Friday, April 18, 2008

The Myth of Social Cost

The Myth of Social Cost by Steven Cheung

May be Steven Cheung' books are out of fashion. I found this book selling at a nominal cost of $20. Steven Cheung said that it could hardly be called a book but rather a long paper. With a long prologue and a long epilogue, they marginally make a 93-page small book. The book may be small, but the idea is big.



The title of the book is on social cost, while the Chinese title is social damage or social loss. The main focus of the book is actually on externalities. In economics, an externality is an impact, which may be positive or negative, on anyone not party to a given economic transaction. Social cost falls into this category when the society is not a party to the transaction. Social cost generally has a negative meaning. However, externality also includes social benefit. There is social damage only when the social cost is greater than social benefit.

Externality is a subject made famous by Arthur Pigou. He advocated that externalities could be rectified by government intervention or taxation. Such kind of taxation, now known as Pigovian tax, is a tax levied to correct the negative externality of a market activity. A Pigovian tax may be levied on producers who pollute the environment to encourage them to reduce pollution, and to provide revenue to counteract the negative effects of the pollution. Pigovian taxes are sometimes called sin taxes, such as those on alcohol and cigarettes. Followed up by John Keynes, this school of thought led to the Keynesian economics which believed that the government should be responsible for shaping the economy through government spending and intervention.

Steven Cheung, together with economists Ronald Coase and others in UCLA, Chicago University, University of Washington, and Virginia Polytechnic Institute and State University were on another route finding out the flaws in the Pigovian analysis. Their line of work was best known in the achievement of Milton Friedman of the monetarist school of economic thought.

The book has a lot of mathematical presentations which are hard to understand. But the narrative part is eloquent in rebutting many illustrations of externalities used by Arthur Pigou and others. It adequately satisfies the aim of the book in exposing the myth of social cost.

Pigou raised the case of the railroad through the wheat field as an example of externalities. He proposed that the railway company should compensate the owners of the wheat field because the cinder of the train would damage the wheat. However, upon investigation, the wheat production by the railroad was increased because the train scared away the birds which fed on the wheat. Another example was the noise produced by an airport as an externality to land price. The contrary was true because the land price increased owing to its proximity to the airport.

Another famous example was the bees and apple farming proposed by Meade. He said that the bees collected pollens from the apple flowers and made honey, but the beekeepers did not pay anything to the apple farmers. Such externality should be regulated by a tax on bee keeping to compensate apple farmers. However, the truth was that bees collecting pollens also helped fertilize the apple trees. The force of the market was revealed from the fact that there were contracts between apple farmers and beekeepers on the rental of space in the apple farm for setting up beehives.

Steven Cheung explained that the book was not meant to be used as argument against government intervention. The main point was that "application of economic theory must rest upon careful empirical investigation to ensure that the facts are true, that the hypotheses are testable, and that the tests are performed." John Burton, in the epilogue of the book, added a general conclusion for public policy, "Given the inherent defects, complexity, cost and bias of an intervention solution, the general rule should be to let the price system deal with externalities whenever possible. Government intervention, domestic or supranational, is best kept as a solution of the last resort. Even so, government intervention must be carefully scrutinized, because the costs and external side effects may outweigh the benefits. The mere existence of externalities does not provide a clear case for some kind of public intervention."

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