold fields. These companies with their mechanized equipment extracted gold much more efficiently than was possible by simpler means.

The equipment they used came in many varieties, but two kinds were particularly prominent due to their power and and effect on the landscape and rivers. The first of these, water cannons, were used to practice a kind of gold extraction know as "hydraulicking" in which sediments were blasted and washed into sluices where the gold would settle out. The second kind, dredgers, were used as platforms for processing large quantities of sediment in the alluvial plains at the base of the hills. Near Sacramento today there are still many places where you can see large fields full of lumpy hills of gravel and stones. These are the remnants of the work done by the dredgers.

All of this activity washed enormous quantities of sediment into the rivers that come down out the the Sierra Nevadas. For those of you not familiar with the physical geography of California, all of the drainage from those mountains comes into California's central valley. There is only one way out for all of that water, and that is through the San Joaquin Delta, into the San Francisco bay, and out to the Pacific. The sediments that were washed down from the hills dramatically impacted these waterways. One of the most noticeable effects was the great flood of 1850 that all but destroyed Sacramento. There is some argument about whether the flood was caused by the plug of sediments working its way through the river system, but it has been cited as a likely contributing factor. Another deleterious effect was the silting up of the San Francisco Bay. A considerable amount of usable area in the east bay was lost to infill from the sediments. Shipping lanes had to be dredged to keep them from becoming impassable. Less well documented, but doubtlessly significant, were the costs to wildlife in the affected wetlands.

It has been estimated that the economic damage to the San Francisco Bay alone was greater than the value of all of the gold that was extracted.

Economists call it an externality when the actions of one group cause consequences that are borne by others. The costs of the damage done downstream by the gold miners was real, but the miners were not held responsible for it. The result was that all of their efforts caused a net loss of wealth for California, even though they created wealth by extracting the gold.

The problem isn't that the miners wanted to extract the gold, or that they didn't care about what happened downstream (they may not have even known). The problem is that because they weren't forced to bear all of the costs associated with extracting the gold, they extracted too much gold, and used processes that were too costly - costly to others. If the miners had borne the costs, as well as the rewards, of their activity, they would have extracted less gold with cleaner processes, and the people of California as a whole would have reaped a net increase, instead of a loss, of wealth.


  1. I wonder if the net loss argument is accurate: certainly, if you calculate the value of the total gold mined vs. the costs of cleanup, impact on wildlife, etc, viewing it as a net loss is one perspective. However, one could argue that the overall associated benefits of the gold rush and subsequent large scale mining of gold, which set in motion a host of other activities, including a mass migration of workers and settlers that eventually turned California (and indeed many of the other western states, when silver and other ores were found when gold "ran out") from remote, unsettled territories into one of the most prosperous regions in the world. Businesses were formed, cities and infrastructure setup, farms established, etc. Where would the west be now if not for the resulting benefit of the Gold Rush and the influx of capitol from the mining? Certainly the large scale methods of mining were destructive, but I suspect that if there had been restrictive requirements and government regulations choking the ability to mine for gold, we would not have seen anywhere near the ultimate expansion of wealth we have today in the region.


  2. Jared,

    I'm sympathetic to your point. But consider, the estimate of the economic damage to the bay was mostly dominated by a decrease in suitable harbor space in the east bay. Harbors are extremely important to economic growth, and probably have more of a long term positive effect than does a boom (and later bust) of any industry, including mining. You may be right, but I'm persuaded by the idea that lost harbor space hurt growth of businesses and cities more than the gold rush helped. Ultimately, whether the California gold rush was a net benefit or not is an empirical question, with a real answer, though that answer may be very difficult to accurately measure.

    However, aside from questions about this particular example, the principle that IF I can successfully impose the costs of my (profitable) activity on other people THEN I will be inclined to do more of that activity, is pretty obviously true. And it's further true that in a situation like that, the total costs can sum up to MORE than the total benefits (because I don't bear the costs, so they don't act as a check on my activity), therefore representing a net loss to society overall, even though I made out like a bandit. This is bad for society as a whole, and it is also a kind of tricky redistribution of wealth FROM the people who bear my costs TO me.

    I suspect that an important part of your objection is to government intervention being the means of addressing the situation. I'm plenty libertarian enough to hear that argument. So I wonder, is there some other way to handle this problem besides using direct government regulation? Essentially this is a property rights issue (the owners of the bay had their property rights infringed when the bay was damaged). Do you think that the problem could be addressed by improving the definition of property rights, so that the property owners could defend their rights without the need for a regulating government body (e.g. the EPA)?

  3. I don't disagree with the theory of externalities, I was mostly just giving my perspective on that specific example. The more I thought about it, the more it seemed that the premise of a net loss based on the Gold Rush and mining was flawed and the overal impact was actually one of huge monetary growth and benefit.

    As for a means to address the problem of external consequences, I think addressing it in the courts by property owners is appropriate: I guess if the land impacted is public land, the government would file suit to protect our interests. There really isn't a great solution to these issues in a truly free society (as with many other problems). It seems with freedom we get less protection; or alternately, we give up freedom for greater protection. I prefer freedom over protection.

    I also find it interesting that this argument frames a situation from history through the lens of our current thinking. Certainly, landowners could have filed suit back in the 19th century against the large mining companies that used the destructive techniques cited. I assume they didn't because either they didn't see the "net loss" claimed in this example, or perhaps they realized the greater benefit of the mining, or perhaps they didn't seek redress from the courts as readily as we do today. One of the great evils of our time (in my opinion) is the strangle hold lawyers and the courts have upon our society. While ceratinly good has come from lawsuits that have addressed wrongs, I think most of what goes on in litigation is a horrible drain on resources and time and the only ones who benefit are the attorneys (I admit I may have a jaded perspective based on my line of work).

    So ultimately, I don't have a great answer for addressing it. I shudder to think what would happen if we left this type of problem in the hands of a regulating body of the government: it would further increase the cost of doing business and punish the smaller businesses who can't afford to complete multiple land use studies and wait for months or years just to get approval for a project. I also suspect it will hinder growth and investment in developing businesses impacted, though ultimately the large wealthy companies would find a way to deal with the regulation. Would this inequity in access to compete in business and the overall stifling of growth be more punitive ultimately than any net monetary loss due to a lack of regulation? I don't know...

  4. I agree with you that there are questions about that particular example.

    One NICE thing about litigation, is that with enough cases we end up with clear definitions of responsibility. Once that happens there's considerably less need to go to court, because everyone has a pretty good idea what the outcome will be in court. At least, that's how it SHOULD work.

    Externalities are a big problem, though, and they are the basis for an INCREDIBLE amount of regulation. It would be nice if we could start finding other ways to handle them. It is really important to note that they are about conflicting rights. My right to do business can conflict with your right to be free from noise, pollution, etc. in your own home. Who has the more important claim? Should I pay you for the noise I make? Or should you pay me if I'm forced to not make noise? And what solution makes the whole society the most well off?

  5. Robert, did you hear the EconTalk a few weeks ago about "too many property rights"? I think it relates to this externality topic. I am curious to know what you thought of it.

  6. Justin,

    I haven't listened to it yet, put it's on my mp3 player and I can't wait! Is it pretty good?

  7. It definitely helped open my eyes to a topic I have not thought much about, so in that sense I would recommend it.

    On a related note, I have a hard time listening to EconTalk anymore because I am annoyed by Russ's predictable questions, retorts, and appeals to Hayek. But his quality of guests makes it hard to resist.

  8. I hear you on your criticisms of the show. Honestly, I find I get that way with just about everything. With enough exposure, I just get all to familiar with the perspective/biases/formula being applied in any publication. I've just about had it with The Economist, for example, after many years of enjoying it.