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Externalities

In economic activity, there are sometimes ‘externalities’ or spillover effects to other people not involved in the original exchange.  Positive externalities result in beneficial outcomes for others, but negative externalities impose costs on others. Prof. Sean Mullholland at Stonehill College addresses a classic example of a negative externality, pollution, and describes three possible solutions for the problem: taxation, government regulation, and property rights. The first two options are difficult to monitor and may create perverse incentives.  A better solution to overcome the externality is property rights, as described by Ronald Coase. As long as property rights are well-defined, divisible, and defendable, parties can negotiate to reduce the impact of the pollution.


  • Externalities  [Article]: Bryan Caplan explains the fundamentals of positive and negative externalities and examines various applications of the theory.

  • Market Failure  (Video): Milton Friedman explains some of the shortcomings of conventional market failure analysis and provides an example of a private solution to a public goods problem.

  • The Problem of Social Cost  [Article]: Ronald H. Coase examines the concept of externality and its relation to property rights.

  • The Ultimate Externality  [Article]: Donald J. Boudreaux finds that government is often a much larger source of negative externality on net than the market.


Externalities

Voluntary exchange will only take place if both parties perceive that they’re better off. Sometimes these exchanges result in spillovers. We call these spillovers externalities. If a spillover is beneficial, we call these positive externalities. If they’re costly, we call them negative externalities.

Let’s talk about negative externalities for a minute. Imagine being a corn farmer and growing corn. What are the private costs that you face that help you determine how many ears of corn to grow? Things like fuel, seed, fertilizer; these are your private costs. But it turns out that every spring and summer when you lay down the fertilizer some of this flows into the stream nearby and flows into a lake downstream, oftentimes resulting in large fish kills. All those downstream, the fisherman, the recreationist, and the landowners all incur a negative externality.

There are three broad categories of ways in which we can address these externalities. The first is taxation, the second, regulation, and the third is by using property rights and the Coase theorem. Let’s talk about these individually.

First taxation. Economist A. C, Pigou first suggested that we could impose a tax on the producer that would reduce the amount of production of whatever good is producing the negative externality. The benefit of this, of course, is that you would reduce the amount of negative externality being imposed downstream. However the difficulty is monitoring. It’s difficult to know exactly how much fertilizer is being laid out in our example or how much pollution is being emitted from various point sources. And so the monitoring costs are quite high.

The second way that we can address externalities is through regulation. There are many examples. Let me name two. One is through technology-specific methods. This is where the government requires producers to use a certain technology to reduce pollution or emissions. The benefit is that monitoring costs are quite low. You don’t need to have somebody out there constantly monitoring the amount of emissions because you know that technology is present and working. The downside is that it reduces the incentive for firms to find innovative ways to further reduce their emissions.

The second of these regulatory methods is by simply restricting the quantity produced, either of the output or of the pollution being produced through production. The benefit of this, of course, is that now firms have reason to find innovative ways to reduce the pollution. The difficulty is that the monitoring costs are quite high.

The third broad way to address externalities is the property rights solution suggested by economist Ronald Coase. He said if property is well defined, divisible, and defendable, and negotiation costs or transaction costs are low, simply by assigning the property right, we can overcome the externality. Well defined, divisible, and defendable. These are the three characteristics that you must have in order to have a fully functioning property rights solution.

Well defined: what is the object over which the owner has rights, in what manner may this owner exercise his or her rights? Divisible: are these rights separable and can they be traded? Defendable: are these rights enforceable? Are these rights recognized either by a custom, by the community, or a third government agent?

Let’s go back to our example. Let’s assign the property rights of the lake to the farmer. You may first imagine that the farmer doesn’t change his or her behavior. However, now the fisherman and recreationist downstream can negotiate with the farmer to reduce the amount of fertilizer that he or she lays on the field. This reduces the amount of fish death downstream. We could also, conversely, assign the property rights to the fisherman, whom you may initially think would require the farmer to stop using fertilizer on the land. However, now the farmer has the incentive and the knowledge to negotiate with the fisherman downstream. The fisherman will allow some positive amount of fertilizer, but not as much as before.

In each scenario, we come to a solution that internalizes the externality or overcomes it. The fisherman and the farmer now know the cost of the externality and are able to negotiate in order to overcome it. The benefit of this to other regulations is that the monitoring costs are very small. Not only that, there is incentive for either the farmer or the fisherman to find ways to reduce the negative impact on social welfare. Coase theorem overcomes these monitoring costs by using local information that is not available to an agent determining the taxation or regulation.

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