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Externalities: Costs, Benefits, Solutions

Externalities: Costs, Benefits, Solutions

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An essay for the 2011 Undergraduate Awards Competition by Robert Farhat. Originally submitted for Economics of Policy Issues at Trinity College, Dublin, with lecturer John O'Hagan in the category of Business & Economics
An essay for the 2011 Undergraduate Awards Competition by Robert Farhat. Originally submitted for Economics of Policy Issues at Trinity College, Dublin, with lecturer John O'Hagan in the category of Business & Economics

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Published by: Undergraduate Awards on Aug 29, 2012
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Externalities are costs or benefits not expressed in a market and hence
not internalized in buyers’ or sellers’ market decisions.”
(Hillman, 2009)T
his essay shall outline externalities’ various attributes, and discuss some
 of their different solutions, in particular private ownership, the Coasetheorem, and the role of government.
Externalities can be positive (such as a healthy population) or negative (such aspollution). Some are as a result of production, while some are as a result of consumption (e.g. smoking). Take the example of a factory located by a river,
which is a source of a fisherman’s produce. In a free market economy the factory
will try to maximize profits and will not take its pollution into account. However,by polluting the river it is imposing a cost on the fisherman which is not internalised
in other words, a negative externality. On the other hand, if it released some beneficial nutrients into the river this would be of benefit to thefisherman
a positive externality. Either way, the market outcome is inefficient,because the social cost is not taken into account. The true marginal cost of supply consists of the private marginal cost which the markets take into account,plus the marginal costs associated with externalities, which the markets do not.It should be noted that in most cases externalities are unintended side effects.
“There is no goodwill intended
from a positive externality and no malice
intended from a negative externality.” Most people who seek a good education
do so in their own interests, in terms of job opportunities, income, etc. Thebenefit to society of having a well-educated workforce is not taken intoconsideration. Similarly, smokers do not actively seek to create anuncomfortable environment for others who may be in the same room as them.The positivity or negativity of an externality can often be quite subjective. If alarge music
venue’s music is so loud that people who live in the area can hear it,
those who like the music would consider it a positive externality, while those
who don’t would consider it a negative one.
Externalities are often linked to public goods. When a prod
ucer’s pollution
affects many people, it damages their environment, which is a public good. But since
collective action
is required to counteract this problem, there is always the
incentive for those affected to free ride on others’ willingness to take ac
tion,which can result in nothing being done about it.In some cases, negative externalities can lead to what is known as the
tragedy of the commons
(Cornes, 1985)
For example, when land is not privately owned, anypersonal
use of it takes away from others’ ability to use it, and hence
has anegative externality. A classic example is that of fishing in international waters.Each fisherman has the incentive to fish as much as will maximize his/herprofits, hence depleting the supply of fish. We can use game theory to look athis particular transaction. Both agents have two choices: to limit fishing or not to. The best option is for both agents to agree to limit their fishing and hence asustainable supply of fish will remain. However, each agent has the incentive torenege on such an agreement and increase fishing, hence the Nash equilibrium is
that neither agents limit their fishing and this is a Prisoner’s Dilemma.
Fisherman 2 Limit Fishing Limitless fishingCountry 1Limit Fishing 3,3 (6) 1,4 (5)Limitless fishing 4,1(5) 2,2 (4)
Private Ownership Solutions
The problems described above present difficulties for a market economy but anumber of possible solutions exist, the first of which I shall discuss is that of private ownership. As has already been mentioned, the
tragedy of the commons
results in the overuse and depletion of resources - a negative externality. Privateownership can resolve the problem, as the depletion effect of using up on
e’s own
land would be internalised. It places restrictions on the amount of land that anagent can use and removes the incentive to over-consume, encouragingconservation.
However, how legal ownership rights are distributed can be contentious and canlead to rent seeking.
(Buchanan, 1980)
If the cost of rent seeking dissipates orexceeds the benefit of private ownership, the social benefit of private ownershipbecomes nullified and it ceases to be worthwhile. Moreover, if we start from astate of anarchy
where no government exists to distribute legal ownershiprights
free access to the commons is the default scenario until a powerful groupseeks to take control, as was the case with European Conquests in the NewWorld.There are also private ownership solutions to reciprocal beneficial externalities.Take the example of bees and apples. The owner of an apple orchard benefitsfrom bees that pollinate his/her apple trees, while a beekeeper benefits from the
trees as they provide nectar for the bees’ to produce honey. The beekeeper will
choose the appropriate quantity of bees that will maximise his/her profits.However, he/she does not take the external marginal benefit of bees to the appleorchard owner into consideration, hence potential benefit is lost. The solution iscommon private ownership of both the orchard and the bee farm, so that theseexternal benefits will be internalised.
(Cheung, 1973)
While far more complex,modern mergers and acquisitions often take place for similar reasons.However, in some cases common ownership is not an option. In the earlier caseof a factory and fisherman, the fisherman is merely consuming and cannot beowned by the factory. One alternative solution is to come to a contractualagreement, staying under private ownership. However, this can often involvehigh legal costs, outweighing the benefits of cooperation, and it of courserequires a government to enforce the contract.
The Coase Theorem
The Coase theorem is a theory which “predicts that externalities between people
will be voluntarily internalised by private negotiation, provided that legal rights
have been specified and that costs of reaching agreement are not too high.”
(Hillman, 2009)
(Coase, 1960)
It predicts that agents will resolve an externalityby maximising the difference between total benefit and total cost.

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