Carrot or Stick?

If you have been reading Economic Forces for any reasonable length of time you know that we love to write about externalities. For the uninitiated, externalities are benefits (positive) or costs (negative) created by market interactions, but that are not internalized by the participants in the market. I think that the reason that we write so much about externalities is that once you start to really think about the topic, you continue to uncover unanswered questions.

We usually start with the question of how we deal with externalities. Sometimes this is a question about whether externalities should be handled privately through the courts or publicly via taxes, subsidies, or government regulation. I have addressed some of that before. Today, what I would like to address is the question of whether externalities should be handled using a carrot (reward) or a stick (punishment).

Let’s think about a simple example. Consider a farm located next to a ranch. The farmer is growing crops. The rancher is raising cattle. Their day-to-day business is taking place in different markets. However, the rancher’s production decisions might affect the production of the farmer because the rancher’s cattle might trample the farmer’s crops.

This raises a question about how this potential cost of trampled crops should be dealt with. Non-economic arguments usually entail something like punishing whoever is to blame for the problem. In this case, one might say that the cattle (and thus the rancher) are to blame. After all, if not for the cattle, there would be no trampling. However, it is unclear what that means. For example, one useful way to frame this is that both the cattle and the crops are inputs into the destruction. It is true that the amount of destruction could be reduced by the rancher having fewer cattle. It is also true that the amount of destruction could be reduced if the farmer plants fewer crops. In other words, just as one could argue that “if not for the cattle, there would be no trampling,” one could also argue that “if not for the crops, there would be no trampling.”

It is not clear what blame means without defining property rights. Yet, how to define property rights is the fundamental economic question here. For example, there are a couple possible solutions to this problem. One might say that the rancher should compensate the farmer for any damage caused by ...