The Ethical Economics
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Economic activities sometimes have indirect, and often unintended, detrimental effects upon others in a community. Prime examples include water, air, and noise pollution caused by production or consumption activities. The problem is akin to dumping your garbage on your neighbor’s lawn. Commonly known in economics as negative externalities, these effects generally cause the over-production or over-consumption of these goods relative to what would be best from a social point of view.

The standard neoclassical economic model that generates the efficiency of economic nirvana ignores the possibility of negative externalities. In other words, the model assumes externalities simply do not exist. Including them in a standard model reduces efficiency and opens up the possibility of government taxes or regulations to correct for the problem. An alternative to government intervention can sometimes be found via negotiation and compromise among the affected parties. For example, the perpetrator causing the negative external effects could offer to compensate those negatively affected for their losses. Alternatively, those negatively affected could offer to pay the perpetrator to reduce or eliminate their damaging behavior. Who pays whom, according to a well-known economics result introduced by Nobel prize winner Ronald Coase, depends on the property rights over the resource being damaged.

Regardless of which mechanism is used, correction of the problem for society’s benefit requires participants to behave in a cooperative manner and that implies ethical behavior. One could invoke the well-known golden rule as the ethical principle at work here and argue that one should not do anything with an effect on others that you would not wish to have done to you. For example, don’t dump your garbage on someone else’s property, if you don’t want others to dump their garbage on yours.

A strict application of the golden rule may imply, though, that the optimal policy would always be to not pollute. After all, I would certainly prefer never to suffer any negative effects caused by others’ behavior. However, we know from economics models that when the benefits of production activity are high and the pollution costs are relatively low, then the optimal production level, and therefore pollution level, is not zero. To determine an acceptable outcome requires measurement of all the costs and benefits together with a willingness to cooperate and compromise. A polluting business may of course prefer to pollute freely since this would maximize its profit, assuming it is not run by environmentally-concerned owners. The disaffected public would of course prefer to have zero pollution since this would maximize their utility. The optimal solution is usually somewhere between these two extremes.

Another way to state the ethical principle here is that the correction of externalities requires consideration for others, or, good neighborliness. Being a good neighbor means recognizing when your activities pose harm to others and being willing to work towards a mutually acceptable compromise. Of course solving these problems, even with cooperative participants, can be very difficult. Measuring the costs and benefits is often contentious. The polluters will be inclined to look for measurements that minimize the cost estimates, whereas those affected by pollution will seek measurements that exaggerate the estimates. For this reason, government taxation or regulation may be necessary because it can force stakeholders to accept a kind of mediated solution.

Additionally, sometimes external benefits of economic activities are positive, not negative. Education of the population provides skilled workers to the market and can enhance the overall standard of living of a community. Similarly, products such as roads, bridges, parks, national security, and an effective legal system can all be shared widely and freely once these are produced and will contribute to the efficiency of the economic system. Provision of these “public goods” by private markets faces the difficult problem of free-riding and generally results in inefficient levels of supply. Thus, to make these products and services available at the optimal level may require either government intervention via public provision or subsidization, or, a high level of cooperation within a community. People need to have a sense of community for the private contribution and provision of these items, or, be willing to accept a social contract enabling government to provide these items while taxing its citizens for the means to do so. Again, good neighborliness and a willingness to be cooperative by sacrificing something for the sake of the larger community is a necessary behavior to assure economically efficient outcomes in the presence of externalities.

Steven Suranovic, December 1, 2019

Ethical Principles
Promoting Economic Efficiency

  • Be a Good Neighbor
    • Do not wantonly cause negative spillover effects on others



  • Negative external effects causing losses in well-being to others are not captured in the price and quantity decisions of a market.
  • In many cases, the benefits of reducing the external effects are greater than the costs implying that market efficiency can be improved through either a cooperative agreement or with a government policy intervention.