Individuals, especially homeowners, who express opposition to changes in their neighborhood often do so on the basis of preserving the “character” of their neighborhood. For this expression, they earn themselves the scornful moniker of NIMBY, although such labels rarely lead to productive discussion. (See this essay by Daniel Herriges for more on the subject.) But is the label appropriate? These homeowners may have bought their home – a particular bundle of lumber, pipes, and plaster on a particular plot of land – with the expectation that they were also purchasing a particular view from their front porch, or a particular decibel level of noise on their street. So, if a developer or nonconforming neighbor proposes to alter that view or bring in new development that would raise that noise level, the homeowner will be adversely affected without any available recourse.

This brings into the conversation the idea of externalities. An externality is “a side effect or consequence of an industrial or commercial activity that affects other parties without this being reflected in the cost of the goods or services involved.” Externalities can be either positive or negative. For instance, a bakery might produce delectable smells that people who are simply wandering by – and not necessarily customers of that bakery – still get to enjoy. On the other hand, an airport might be a loud and dirty annoyance for those who live nearby, whether or not they ever fly out of it. In general, externalities result from unclear ownership of the resource under consideration, and when they are not accounted for, they either lead to a dearth or excess of the transactions that generate them, for both positive and negative externalities, respectively.

Let’s consider an example of a valley that contains a factory and a house. The factory has an incentive to produce as many gadgets as it can do so profitably. If it makes too many, then it will not be able to sell the last few gadgets for more than it cost to make them, but if it produces too few, then it will miss an opportunity to sell additional gadgets at a price greater than their cost. If the factory produced no pollution, this would be the end of the story.

However, let’s say that the factory releases a certain amount of pollution for each gadget that it produces. Now, this is a cost that is borne by the homeowner, which is not accounted for in the factory’s decision of how many gadgets to make. But what if the homeowner alone owned the right to pollute the air? In this case, the factory would probably be willing to pay the homeowner some amount of money to produce a certain number of gadgets. This number would be lower than before, but likely still more than zero. The homeowner would be willing to make this exchange as long as the cash from the factory was worth more to him or her than the cost of the pollution.

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