The prevalence of externalities in consumption and production of goods and
services generates a number of discussion points indicating weaknesses in the
general rules relating to allocative efficiency in the market economic system.
After defining and illustrating externalities this essay will discuss the
implications of externalities in relation to the general rules of allocative
efficiency and then critically evaluate the various methods suggested for
dealing with the problems of externalities .
When discussing externalities there are a number of useful definitions and
descriptions of what an externality is . In basic terms an externality "is a cost
or benefit arising from an economic transaction that falls on a third party and
that is not taken into account by those who undertake the transaction."1 In a market economy this generally
means that an externality occurs where there is "a direct effect of the actions of
one person or firm on the welfare of another person or firm in a way which is
not transmitted by market prices. " 2
This externality can arise from the "the effects that consumption of an item by
one consumer may have on the welfare of others" 3 or from "the effects that the production
of one product may have on the production possibilities of others." 4.
Externalities may take two forms. Firstly there are negative externalities. A
negative externality occurs where consumption or production of a good
generates a cost borne by someone outside of the production or consumption of
that good. A negative externality in consumption could for example be the
exhaust fumes produced by the driving of cars or the damage done to sand
dunes by tourists driving 4WD vehicles in sensitive areas. The most obvious
example of a negative externality in production is the pollution caused by many
industries.
Positive externalities occur when a benefit accrues to someone outside of the
production or consumption of a good. An example of a positive externality
might be that by individuals consuming vaccine against the influenza virus ,
those who do not vaccinate themselves receive the benefit of a reduced
prevalence of the virus in the community. When it comes to a positive
externality in production the damming of rivers for electricity is a good
example as the damming not only provides for flood mitigation for those living
downstream of the river but also provides an area for enjoying water based
recreational activities. 5
The prevalence of externalities in the market based economy suggests that the
optimality rules normally assumed to lead to allocative efficiency may not in
fact lead to the most socially efficient outcome. The presence of externalities
thus represents an example of market failure to achieve allocative efficiency.
The reason for this is that in the presence of externalities the market price of a
good may not reflect the true societal cost or benefit and hence may be under or
over produced. Figure EE1 illustrates the implication of negative externalities
for allocative efficiency.
In a free market where the optimality rules have been followed the quantity
produced will occur at quantity Xp and price Pm , the point where demand (D)
equals the private marginal cost (PMC). However where a negative externality
exists the market fails to produce the socially optimal level of production. This
is because the marginal damage (d) , generated by the negative externality, is a
cost not taken in to account in the market. When a social marginal cost (SMC)
curve is generated it is possible to see that socially optimal level of production
is in fact X* and that the product should be sold at a higher price P* to reflect
the fact that the true social cost of the product is higher than the private cost.
Positive externalities also have their own special implications for the
achievement of allocative efficiency. Figure EE2 illustrates the implications for
the optimality rules of a positive externality. The market equilibrium in this
situation occurs at quantity Qp and price Pm where the private marginal benefit
(PMB) of the item equals its marginal cost. However this item produces an
external benefit (b) which is not taken in to account by the market. The
socially optimal quantity of this item actually occurs where the social marginal
benefit (SMB) curve derived by summing the private marginal benefit and the
external benefit , equals the marginal cost of producing the item. This analysis
suggests that the allocatively efficient situation occurs at quantity Q* and price
P* .
The conclusion which can be drawn from this is that true allocative efficiency
will not be achieved unless the external benefits and costs associated with
externalities are taken in to account when making economic analysis. Given the
problems for allocative efficiency which are caused by the presence of
externalities , what then are the possible solutions to correct these examples of
market failure.
This solution may be feasible for firms but how do individuals fit in to this
scenario ? How , for example , do firms producing air pollution , merge with
the multitude of people who may be affected by its pollution. And even if we
attempt to suggest that the individuals should purchase the firm , which in
theory would internalise the effects , how is this to be effected in practical
terms. Thus again , whilst mergers suggest a theoretical solution to the problem
of externalities in many instances they are not practical solutions.
Figure ES1 represents the situation of two firms (a and b) with identical costs
but different marginal benefit curves (MBa and MBb). The free market
situation with no government regulation will produce quantity Xp pollution at
the point where the marginal benefit curves of the firms intersect the private
marginal cost (PMC) curve. When the firms take in to account the damage (d)
that is caused by their actions the optimal amounts of pollution for each firm is
Xa and Xb respectively. Given different marginal benefit curves, moves by the
government to have all firms reduce their pollution by the same amount or to
limit pollution to a set amount such as X* may not be the efficient outcome.
Therefore whilst regulatory limits and use of fines may appear a simple solution
, it may not be efficient . Other problems of this approach include such things
as monitoring and detection of firms breaching the pollution laws.
As Figure ES2 shows , the free market equilibrium will occur where demand
(D) , equals the private marginal cost (PMC) of production. This occurs at
quantity Xp. However the optimal amount of production occurs at Q* where
social marginal cost (SMC) , which takes in to account the damage (d) caused
by producing the item , equals D.
Now observe the effect of introducing a Pigouvian tax of (t) which is equal to
the marginal damage (d) of the externality at the optimal level . By
implementing the tax the firms effective supply curve is raised to become its
private marginal cost plus the tax. As a result there is a rise in the price of the
good and a contraction in demand for it. The allocatively efficient level of
production is achieved at price P1 and quantity Q*.
Pigouvian taxes therefore offer a more effective means of achieving allocative
efficiency than straight out regulatory limits or fines. Pigouvian taxes however
do still suffer from some of the same weaknesses as regulation of pollution. In
order to tax polluting firms the government or enforcing body must be able to
determine which activities produce pollution , determine which pollutants do
the harm and finally come up with some estimate on the value of the damage
being caused. Usually an estimate of these things will have to be made ,
meaning that the tax will only move us closer to the optimal position rather
than onto it. However with improving technology and greater understanding of
environmental cause and effect Pigouvian taxes may become increasing
effective in moving us towards the optimal level of production in externality
producing industries.
Firstly , the establishment and enforcement of greater private property rights by
the legal system would allow victims of negative externalities to sue the
offending party for compensation for the damage caused. For example , if
property rights to a section of river are assigned to a particular fishing club ,
then that club will be able to sue the chemical firm upstream which pollutes the
river and kills the fish stock in the fishing clubs section of the river.
The Coase Theorem suggests that " the efficient solution will be achieved
independently of who is assigned the ownership rights , so long as someone is
assigned those rights" 11 The
reasoning for this is that if the chemical firm is assigned the property rights ,
the fishing club will be prepared to pay the chemical firm an amount up to the
value of the damage being caused , to have the chemical firm reduce its output
and that at any point past X* the damage being caused exceeds the firms profits
from doing so . Hence the firm is willing to accept the payment to reduce its
output to X* . Similarly if the fishing club has the rights , it will not allow the
firm to produce past X* as the damage caused to the fishing club is greater than
any payment the firm would be willing to make. The establishment of property
rights thus creates a framework which allows bargaining and the achievement
of the socially optimal outcome.
Property rights too have a number of problems. There may be problems for
example of assigning and defining property rights and the enforcement of
property rights would most likely involve a number of significant alterations to
existing property law. There are also problems associated with the bargaining
model such as the costs of bargaining , difference of bargaining power , and
difficulty in identifying and quantifying the damage being caused. Thus whilst
property rights offer an innovative solution to the problem of externalities there
is still much work to be done in this area.
The pollution rights approach to negative externalities involves the government
creating a market for pollution rights. The supply of pollution rights, and hence
the quantity of pollution produced , is fixed at quantity X*. Firms not prepared
to pay the market price of P* to purchase pollution rights must either cut back
their pollution or adopt technologies which produce less negative externalities.
Tradeable pollution rights can help achieve allocative efficiency as an increase
or decrease in demand will be reflected in a change in the price of the rights
,but the amount of pollution produced will not exceed the optimal level
determined by the number of pollution rights available.
Pollution rights however raise a number of problems which still need to be
addressed. For example in determining the number of pollution rights to be
sold the government must determine the point where "the marginal social cost
of pollution equals the marginal abatement cost." 12 . This in turn creates the problem of
the government having to buy back or issue more pollution rights whenever
there is a change in these factors. Plus there still remains the problems of
monitoring firms to ensure they are not producing more externalities than their
rights allow. Again , tradeable pollution rights present a market based solution
which may become more viable with improvements in technology and science.
Introduction
What is an externality?
Implications of externalities for allocative efficiency
Solutions to externalities
Social Conventions
One approach to dealing with negative externalities is through social
conventions and tradition. The argument here is that "certain social
conventions can be viewed as attempts to force people to take in to account the
externalities that they generate." 6
and through tradition " recognition of signals and appropriate responses are
instilled as part of the culture." 7 The
example associated with this is impressing on people from a young age that
even though one bears a cost by holding on to litter until a bin is found that one
should do so because of the externality which litter creates. Whilst this is an
interesting suggestion it perhaps raises more problems than it answers. Will an
individual be held to social conventions when there is a substantial cost in
doing so ? And how does one apply a solution designed for dealing with
individuals , to teaching and enforcing social conventions on large , possibly
multi-national corporations? Thus whilst social convention may have appeal in
dealing with some socially unpleasant , externality generating activities, its
overall usefulness may be limited to low cost externalities generated by
individuals.
Mergers
Another possible solution to the problem of externalities may be for the parties
involved to merge. For example if a fishing companies profits are being harmed
by the pollution produced by a steel mill then the problem of this externality
can be solved by merging the parties involved and internalising the effects.
"For instance , if the steel manufacturer purchased the fishery, he would
willingly produce less steel than before , because at the margin doing so would
increase the profits of the fishing subsidiary more than it decreased the profits
from his steel industry." 8 This
suggestion too however may be seen as having a number of problems in its
practical implantation.
Regulatory Limits
The most common approach to solving the problem of externalities , especially
pollution , is the imposition of regulatory limits on the amount of the
externality produced and the imposition of fines on those parties who produce
externalities beyond the regulated limit. Whilst this approach appears to offer a
simple solution to limiting externalities , requiring all firms to reduce their
externality by the same amount or to the same level as other firms may not be
efficient. This can be seen by reference to Figure ES1 below.
Pigouvian Taxes - a.k.a. - corrective taxes
Another possible solution to the problem of negative externalities such as
pollution is the imposition of corrective taxes designed to induce producers to
limit their production of a good to the socially allocatively efficient level of
production. A Pigouvian tax is " a tax levied upon each unit of pollution in an
amount just equal to the marginal damage it inflicts upon society at the efficient
level of output." 9 Figure ES2
indicates the effects of a Pigouvian tax on a firm producing a negative
externality such as pollution.
Property Rights
The establishment and enforcement of private property rights provide an
alternate framework for the solving of externalities . "A private property right
is a legally established title to the sole ownership of a scarce resource that is
enforceable in the courts." 10 Private
property rights offer a number of solutions to the problems posed by
externalities.
Coase Theorem & Bargaining
The other way in which property rights can assist in achieving allocative
efficiency is by providing a framework in which bargaining may take place.
Consider the situation illustrated in Figure ES3 below which builds on our
fishing club example .
Tradeable Pollution Rights
Another approach which has been suggested in recent times is the creation of a
market for tradeable pollution rights. This is illustrated in figure ES4.
