The theory of positive externalities is often used to justify the necessity of government intervention into private property. The classic argument goes along these lines. A honey farmer sets up his business across the road from an apple farmer. The bees can travel across the property lines and fertilize the trees, thus increasing the productivity of the apple farmer. The apple farmer benefits from a positive externality due to the neighborhood effect of the honey farm while incurring no cost himself. According to the theory, the government is justified to tax the apple farmer or regulate his business in order to compensate the honey farmer for the productivity of his bees.
That analysis is superficial. Let us closely examine the business incentives of the two farmers. The presence of bees on the apple farmer increases the output of apples. This means that the marginal benefit of a bee hive is a certain amount for the honey farmer and also a positive amount for the apple farmer, while the cost remains the same. This implies that, should the two enterprises merge together and combine the production of apples and honey, the values of each enterprise’s share would increase substantially. Two private individuals thus have an incentive to combine their property whenever a positive neighborhood effect exists.
Suppose that we hold the marginal cost of a bee hive constant at 6. The honey farmer operating on his own will purchase two hives (first hive 10-6=4 in profit, second hive 8-6=2 in profit, total profit is 4+2=6). The apple farmer will receive 5+4=9 in “external” profit. The two separate enterprises therefore profit 6+9=15.
Marginal Revenue Honey Apple Merged
Farmer Farmer Businesses
First hive 10 5 15
Second hive 8 4 12
Third hive 5 3 8
Fourth hive 3 2 5
Fifth hive 1 1 2
However, once the enterprises are merged together, the marginal revenue of a bee hive increases. That means it is profitable to purchase a third bee hive. Total profit becomes 15-6=9, 12-6=6, 8-6=2. 9+6+2=17.
As before, the honey farmer receives 6 in profit from his share in the partnership. The apple farmer receives 9 in profit from his share of the partnership. That leaves 2 units of profit that they can split up however they deem fit.
Those 2 units of profit represent the gains from scale of merging the businesses together.
The incentive to combine property into firms is present whenever there are positive neighborhood effects. The same incentive exists for negative neighborhood effects (marginal costs are shared between the partners instead of marginal revenues).
This allows us to create a free market justification for zoning and urban planning. In a free market, two adjacent property owners who recognize that positive value effects of a nice neighborhood have an incentive to partner up and merge their property, or certain parts of their property, together, or to sign covenants restricting their use of the property to strictly neighborhood-positive uses. Similarly a large land owner who wishes to create a neighborhood from his land will restrict the use of the property he sells to strictly neighborhood-positive uses. Additionally, as we have seen that merging the bee farm and the apple farm results in it being profitable to purchase one more bee hive, a neighborhood firm will find it profitable to purchase and operate the “public goods” that have a positive effect on the whole neighborhood, including but not limited to roads, parks, monuments, and so on.
Under a free market then, neighborhoods with the best neighborhood-positive regulations and infrastructure, that is to say the best neighborhood firms, will attract more residents and neighborhoods with the least or no neighborhood-positive regulations will be abandoned. This process of competition will create increasingly more profitable neighborhood firms, competition to take over the failed neighborhood firms, and thus better zoning and urban planning regulations over time.