Externality

Know this topic well? Help others and get FREE products!

Most economists argue that markets ordinarily are the superior means for fulfilling human wants. In a market, deals are ideally struck between consenting adults only when the parties feel they are likely to benefit. Society as a whole is thought to gain from the aggregation of individual deals that take place. The wealth of a society grows by means of what is called the hidden hand of free market mechanisms, which offers spontaneous coordination with a minimum of coercion and explicit central direction. However, the market system is complicated by so-called externalities, which are effects of private market activity not captured in the price system.

Economics distinguishes between positive and negative externalities. A positive externality exists when producers cannot appropriate all the benefits of their activities. An example would be research and development, which yields benefits to society that the producer cannot capture, such as employment in subsidiary industries. Environmental degradation, on the other hand, is a negative externality, or an imposition on society as a whole of costs arising from specific market activities. Historically, the United States have encouraged individuals and corporate entities to make use of natural resources on public lands, such as water, timber, and even the land itself, in order to speed development of the country. Many undesirable by-products of the manufacturing process, in the form of exhaust gases or toxic waste, for instance, were simply released into the environment at no cost to the manufacturer. The agricultural revolution brought new farming techniques that relied heavily on fertilizers, pesticides, and irrigation, all of which affect the environment. Automobile owners did not pay for the air pollution caused by their cars. Virtually all human activity has associated externalities in the environmental arena, which do not necessarily present themselves as costs to participants in these activities. Over time, however, the consequences have become unmistakable in the form of a serious depletion of renewable resources and in pollution of the air, water, and soil. All citizens suffer from such environmental degradation, though not all have benefited to the same degree from the activities that caused them.

In economic analysis, externalities are closely associated with common property and the notion of free riders. Many natural resources have no discrete owner and are therefore particularly vulnerable to abuse. The phenomenon of degradation of common property is known as the Tragedy of the Commons. The costs to society are understood as costs to nonconsenting third parties, whose interests in the environment have been violated by a particular market activity. The consenting parties inflict damage without compensating third parties because without clear property rights there is no entity that stands up for the rights of a violated environment and its collective owners.

Nature's owners are a collectivity which is hard to organize. They are a large and diverse group that cannot easily pursue remedies in the legal system. In attempting to gain compensation for damage and force polluters to pay for their actions in the future the collectivity suffers from the free rider problem. Although everyone has a stake in ensuring, for example, good air quality, individuals will tend to leave it to others to incur the cost of pursuing legal redress. It is not sufficiently in the interest of most members of the group to sue because each has only a small amount to gain. Thus, government intervention is called for to protect the interests of the collectivity, which otherwise would be harmed.

The government has several options in dealing with externalities such as pollution. It may opt for regulation and set standards of what are considered acceptable levels of pollution. It may require reduced lead levels in gasoline and require automakers to manufacture cars with greater fuel economy and reduced emissions, for instance. If manufacturers or social entities such as cities exceed the standards set for them, they will be penalized. With this approach, many polluters have a direct incentive to limit their most harmful activities and develop less environmentally costly technologies. So far, this system has not proved to be very effective. In practice, it has been difficult (or not politically expedient) to enforce the standards and to collect the fines. Supreme Court decisions since the early 1980s have reinterpreted some of the laws to make standards much less stringent. Many companies have found it cheaper to pay the fines than to invest in reducing pollution. Or they evade fines by declaring bankruptcy and reorganizing as a new company.

Economists tend to favor pollution taxes and discharge fees. Since external costs do not enter the calculations a producer makes, the producer manufactures more of the good than is socially beneficial. When polluters have to absorb the costs themselves, to internalize them, they have an incentive to reduce production to acceptable levels or to develop alternative technologies. A relatively new idea has been to give out marketable pollution permits. Under this system, the government sets the maximum levels of pollution it will tolerate and leaves it to the market system to decide who will use the permits. The costs of past pollution (in the form of permanent environmental damage or costly cleanups) will still be borne disproportionately by society as a whole. The government generally tries to make responsible parties pay for clean-ups, but in many cases it is impossible to determine who the culprit was and in others the parties responsible for the pollution no longer exist.

A special case is posed by externalities that make themselves felt across national boundaries, as is the case with acid rain, ozone layer depletion, and the pollution of rivers that run through more than one country. Countries that suffer from environmental degradation caused in other countries receive none of the benefits and often do not have the leverage to modify the polluting behavior. International conservation efforts must rely on agreements specific countries may or may not follow and on the mediation of the United Nations.

Internalizing Cost; Trade in Pollution Permits

Mann, D., and H. Ingram. "Policy Issues in the Natural Environment." In Public Policy and the Natural Environment, edited by H. Ingram and R. K. Goodwin. Greenwich, CT: JAI Press, 1985.

Marcus, A. A. Business and Society: Ethics, Government, and the World Economy. Homewood, IL:. Irwin Press, 1993.

This is the complete article, containing 1,029 words (approx. 3 pages at 300 words per page).