Economic externalities are (positive or negative) goods or services generated by an economic activity whose costs or benefits do not fall upon the decision-taking agent. Pollution is a leading and important example. They may, alternatively, be thought of as residuals, the difference between ‘social’ and ‘private’ costs and benefits. The divergence was first popularized and elaborated by Pigou in The Economics of Welfare (1920) and is believed to be a major reason for market failure: for example, the market will overproduce goods with high external costs. For that reason a main principle of cost-benefit analysis is that all costs and benefits, no matter to whom they accrue, should be included. Popular discussion rightly emphasizes external costs associated with production, but one should not entirely ignore positive production effects (apples and honey) or effects on the consumption side, either positive (attractive dress) or negative (radio noise).
Various policies are, in principle, available for dealing with externalities. For example, the extent of an activity may be regulated, as in the case of the discharge of industrial effluent into estuaries. Using partial equilibrium analysis the regulation should set the amount of discharge at an optimum, that is, where marginal social cost and benefit are equal to one another. This is, of course, very difficult to calculate, so rough rules of thumb are used instead. Economists often argue for the direct use of pricing: the agent is charged a tax (or paid a subsidy) equal to the value of the externality at the margin. The congestion tax is an example of this. Such taxes and subsidies are referred to as Pigouvian: they are intended to internalize the externality. Internalization may also come about spontaneously by the merger of two units inflicting large externalities upon one another (as in industrial integration).
The tax-subsidy solution is often objected to on the ground that it is open to injured parties to bring an action in tort against the offending agent. If agents know this to be the case, they will take expected compensation for damages into account and externalities will automatically be internalized. On this view not only would Pigouvian taxes not be needed but also they would, if imposed, lead to an over-restriction of activity (Coase 1960). Property rights are seen to be crucial, as they define rights to compensation: defenders of the market system therefore argue that externalities do not constitute market failure provided that property rights are adequately delineated. The direction of compensation naturally depends on the initial distribution of legal rights.
The alternative solutions are closely related to one another. Take the case of a major oil spillage which fouls beaches and destroys fishing and wildlife. If spillages are to be ‘banned’ the fine must be at least equal to the Pigouvian tax. If there is to be a legal contest, it will have to be fought between states and oil companies rather than through improvised groups of holiday-makers, workers in the fishing industry and wildlife enthusiasts. And fines/compensation must not give an outcome which is totally unreasonable in relation to the optimum (possibly, though not certainly, zero) amount of spillage.
David Collard
University of Bath
Reference
Coase, R.H. (1960) ‘The problem of social cost’, Journal of Law and Economics 3.
Further reading
Pearce, D.W. (ed.) (1978) The Valuation of Social Cost, London.
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