Externalities are costs or benefits of market transactions that are not reflected in the market price and that affect individuals who are not participating in the market.
Solutions to externalities include the following
- Internalize Externalities
The government should require companies to internalize externality’ costs through taxes and fees.
Companies should pay for the costs of cleaning up the problems they create.
To pay for the costs of pollution, they should compare the total costs and revenues of production and determine if it is profitable to produce.
Limitations
It is difficult to place a monetary value on social costs such as death, extinction, the deforestation, etc. and hence it is not always easy to put this policy into practice.
Regulations are not always enforced, and governments may simply choose to relax their standards in order to avoid hurting businesses.
Pigouvian tax
Suggested by a British economist A.C. Pigeon and hence referred to as Pigouvian tax.
A tax should be levied on each unit of a polluter’s output in an amount just equal to the marginal damage it inflicts at the efficient level of output.
The marginal damage done at the efficient output Qs is distance cd.
The vertical distance between MSC and MPC is MD (i.e. cd=VQs). The tax raises the firm’s marginal cost.
For each unit the firm produces it has to make payments both to the suppliers of his inputs (measured by MPC) and to the tax collector (measured by cd).
Geometrically the firm’s new marginal cost schedule is found by adding cd to MPC at each level of output – by shifting up MPC by a vertical distance equal to cd
Profit maximization requires that the firm produce up to the output at which marginal benefit equals marginal cost.
This now occurs at the intersection of MB and MPC+cd which is at the efficient output Qs.
In effect the tax forces the firm to consider the costs of the externality that it generates and hence induces him to produce efficiently.
Note that the tax generates revenue cd dollars for each of the PSd units which produced (PSd = OQs).
Hence tax revenue is CdxPSd, which is equal to the area of rectangle PSJCd.
Weaknesses of Pigouvian tax
- It is difficult to estimate the marginal damage function and hence hard to find the correct tax rate. This can be addressed through several ways
- an indirect measure such as the number of miles driven by vehicles that produces noxious fumes
- a special sales tax on the car even though it is not ownership of the car per se that determines the size of the externality but the amount it is driven.
- Another weakness is that the tax approach assumes that it is known who is doing the polluting and in what quantities. In many cases these questions are very hard to answer.
2. Social Conventions
This deals with negative externalities through social conventions and traditions.
Certain social conventions are attempts to force people to take in to account the externalities that they generate.”
Through tradition “recognition of signals and appropriate responses are instilled as part of the culture.”
Example: Private and public health practices of observing hygiene e.g. how to dispose waste
Weakness: Its overall usefulness may be limited to low cost externalities generated by individuals.
3 Property Rights
A private property right is a legally established title to the sole ownership of a scarce resource that is enforceable in the courts.
A private property right is a legally established title to the sole ownership of a scarce resource that is enforceable in the courts.
Private property rights offer a number of solutions to the problems posed by externalities.
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.
Example: property rights to a section of river are assigned to a fishing club which sue the chemical firm/upstream which pollutes the river and kills the fish stock in the fishing clubs’ section of the river.
Private property rights offer a number of solutions to the problems posed by externalities.
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.
Example: property rights to a section of river are assigned to a fishing club which sue the chemical firm/upstream which pollutes the river and kills the fish stock in the fishing clubs’ section of the river.
4 Coase Theorem & Bargaining
Provision of a framework in which bargaining may take place.
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
If transactions costs are zero (or low) then a private voluntary bargaining solution will produce an efficient outcome.
According to Coase theorem, whenever there are externalities, the parties involved can get together and make some set of arrangement by which the externality can be internalized to ensure efficiency
Most externalities are dealt by the assignments of property rights.
These rights confer on a particular agent the right to control some assets and to receive fees for the use of that properly.
Example: A firm may possess a right to the environment and hence parties concerned about the environment could arrange to purchase back these rights from the firm thereby reducing the firm’s stock of rights and hence the level of pollution.
Hence the price that the parties (consumers) are willing to pay reflects their valuation of the environment.
On the other hand, consumer could hold back the rights to the environment and firms would purchase these environmental rights and hence the right to pollute
Graph for property rights and bargaining
5 Mergers
It entails the parties involved to merge.
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 internalizing the effects.
If the steel manufacturer purchased the fishery, it would willingly produce less steel than before, to increase the profits of the fishing subsidiary more than it decreased the profits from his steel industry.
However, there are several limitations in practical implementation of mergers
- 6 Tradable Pollution Permits
Government here sells permits to producers to pollute.
Tradable emission permits allow the government to give companies licenses to pollute at a certain level.
Companies can buy, sell, and trade these permits on the market.
Therefore, it is in the interests of companies to pollute as little, as possible.
If they pollute at a level higher than their permit allows, they have to buy permits from another company.
Limitations of tradable pollution permits
It requires knowledge of who is polluting and in what quantities which might not be available.
The auctioning scheme is that large firms might be able to buy up pollution licenses in excess of the firms cost minimizing requirements to deter other firms from entering the market.
7) Regulation
Each polluter is required to reduce pollution by a contain amount or else face legal sanctions.
In case of pollution 2 classes of regulation (control) can be distinguished.
(a) Direct regulation
(b) Input regulation
The direct regulations involve the setting up of critical level of pollution and monitoring the level of pollution of the firms and prosecute firms that exceed critical level.
Input regulation involves regulating the production process.
Most government relies heavily on input regulation since in most cases it is easier to monitor inputs than to measure level of pollution.
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