Perhaps one of the most significant cases of externalities is the extensive use of the military draft. The taxpayer benefits by not paying the full cost of staffing the armed services. The costs which he escapes are the additional sums that would be needed to acquire men voluntarily for the services or those sums that would be offered as payment by draftees to taxpayers in order to be exempted. With either voluntary recruitment, the "buy-him-in" system, or with a "let-him-buy-his-way-out" system, the full cost of recruitment would be brought to bear on taxpayers. It has always seemed incredible to me that so many economists can recognize an externality when they see smoke but not when they see the draft. The familiar smoke example is one in which negotiation costs may be too high (because of the large number of interacting parties) to make it worthwhile to internalize all the effects of smoke. The draft is an externality caused by forbidding negotiation.
This is a quote from Harold Demsetz, "Toward a Theory of Property Rights," American Economic Review, Papers and Proceedings of the Seventy-ninth Annual Meeting of the American Economic Association. (May, 1967), pp. 347-359.
I highlight this for two reasons.
1. The less-important "inside-baseball" (actually "inside-academia") reason is that, although I read this article early in my time learning economics (actually, at around age 19) and it is, I believe, one of Demsetz's most referenced articles, this is the first time that I've noticed that it's in AER's Papers and Proceedings. Why is that significant? Because academic economists tend to put a much smaller weight on articles in Papers and Proceedings because such articles are not peer-reviewed. I'm not challenging that smaller weight in general. I'm simply pointing out that it's interesting that a classic in economics was not peer-reviewed in the narrow sense. My guess, though, is that Harold showed it before giving it, or before signing off on the final publication, to some pretty heavy-hitting peers at the University of Chicago.
2. The more-important reason for citing this paragraph is that it reminds us that there is nothing inherent in the concept of externalities that says that externalities occur only in the private sector. The biggest externalities, in fact, occur in the government sector. Think of Stalin, Hitler, and Mao. Or, even in less dramatic terms, think of the huge costs to the world due to Woodrow Wilson getting the United States into World War I.