External costs (externalities for short) are often called social costs by economists. They repre- sent the total cost to society of any form of economic activity and ...
externalities1 Stephanos Avgeropoulos and John McGee
External costs (externalities for short) are often called social costs by economists. They represent the total cost to society of any form of economic activity and may diverge from private costs as reflected by the normal operation of the price mechanism. The production and/or consumption of some products may give rise to some harmful or beneficial effects that are borne by organizations or people not directly involved in such production or consumption. Such side effects are called externalities, spillovers, or external costs. Early works on externalities include Sidgwick (1887) and Marshall (1890). A few years later, Pigou (1920) considered the legal implications of externalities, and determined that where externalities exist in the form of social costs, it is efficient for common law to be applied so as to force the internalization of such externalities. Coase (1937), however, disagreed with this view, claiming that some externalities are sometimes self-correcting, and suggested that holding the party which created the externality liable under common law is not necessarily efficient; instead, efficiency would be best achieved by balancing costs and benefits in which the role of causality was not decisive.
TYPES Externalities can be categorized along a number of dimensions. The first is whether they are negative or positive, according to whether the party which is affected by them benefits or suffers. Second, externalities can be production or consumption based according to their source. Third, there are technological and pecuniary externalities. Technological externalities, the most common kind, simply relate to the indirect effect of a consumption or production activity on the consumption or production of a third party. Pecuniary externalities, on the other hand, work through the price system when prices play additional roles other than equating demand and supply, such as when they transmit information in an asymmetric information environment, or when they are affected by some party, in which
case this change also affects the welfare of other parties (e.g., one industry’s increasing consumption of petroleum affects another industry’s welfare through the higher petroleum prices). Turning to examples of some types of externalities, external costs of production may include oil spills or the impact of extensive farming on wildlife. External costs of consumption, on the other hand, may include the impact on nonsmokers of smoking in public places or the effect of a neighbor’s decision to plant trees, the roots of which may travel beyond the boundaries of the land on which they are planted and cause damage to nearby properties. External benefits of production, on the other hand, may come in the form of lower training costs when a worker goes to work for another firm, improvements to regional infrastructure, such as rail facilities, which may result from the needs of one firm but subsequently be used by others, or the growth in peripheral supplier businesses, or technology spillovers, which can often explain the clustering of similar firms in certain geographic areas. Similarly, external benefits of consumption may include the existence of a well-maintained garden, which increases the value of neighboring properties, or the installation of a new, quieter air conditioner.
SOURCES Externalities arise primarily because of an incomplete definition of property rights in the law. For example, they enable an industry which pollutes its environment through the use of its assets to pass on the costs of cleaning up to the rest of the community.
CONSEQUENCES Externalities, which are identified by discrepancies between social and private costs, typically lead to market failure. The most commonly encountered implication of externalities is the misallocation of resources by the market mechanism, that is, allocative inefficiency (see EFFICIENCY). This typically comes about in two distinct ways. First, externalities may cause a deviation in the prices of goods from the marginal cost of producing them and, second, externalities in the form of information
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2 externalities spillovers may lead firms to invest at suboptimal levels, if they have reason to believe that they will be unable to recoup the full cost of, say, some R&D investment.
SOLUTIONS A number of solutions exist to reduce the impact of externalities. These include prohibition, directives, or other regulation to eradicate or limit activities that generate externalities. For example, cars may only be permitted to be driven for up to a set number of days per week, or a requirement may be imposed for safety devices such as seat belts to be installed, in order to reduce fatal accidents. Another method, which is more suited to dealing with production externalities of nonpublic goods, is forced internalization, whereby the party that generates the externality is forced to deal with itself, effectively eradicating the externality, which becomes part of the producer’s own set of constraints. A company that pollutes a river may be obliged, for example, to acquire or merge with another company which makes heavy use of the polluted water further downstream. A rather less radical method of forcing internalization is by means of financial transactions such as (Pigovian) taxes (or subsidies, as appropriate) or the marketing of externality generation rights, that is, the artificial creation of a market for the externality. Finally, as has been shown by Coase, it may be possible to reduce the harm caused by externalities if the parties involved cooperate voluntarily. An example may be the situation in which a city that suffers from airborne pollution pays the offending factory to install improved equipment or relocate. As far as a choice between the above methods is concerned, each is likely to have different enforcement costs and a different probability
of evasion, so the specific circumstances will dictate the most appropriate one. In principle, it is more efficient not to eradicate the externality, but to limit it to the point at which the benefit from any further marginal reduction equals the cost of any such reduction.
ENDNOTES 1 Original
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