In the case cited by the newspaper excerpt above, the EPA was requiring the city of Weatherford, Oklahoma to install liners in their existing landfills. In other words, the EPA was mandating that Weatherford make a specific resource transfer. Why couldn't the residents of Weatherford be trusted to make the right decision about this resource transfer? Installing liners in their municipal-owned landfills would make the citizens of Weatherford better off. There would be a decreased probability that landfills would ooze harmful substances into the local community. This would mean greater health, and happiness, for the residents of Weatherford.

Against this benefit is the cost of installing the liners. As we know, these costs represent the lost happiness that consumers elsewhere in the economy would experience if resources--such as the labor and materials employed in installing the liners--were withdrawn from other activities. If the residents of Weatherford decided that the increased happiness they would receive from having a safer environment was greater than the costs of installing the liners, one would expect that their political leaders--like Mayor Gary Rader--wouldn't need federal mandates to make them do the right thing.

The problem here is that there is a third group of consumers whose interests are not being considered. If harmful substances leach into Weatherford's soil and groundwater, that doesn't just hurt the citizens of Weatherford. Not too far away are the cities of Clinton, Thomas, and Hydro. Their citizens could also be harmed by Weatherford's leaky landfills. When Weatherford considers the costs and benefits of installing liners in their municipal landfills, it doesn't consider how the citizens of neighboring towns feel about this. That's natural, since the city of Weatherford has no way of collecting revenues from the citizens of other cities. But it is unfortunate. Because it means that Weatherford will not "feel the joy" that other citizens will receive from new landfill liners. This POSITIVE EXTERNALITY could cause Weatherford to make a socially incorrect resource decision.

Suppose the costs of the new liners is $9 million, and that the citizens of Weatherford would be willing to pay about $5 million to have these new liners put in. Further, suppose the residents of the neighboring towns of Clinton, Thomas, and Hydro would be made $7 million happier if Weatherford installed the new liners. We can use our Profit Table to show how the City of Weatherford's budget office might approach this problem (see "Before EPA Mandate").

It's pretty clear that without any mandates from the federal government, Weatherford has no incentive to install new liners in the city's landfills. The residents of the city receive too little benefit ($5 million) to warrant the expense they would have to bear ($9 million). Any local elected official who tried to implement this resource transfer would certainly incur the voters' ire. And that's a shame. The reality of the situation is that this resource transfer would make society better off.

From the perspective of society's happiness, there are only two numbers in the table that matter: $9 million and $12 million. Installing landfill liners is a resource transfer that takes away $9 million of happiness from consumers who are denied the goods and services that these resources could have produced doing something else. But in exchange, the citizens of Weatherford, Clinton, Thomas, and Hydro collectively receive $12 million in happiness. Therefore, the net gain to society's happiness of installing the landfill liner is $3 million.

Now the EPA steps in. They tell Weatherford that they better fix their landfill problem--or else. Or else what? Or else the EPA will hit the city of Weatherford with a very substantial penalty, a $7 million fine. This changes everything. Now the mayor and the city manager huddle over the city's budget and come to an entirely different conclusion. By installing the new liners, the city can make its citizens $5 million better off, and avoid having to pay the $7 million fine. Once this PENALTY AVOIDANCE BENEFIT is factored in, the citizens of Weatherford, and their elected officials, decide it is in their best interests to do what the EPA says. In effect, this penalty avoidance benefit helps the citizens of Weatherford to "feel the joy" that their neighbors receive from having Weatherford's landfills lined.

In this fashion, the federal government encourages a resource transfer that increases society's happiness by $3 million.² This is a clear demonstration that an environmental mandate in the presence of externalities can make society better off. But will it? Once again, that is an entirely different question.

To show how government intervention could make things worse, let's suppose that everything about the problem is exactly the same--with one exception: This time, we assume that the citizens of the neighboring towns get only $1 million of pleasure from Weatherford putting liners in their landfills. The only effect this has on the numbers in the Profit Table is that now the gross Benefit from installing the liners is only $6 million, instead of the $12 million in the previous example. Importantly, this change in the valuation of the benefit by residents of Clinton, Thomas, and Hydro alters nothing from the perspective of Weatherford's city budget.

It's still the case that before the intervention by the federal government, Weatherford had no incentive to install the new liners. And it's still the case that after the intervention, it is in Weatherford's best interests to do what the EPA says. But now the only two numbers in the table that matter from the perspective of society's happiness are $9 million and $6 million. The EPA's environmental mandate has forced through a resource transfer that is going to deprive consumers of $9 million of happiness while producing a gross Benefit of only $6 million. Rather than increasing society's happiness, this same environmental mandate has now caused society's happiness to decrease of $3 million.

Why the different result? Why did government intervention increase society's happiness in the first example, but decrease it in the second? It has to do with the size of the penalty compared to the size of the externality. In the second example, the penalty was too large relative to the external benefit received by the residents of Weatherford's neighboring towns ($7 million versus $1 million). You see, the purpose of the penalty is to help Weatherford "feel some of the joy" that citizens in other towns will get from the resource transfer. In other words, the penalty is supposed to mimic the information that the price system should be reporting, but isn't.

By threatening Weatherford with a hefty fine, the EPA manufactured an extra $7 million incentive for Weatherford to install the landfill liners. Unfortunately, this extra incentive sent the wrong information to Weatherford. It overstated the benefit that the landfill liners would produce for the other towns. It caused Weatherford to "feel too much joy" from this resource transfer. As a result of this bad information, the EPA induced Weatherford to misallocate society's resources. If only the EPA had set the penalty at $1 million instead of $7 million, Weatherford would not have made this mistake.

This illustrates an important lesson for government intervention: IN ORDER FOR GOVERNMENT INTERVENTION TO IMPROVE RESOURCE ALLOCATIONS IN MARKETS WITH EXTERNALITIES, GOVERNMENT MUST SET THE PENALTIES/REWARDS EQUAL TO THE VALUE OF THE EXTERNAL BENEFITS/COSTS RECEIVED BY THIRD PARTIES. If the penalties/rewards are too large, government intervention can make society worse off.

But how can government know the size of the externalities? It can't. Once again, the problem here is lack of information. When there is a market imperfection due to externality, firms will misallocate resources because prices contain incomplete information. The interests of the third party are not being reported by the price system. But they're also not being reported by anybody else. Who can look into the hearts and souls of the citizens of Clinton, Thomas, and Hydro to know how much happiness they would get from having liners put into Weatherford's landfills?

The whole wonder of the price system is that it is able to produce information that is virtually unknown and unknowable by any other means. When the price system fails, we are back to the world of the central planner trying to figure out who wants what. We are forced to depend on panels of "experts"--like the EPA--as they make their best subjective guess about the unseen sizes of the externalities.

Does this imply that government should never intervene when there are externalities present in a given market? Of course not. If a city's landfill is leaking toxic chemicals and people are falling over dead all around town, then reasonable people will agree that spending $9 million to line that landfill is a justifiable expense. It gets a lot trickier, however, when the externalities are smaller and not so visible. How large a number should one assign to externalities in cases like Weatherford's, where people are not falling over dead all around town? Reasonable people can--and will--disagree. But it doesn't help when EPA administrators like Roger Meacham unequivocally state, "the benefits outweigh the costs." The regulators entrusted with making these resource decisions ought to realize that the benefits of their actions cannot be known for certain--and that they have the power to do harm, as well as good.