Externalities take place when consumers/manufacturers activities have an unintentional or indirect impact on other consumers/manufacturers without affecting prices. According to Sankar, externalities may cause positive and negative effects (6). In other words, if the consumer or a group grants certain benefits to other economic agents, the externality is positive; if any activity is disadvantageous to other groups or individuals, then the externality is negative (7). According to Stiglitz (216), “Externalities arise whenever an individual or firm undertakes an action that has an effect on other individual or firm”. The externalities phenomenon tends to have a spillover effect in the case of technical advancements, when certain IT innovation benefits not only the inventor but also the society progress as well entering into the pool of industrial knowledge. The question of whether positive or negative externalities for the environment prevail remains open. Pollution, carbon dioxide emissions, nature damage are extremely serious negative externalities, which result in health costs and costs of purification technologies. There is also another externality problem outlined by Stiglitz as common resource problem, access to which is not legally restricted (sea fish, or forestry) (217).
Analyzing the externalities issue, it is important to mention that any positive externality has a broad social-related impact, which is higher than any private benefit. At the same time, any generated negative externality results in a high social cost prevailing any private cost. Therefore, in the presence of any externality social/private benefits vs social/private costs have different implications. According to Baumol and Oates, the externality phenomenon does not affect prices (12). What does it mean? The consumer/manufacturer cannot use efficient markets to give other economic agents to do the right things. Economists call this concept “a missing market” or “market failure”, which violates one of the basic 1st welfare theorem assumptions urging the economy to deliver inefficient outcomes.
Market Failure and Environmental Externalities
Environmental issues such as depletion of resources or pollution of air/water take place when the market is inefficient and/or government fails to manage the situation. It means that the market prices underestimate the social value of the environmental goods. Markets can function efficiently in case the property rights are perfectly defined while the transaction costs are low. Environmental resources such as water, air, atmosphere are non-rivalrous, non-excludable public goods (Baumol and Oates 13). Therefore, the property rights are not functioning adequately putting these resources into the public care and labeling them as “free of charge goods”. Thus, no price is paid for such goods even if their social value is extremely high and beneficial for all members of society. However, according to Stiglitz “even when property rights are not assigned to a single individual, the market may find an efficient way of dealing with the externality” (219). In case the property rights are non-existent for a certain common resource good then the legal system has to protect against externalities (Stiglitz 219).
According to Sankar, the market/policy failure exists due to two reasons: absence of property right definitions for goods within the public domain and extremely high costs of market operations (2). Since mutual ownership of resources without cost sharing or adequate charges may result in resource over-usage, it is important to consider the consequences of each other actions to avoid the well-known “tragedy of the commons” (Hardin 1243). Fishery and forestry represent a separate group of public goods not subjected to common property regimes while are able to provide marketed and non-marketed outputs (Sankar 3).
Economists present several classifications of environmental externalities depending on the effect they cause on consumers and regions. Pollution/degradation of water and air resources, local pollutants (manufacturing pollution), worsening of mountain ecosystems, greenhouse carbon dioxide emissions, climate change, biodiversity loss and others represent local/global public bads having certain public good characteristics (namely non-rivalry and non-excludable) (Cornes and Sandler 12). Any type of externality has to be determined from the environmental governance viewpoint considering the fact that any environmental issues are assigned to the lowest appropriate governing unit, be it a country, region or local level. However, it should be noted that ecosystem boundaries and legal/administrative borders may not always coincide (Saez 10).
Summing up different definitions environmental externalities expressed in terms of the public goods, it is important to understand that the use of such a good “ does not preclude others from using it” (Baumol and Oates 13). Some economists argue that there is no such thing as absolutely non-rivalrous and non-excludable public good. If this is the case, it may result in problems with production of such good causing market failure and the so-called public goods problems (Chart 1)
Chart 1. Environmental externalities through public good classification (Baumol and Oates 13)
Externalities and Inefficient Market Outcome
The free market characteristics presuppose that price vs quantity balance private marginal cost and private marginal benefit while the social marginal cost equals to social marginal benefit making up a social optimum. However, the 1st welfare theorem fails to work making the private market inefficient in case of certain externalities, such as:
Negative production externality resulting in over-manufacturing of goods when the social marginal cost curve is above the private marginal cost curve (Graph 1, Appendix);
Positive production externality resulting in under-manufacturing of goods when the social marginal benefit curve is above private marginal benefit curve (Graph 3, Appendix);
Negative consumption externality resulting in overconsumption of goods when social marginal benefit curve is below private marginal benefit curve (Graph 2, Appendix);
Positive consumption externalities resulting in under-consumption of goods when the social marginal benefit curve is above the private marginal benefit curve (Graph 3, Appendix).
Therefore, the externality type and effect depends on whether it is associated with goods manufacturing or consumption and, accordingly, with positive or negative influence.
Solutions to Negative Externalities Suggested by the Private Sector
The issue of externalities solutions is discussed in the Coase theorem. Ronald Coase, a world known scientist and Nobel Prize winner, suggested that the externalities may be found outside of the free market boundaries though it is difficult to understand whether exactly the private or government activities determine the price able to fully match the externalities’ costs and benefits (Saez 18). Besides, the situation when the property rights for the entire pool of resources are granted to a single individual is impossible (Stiglitz 218) Therefore, there are two parts of the Coase Theorem claiming that (Graph 4, Appendix):
The socially optimal market equilibrium quantity is achievable if the costless bargaining and the property rights are adequately determined
The type of the assigned economic agent does not predetermine the efficiency of externality problem solution.
This theorem is problematic to be applied in practice due to a huge diversity of externalities causing market failure (e.g. global warming problem affecting multiple economic agents) or shared ownership phenomenon making multiple individuals agree to the Coase theorem solutions. Besides, there is a number of other milestone problems preventing the Coase theorem function properly such as transaction costs, the free rider problem, etc. According to Stiglitz, if there should be government intervention stronger than just establishing of clear property rights then the private solutions to the internalizing of externalities simply fail (221).
Public Sector Solutions to Externalities Problem
In order to prevent environmental externalities the special Environment Protection agency was formed in the US in 1970. The agency put forward the two basic concepts neutralizing the negative externalities: 1) the price policy (Pigouvian taxation) expressed in terms of tax (marginal damage per unit); 2) manufactured quantity regulation when only the socially efficient quantity is manufactured (Freeman 15). In the ideal world, both measures are identical; however, in practice, the taxation policies are more efficient in addressing externalities issues (Graph 5, Appendix).
Stiglitz (224) refers to public sector solutions to externalities through the prism of fines and taxes as the simplest form of market-based concepts, which “involve fees and taxes imposed in proportion to the amount of pollution emitted” or in other words the private marginal cost should become equal to the social marginal cost. This form called the Pigouvian taxes reflecting the social cost of pollution. Among other measures of emission control Stiglitz offers the subsidizing for pollution abatement by financing of corresponding pollution abatement equipment (225, 231). Efficient level of expenditure on the implementation of purification equipment enables the private sector to achieve an acceptable level of social and private benefit. Moreover, innovation of manufacturing and proper governmental regulation can efficiently internalize the negative effect of externalities promoting the spillover of technological advancements.
Conclusion
Externalities can be referred to the public finance domain when the actions of one economic agent affect another without compensating (being compensated by) for this effect. If this is the case then the market failure is obvious and active interference of the government can be fully justified. There are two ways of such an interference to neutralize the effect of externalities: price-based (fines, taxes and subsidies) and quantity based (legal regulations). What factors may prove to be more efficient than the others, depends on the flexibility of the quantitative public regulation measures, heterogeneity of the economic agents and the uncertainty of the externality reduction costs.
Works Cited
Baumol, W. and W.E. Oates. "Theory of Environmental Policy." Cambridge University Press (1988): pp. 1-35. Print.
Cornes, R. and T. Sandler. "The Theory of Externalities, Public Goods, and Club Goods." Cambridge University Press (2012): pp. 1-25. Print.
Freeman, A. M. "Depletable Externalities and Pigouvian Taxation." Journal of Environmental Economics and Management, Vol 11, (1998): 173-179. Print.
Hardin, G. "The Tragedy of the Commons." Science, Vol. 162 (1968): pp. 1243-1248. Print.
Saez, E. "Externalities: Problems and Solutions." Public Economics Journal (2014): pp. 1-33. Print.
Sankar, U. "Environmental Externalities." Madras Economic Journal (2015): pp. 1-16. Print.
Stiglitz, J. Economics of the Public Sector 3d Edition. New York/London: W.W. Norton & Company, 2000. Print.
Appendices
Negative Production Externalities: Example
Consider the steel plant polluting the river, which faces no pollution measures regulations. It allows ignoring the pollution issues elaborating the production volume plans (Graph 1).
Graph 1. Steel water pollution externality (adopted from Saez 5)
A negative production externality of $100 per produced unit (marginal damage) results in a social marginal cost prevailing the private marginal cost. Simultaneously, the optimum quantity is lower than the equilibrium quantity of the competitive market. As a result, there is an overproduction with the dead weight loss area.
Negative Consumption Externalities: Example
Another example illustrating the externality theory is the economics of negative consumption. For instance, a consumer is a driver using a car on a regular basis, which results in a global warming problem due to extensive carbon dioxide emission or a consumer is a smoker purchasing cigarettes, which results in private marginal benefit prevailing the social marginal benefit (Graph 2).
Graph 2. Negative consumption externality example (adapted from Saez 7)
In the example above $40 per the consumed pack of cigarette results in low social marginal benefits going below the private marginal benefit and social optimum quantity. Thus, the deadweight loss, in this case, is associated with the overconsumption being the result of low competitive market equilibrium quantity.
Positive Product Externality
Positive product externality takes place when the company’s manufacturing increases the social welfare of the society when the company itself is not compensated for this. For instance, the bees produce honey affecting agriculture and environment in a positive way (Graph 3).
Positive Consumption Externality
Positive consumption externality is associated with the fact of individual consumption, which increases the welfare of other agents but does not compensate the individual for this welfare. For instance, a beautiful private house, which is enjoyed by the passengers (Graph 3).
Graph 3. Positive product externality/consumption externality example (adapted from Saez 8)
In the illustration above, the expenditure on oil exploration promises positive externalities to the company in terms of profits; however, results in the social marginal cost, which is below the private marginal cost. At the same time, the social optimum quantity is higher than the competitive market equilibrium quantity. The dead weight area is connected with the underproduction phenomenon.
Graph 4. The Coasian Solution to the Externality problem(adopted from Saez 8)
A Coasian Solution to Negative Product Externalities, which removes negative externality by shifting the private marginal cost curve on the same level as the social marginal cost.
Graph 5. Corrective Taxation policy proposed by the public sector (adopted from Saez 8)
Taxation as a public sector remedy to preventing negative externalities when the private marginal cost curve shifts upward coinciding with the social marginal cost curve. Thus, the taxation policy removes the inefficiency caused by negative externality.
