Monday, December 22, 2014

Externalities and all that

“When all voluntary transactions have been entered into by market transactors, there still remain some interactions that ought to be internalized but which the market forces left to themselves cannot cope with” (Carl Dahlman, JLE, Apr 1979).  There is apparently no residual claimant. Add one and you get the following:

“In many economics textbooks, the presence of externalities is invoked as a justification for government intervention in the marketplace. Yet the private sector often finds its own solutions to externality problems. This is the secret of the shopping mall’s success. Because a property developer owns the entire shopping complex, its profits depend on the entire mall, not on any particular shop. By choosing the right mix of tenants and charging rents that reflect each store’s contribution to the mall’s overall revenues – including the business it brings to other stores – the developer can ‘internalize’ the externality and maximize its profits” (The Economist March 1, 1997).

I am prompted by a recent piece by Jason Potts, “Innovationis a Spontaneous Order” in Cosmos and Taxis (full disclosure, I am a consulting editor).  Potts discusses five spontaneous orders: science, business models, co-operation, clusters and copying.  It is, however, useful to differentiate cities from clusters; Potts seems to use them interchangeably.

The shopping mall described above is a cluster, not a city. Cities could be a collection of such clusters and one has to wonder if there are interactions between the clusters that remain to be internalized.  If so, by who?

Potts elaborates, “The basic units of a cluster are nevertheless knowledge-using and knowledge-generating firms.  Such firms will tend to co-locate to the extent that knowledge externalities can be created and exploited.  This is a property of the ‘absorptive capacity’ of the firms themselves, not of the environment.  (The ‘Coase theorem’ suggests that we would expect firms to bargain and contract their way toward internalizing the externality.)  Innovation networks and clusters simultaneously emerge as the network and special dimensions of this growth-of-knowledge process.  They are the emergent consequence of firms discovering and exploiting knowledge complementarities.  Clusters and innovation are part of a mutually constituting spontaneous order.”

I like the fact that Potts cites the exchange of knowledge. He also cites possible Coasian bargaining toward internalizing. The rest of the paragraph calls attention to my favorite theme: we get innovation networks, spatial clusters and the development of ideas as part of the same process. The right spatial arrangements are the key to growth. What can planners do? Recognize that they are an unlikely residual claimant and let the bargaining and contracting proceed.