Interdependence rethought within ILE

The concept of externality was first introduced to economics, in a formal sense, by Alfred Cecil Pigou in the book "Economics of Welfare" written in 1920 (Medema, 2017).  As Medema points out in his 2017 article, Henry Sidgwick and John Stuart Mill and even Thomas Malthus had identified the idea of externalities earlier but not the word.  From the time of Pigous's 1920 book until about the late 1950's, economists did not really use the idea of externalities.  Medema persuasively argues that it was only used tangentially by economists in developing the new welfare economics, including heavy weights such as all Paul Samuelson, Frank Knight and Abba Lerner. It was mostly used as a potential problem or foil for achieving equilibrium in competitive markets but not an important focus.

It was Tibor Scitovistky (1954) who made the first important contribution to the idea that externalities were direct interdependence rather than interdependence due to the existence of markets (Medema, 2017). This was crucial because prior to this point the interdependence was through the market forces. For example, economies of scale would be a source of interdependence that operated though market forces.  Scitovisky was thinking about pollution or congestion or excess nonie that directly impact another agents utility directly.

Schmid and Samuels and others in the ILE tradition would go further in their thinking about the innovations of how the idea of externalities and interdependence could be used.  They did not privilege the idea of perfect competition or the market at all.  Instead, they started with the concept that the market and the law interacted and that in fact the law (both formal law and informal custom) defined the parameters upon which the market operated.  This is a subtle but crucial difference in how we approach the analysis.  It means that rather than starting with the concept of a "market" and then determining how that market fails, we start with institutions and rules and determine how those shape the market.  After that shaping is done, the market supply and demand then acts.  Externalities or the general idea of interdependence start the analysis rather than become an offshoot or residual of market analysis.

Schmid believed that society could structure rules and that they were public choices to be made. His unique contribution was that choices must be made within the biological and physical constraints and rules that make up the world. There are times when it seems that some institutional economists want to argue that we make choices about what kind of society we want and that these choices are almost unconstrained by any natural forces.  They argue that supply and demand are natural forces from which we cannot deviate.  However, there are "forces" of nature that are the source of interdependence that we must address.

The Covid 19 pandemic is a naturally acting agent, regardless of its source of origin, that obeys biological rules.  The impact of the pandemic is based on public choice rules.  Some people can stay at home and isolate and others cannot.  This reality is based on social or public rules about how our economy operates and the distributional consequences of the pandemic.  There has been a great deal of dissection of the idea of "we are all in this together".  But we can separate out two ideas here.  The virus itself creates interdependence because of its (still to be fully determined) ease of transmission via aerosol and droplets. I can show no symptoms and yet pass the virus to you which can have determinant health effects on you and others.  The social issue is that some people, because of how the economy has been constructed by choice, will face a greater risk of exposure to transmission than others.  Thus, interdependence is real for all by nature but differential based on the public choice of economic structure.

Ultimately, externalities are not the only source of interdependence.  These would include economies of scale, nonrival goods, goods where marginal cost is close or equal to zero, goods where surge or peak capacity is an issue and other examples.  Each of these examples forces the analyst to carefully consider the nature of interdependence and how that interdependence means key questions must be asked. It also forces us to consider the integration the nature of interdependence and the potential institutional rules that guide and shape the interaction.