…comes from pages 149-150 of Carl Dahlman’s 1979 Journal of Law & Economics article The Problem of Externality (emphasis added, footnote omitted):
In case I, the laundry owner correctly anticipates the costs of bargaining to be low enough for him to gain from reducing the smoke outpour from the steel mill: the externality becomes internalized by the steel operator. In case II, he correctly anticipates the cost of smoke reduction would be too high: he thus lives with the smoke. The externality is now internalized by the laundry operator, and there is no inoptimality problem. In case III, the laundry owner decides to bargain for reduction in smoke outpour but finds in the process of bargaining and policing the agreement that it cost him too much to do so. In case IV, he decides to live with the smoke in the belief that it would cost too much to reduce it but is incorrect: he would have gained from reducing it in view of the costs of transacting with the steel operator.
We have already noted that in cases I and II there is no Pareto-relevant externality remaining; the question remains whether there is one in cases III and IV. In case number III there is obviously no Pareto-relevant side effect remaining; on the contrary, there is too little smoke. The laundry owner lost by having the smoke reduced, so total income is lower in case III than it would have been if the smoke had been endured. In case IV, however, the laundry owner should have bargained for a reduction in smoke outpour but failed to do so. This is then the only case that can qualify as a potential externality.
From the point of view of the laundry owner, it would not appear that it is a mistake to endure the smoke: given the information that he has at his disposal, he performs his constrained optimization and does nothing. His information is incomplete or wrong, so he makes the wrong decision: given the correct information there is a loss of income from the enduring of the smoke, and the situation looks very much like that we associate with an externality. Yet that interpretation is fundamentally incorrect, for, with the information that the laundry owner has at his disposal when he makes the decision, he decides correctly, as constrained optimization procedures would have it. It is only later that he may realize that he has made a mistake, in view of additional information that was not available at the time. This can be regarded as an externality only if you assume that “he should have known better” or that there is someone else who does know better.
Once the logical implications of bargaining under transaction costs are fully accepted, it is seen that all existing side effects are internalized one way or the other. An assertion that externalities represent a deviation from an optimal allocation of resources then implies that the analyst considers himself in possession of superior information than what is available to market transactors: he knows the “true” probabilities, as it were. The issue of whether an alternative and improved allocation of resources exists is then seen to hinge on whether there is available relevant information about better alternatives.
People will act on the best information they have at the time. That information may be incorrect; they may make mistakes, and mistakes that were obvious in retrospect. But they are exactly that: retrospect. Unless we assume the policymaker has superior knowledge of everyone’s costs and benefits (possible but not probable), we cannot say ex ante that some policy prescription is necessary or beneficial for solving externalities or other societal ills. It’s quite probable, given people’s subjective costs and benefits, that all costs of an externality have already been internalized, that is to say, an optimal level has already been achieved.
Any political policy that alters how a market works, anything ostentatiously designed to correct a “market failure” runs into the same problem Dahlman discusses here: a knowledge problem. The analyst or policymaker must either prove he has superior knowledge (itself a high hurdle to clear) or merely assume he does. But it is only by retrospect can we determine if there actually is a market failure; it is damn near impossible to see one in real time.