- Email: [email protected]
Externality and Institutions
Book re6iews
logically important sites; and suggests the lessons that can be learned by regular monitoring and assessment. The papers presented in this book demonstrate that protected areas have become an important part of virtually all the NATO countries, with the eastern European countries quickly recognizing that managing biologically important sites for their natural values is an important contribution towards nation-building. Jeffrey A. McNeely IUCN rue Mau6erney 28, 1196 Gland, Switzerland E-mail: [email protected] PII: S 0 9 2 1 - 8 0 0 9 ( 0 1 ) 0 0 1 6 2 - 8
Externality and Institutions Andreas A. Papandreou, Oxford University Press, 1998, ISBN 0198293070, p. 304 With Principles of Economics (1890), Marshall introduced the term ‘‘external economics’’ into economists’ vocabulary, thereby initiating a discussion that would continue for several decades. The main focal points of this discussion have been how to interpret the term ‘‘externality’’, what to associate with it and how to deal with it. Much can be credited to this debate, since it has played a central role in forming our perceptions of concepts economists use everyday, such as economic inefficiency, governmental intervention, market failure, public goods, or poorly defined property rights. In Externality and Institutions, Papandreou critically surveys many of the different characterizations of the term ‘‘externality’’ that can be found in the economic literature. This constitutes the first part of the book. He concludes that there is a need to better recognize the role of institutions. Attempts already made to incorporate institutions endogenously into economic models are, therefore, also evaluated. This is done in the second part of the book.
.
157
After an introduction in chapter 1, the historical journey takes off in chapter 2, starting with Marshall. When Marshall referred to external economies he meant economies dependent on the general development of the industry. On the other hand, internal economies were dependent on the resources of the industry and efficiency of management. Marshall’s division was quite vague and opened up for critique. Papandreou briefly refers to the ideas of, among others, Clapham (1922), Knight (1924) and Pigou (1924). The critical point was that the increase in factor prices, resulting from expansion, was simply the price system working, reflecting the response to an increase in demand for a scarce resource. This is no inefficiency and therefore no cause for alarm. The discussion settled after Viner separated Marshall’s external economies and diseconomies into two categories, in Cost Cur6es and Supply Cur6es (1931). Viner referred to these as pecuniary external economics and technical external economics. Pecuniary externalities are not sources of inefficiencies, whereas technical are. The next period in the ‘external’ history lasted until 1960. This was a period of numerous contributions. Meade, for example, broadened the scope of externality on the industry level (1952). He recognised that externalities could appear both as a response to input and output changes. Economics could also be spread to other industries. Samuelson (1947) looked at a consumption example and wrote two important papers (1954, 1955) on public expenditure. This period ends with Coase’s famous article (1960) The Problem of Social Cost. Although Coase did not directly refer to externality in his article, Papandreou argues it is still an important piece because it introduced transaction costs into economics. From that day transaction costs had a strong impact on the notion of inefficiency and market failure. The third and final period covered the following 30 years. During this period the ecology-economy connection became stronger. Externality became almost synonymous with pollution for some economists. Papandreou points out though that there is a problem of associating externality with a specific phenomenon. In chapter 3, he looks deeper into the work of Baumol and Oates (1975).
158
Book re6iews
In Theory of En6ironmental Economics, Baumol and Oates try to separate out a specific kind of interdependence without reference to institutions or consequences in terms of inefficiency. Papandreou is sceptical of their definition, and argues that externality is present whenever property rights are not fully defined or do not exist. Baumol and Oates cannot escape institutions according to Papandreou. In chapter 4 and 5 the focus is on general equilibrium. Economists aimed at finding the connection between market failure, public goods, non-convexities and externality. In general, equilibrium models, such as Arrow-Debreu (private ownership economies without transaction costs), externality is strongly associated with market failure. In order to explain market failure, there is a need to invoke transaction costs. But how can this be done in a world where by definition we have zero transaction costs? This problem is dealt with differently. Arrow makes a distinction between relative market failure and absolute market failure, where relative market failure is a result of high transaction costs. Heller and Starret (1976), on the other hand, talk about private-economy failure. Externalities are partly determined by how agents, commodities and markets, i.e. institutions, are defined. It would therefore be a nice thing if we could incorporate institutions endogenously into our models. The focus would shift to economic interaction among agents when forming institutions instead of interaction after institutions have been formed. There is, however, a problem. This will take us outside the Arrow-Debrue framework. Once outside we need to redefine the concepts of market failure and externality. In chapter 6, Papandreou also challenges the view that transaction costs are the ultimate cause of market failure. Even though there would not be a market failure if transaction costs were zero, it still cannot provide a useful understanding of causality of failure. What one can conclude from the first part of the book is that externality is clearly a plural concept. This can cause confusion. The reason is that economists do not only use it when referring to a general interdependence, which has no con-
.
nection with consequences and inefficiency. General interdependence means any potential impact that an agent’s decision can have on another agent. Externality also means inefficiency. Something has not been properly accounted for. It has not been ‘internalised’. Most examples in the literature contain a mix of both and reference is often made to a specific institution, an institutional failure. Papandreou, therefore, suggests that economists need to better understand the role of institutions. The second part of the book begins with chapter 8, where we get an insight into the theories of institution formation in the neo-institutional economics literature. Demetz (1967) represents the property rights view on institution formation. According to this theory, property rights evolve if the gains are high enough to outweigh the costs. Private agents take actions. If the costs are too high, the property right will not be created, which is efficient. With this approach everything will be efficient. The problem is that social costs and benefits are not necessarily equal to private costs and benefits. In The Optimal Commons by B.C. Fields (1986), individuals as a community are the institution builders. Papandreou also discusses Umbeck’s contribution (1981). In an ‘anarchy model’ coercion and power are important forces. To reach an optimal allocation one needs to make very strong assumptions. Schotter (1981) presents a game theoretic approach with a random model, where institutions evolve efficiently but may not be optimal. Chapter 9 deals with one of the most commonly used principles in law and economics— wealth maximisation. An efficient legal system is attained through wealth maximisation. Put differently, it means that property rights have been assigned and the liability rules are formulated such that the willingness to pay is maximised over all alternative legal environments, given the costs of transacting. Papandreou concludes that this definition is insensitive to distribution aspects and far too much legitimacy is put on willingness to pay. In chapter 10, Papandreou explores an alternative notion of optimality, where transaction costs have been fully incorporated into the model. The
159
Book re6iews
reason is that the concept of optimality efficiency in welfare economics has been under criticism from institutional economists. Instead of having a world with zero organisational costs for reference point, one should aim at what is actually realisable. But so far this has not been dealt with satisfactorily. If this book was written with the intent that other disciplines but the economic would find it useful, my belief is that in order to benefit from reading it some basic knowledge of economics is necessary. Although it is a nice non-technical summary, Papandreou cannot escape using a variety of economic concepts, perhaps not so familiar to other disciplines. Nevertheless I strongly recommend this book. Papandreou clearly gives a generous exploration of the concept of externality. Not only does he
.
share with us the various approaches economists have used when dealing with this term, he also compares and evaluates them. Furthermore, I have no complaint about the choice of contributors or the numbers of contributors. On the contrary, with so many different authors, you get a more interesting picture, seeing things from different perspectives. Therese Lindahl Department of Economics, Stockholm School of Economics, Box 6501, S-11383 Stockholm, Sweden E-mail: [email protected] PII: S 0 9 2 1 - 8 0 0 9 ( 0 1 ) 0 0 1 6 3 - X
logically important sites; and suggests the lessons that can be learned by regular monitoring and assessment. The papers presented in this book demonstrate that protected areas have become an important part of virtually all the NATO countries, with the eastern European countries quickly recognizing that managing biologically important sites for their natural values is an important contribution towards nation-building. Jeffrey A. McNeely IUCN rue Mau6erney 28, 1196 Gland, Switzerland E-mail: [email protected] PII: S 0 9 2 1 - 8 0 0 9 ( 0 1 ) 0 0 1 6 2 - 8
Externality and Institutions Andreas A. Papandreou, Oxford University Press, 1998, ISBN 0198293070, p. 304 With Principles of Economics (1890), Marshall introduced the term ‘‘external economics’’ into economists’ vocabulary, thereby initiating a discussion that would continue for several decades. The main focal points of this discussion have been how to interpret the term ‘‘externality’’, what to associate with it and how to deal with it. Much can be credited to this debate, since it has played a central role in forming our perceptions of concepts economists use everyday, such as economic inefficiency, governmental intervention, market failure, public goods, or poorly defined property rights. In Externality and Institutions, Papandreou critically surveys many of the different characterizations of the term ‘‘externality’’ that can be found in the economic literature. This constitutes the first part of the book. He concludes that there is a need to better recognize the role of institutions. Attempts already made to incorporate institutions endogenously into economic models are, therefore, also evaluated. This is done in the second part of the book.
.
157
After an introduction in chapter 1, the historical journey takes off in chapter 2, starting with Marshall. When Marshall referred to external economies he meant economies dependent on the general development of the industry. On the other hand, internal economies were dependent on the resources of the industry and efficiency of management. Marshall’s division was quite vague and opened up for critique. Papandreou briefly refers to the ideas of, among others, Clapham (1922), Knight (1924) and Pigou (1924). The critical point was that the increase in factor prices, resulting from expansion, was simply the price system working, reflecting the response to an increase in demand for a scarce resource. This is no inefficiency and therefore no cause for alarm. The discussion settled after Viner separated Marshall’s external economies and diseconomies into two categories, in Cost Cur6es and Supply Cur6es (1931). Viner referred to these as pecuniary external economics and technical external economics. Pecuniary externalities are not sources of inefficiencies, whereas technical are. The next period in the ‘external’ history lasted until 1960. This was a period of numerous contributions. Meade, for example, broadened the scope of externality on the industry level (1952). He recognised that externalities could appear both as a response to input and output changes. Economics could also be spread to other industries. Samuelson (1947) looked at a consumption example and wrote two important papers (1954, 1955) on public expenditure. This period ends with Coase’s famous article (1960) The Problem of Social Cost. Although Coase did not directly refer to externality in his article, Papandreou argues it is still an important piece because it introduced transaction costs into economics. From that day transaction costs had a strong impact on the notion of inefficiency and market failure. The third and final period covered the following 30 years. During this period the ecology-economy connection became stronger. Externality became almost synonymous with pollution for some economists. Papandreou points out though that there is a problem of associating externality with a specific phenomenon. In chapter 3, he looks deeper into the work of Baumol and Oates (1975).
158
Book re6iews
In Theory of En6ironmental Economics, Baumol and Oates try to separate out a specific kind of interdependence without reference to institutions or consequences in terms of inefficiency. Papandreou is sceptical of their definition, and argues that externality is present whenever property rights are not fully defined or do not exist. Baumol and Oates cannot escape institutions according to Papandreou. In chapter 4 and 5 the focus is on general equilibrium. Economists aimed at finding the connection between market failure, public goods, non-convexities and externality. In general, equilibrium models, such as Arrow-Debreu (private ownership economies without transaction costs), externality is strongly associated with market failure. In order to explain market failure, there is a need to invoke transaction costs. But how can this be done in a world where by definition we have zero transaction costs? This problem is dealt with differently. Arrow makes a distinction between relative market failure and absolute market failure, where relative market failure is a result of high transaction costs. Heller and Starret (1976), on the other hand, talk about private-economy failure. Externalities are partly determined by how agents, commodities and markets, i.e. institutions, are defined. It would therefore be a nice thing if we could incorporate institutions endogenously into our models. The focus would shift to economic interaction among agents when forming institutions instead of interaction after institutions have been formed. There is, however, a problem. This will take us outside the Arrow-Debrue framework. Once outside we need to redefine the concepts of market failure and externality. In chapter 6, Papandreou also challenges the view that transaction costs are the ultimate cause of market failure. Even though there would not be a market failure if transaction costs were zero, it still cannot provide a useful understanding of causality of failure. What one can conclude from the first part of the book is that externality is clearly a plural concept. This can cause confusion. The reason is that economists do not only use it when referring to a general interdependence, which has no con-
.
nection with consequences and inefficiency. General interdependence means any potential impact that an agent’s decision can have on another agent. Externality also means inefficiency. Something has not been properly accounted for. It has not been ‘internalised’. Most examples in the literature contain a mix of both and reference is often made to a specific institution, an institutional failure. Papandreou, therefore, suggests that economists need to better understand the role of institutions. The second part of the book begins with chapter 8, where we get an insight into the theories of institution formation in the neo-institutional economics literature. Demetz (1967) represents the property rights view on institution formation. According to this theory, property rights evolve if the gains are high enough to outweigh the costs. Private agents take actions. If the costs are too high, the property right will not be created, which is efficient. With this approach everything will be efficient. The problem is that social costs and benefits are not necessarily equal to private costs and benefits. In The Optimal Commons by B.C. Fields (1986), individuals as a community are the institution builders. Papandreou also discusses Umbeck’s contribution (1981). In an ‘anarchy model’ coercion and power are important forces. To reach an optimal allocation one needs to make very strong assumptions. Schotter (1981) presents a game theoretic approach with a random model, where institutions evolve efficiently but may not be optimal. Chapter 9 deals with one of the most commonly used principles in law and economics— wealth maximisation. An efficient legal system is attained through wealth maximisation. Put differently, it means that property rights have been assigned and the liability rules are formulated such that the willingness to pay is maximised over all alternative legal environments, given the costs of transacting. Papandreou concludes that this definition is insensitive to distribution aspects and far too much legitimacy is put on willingness to pay. In chapter 10, Papandreou explores an alternative notion of optimality, where transaction costs have been fully incorporated into the model. The
159
Book re6iews
reason is that the concept of optimality efficiency in welfare economics has been under criticism from institutional economists. Instead of having a world with zero organisational costs for reference point, one should aim at what is actually realisable. But so far this has not been dealt with satisfactorily. If this book was written with the intent that other disciplines but the economic would find it useful, my belief is that in order to benefit from reading it some basic knowledge of economics is necessary. Although it is a nice non-technical summary, Papandreou cannot escape using a variety of economic concepts, perhaps not so familiar to other disciplines. Nevertheless I strongly recommend this book. Papandreou clearly gives a generous exploration of the concept of externality. Not only does he
.
share with us the various approaches economists have used when dealing with this term, he also compares and evaluates them. Furthermore, I have no complaint about the choice of contributors or the numbers of contributors. On the contrary, with so many different authors, you get a more interesting picture, seeing things from different perspectives. Therese Lindahl Department of Economics, Stockholm School of Economics, Box 6501, S-11383 Stockholm, Sweden E-mail: [email protected] PII: S 0 9 2 1 - 8 0 0 9 ( 0 1 ) 0 0 1 6 3 - X