On Internalization of

Externalities
By –
Anil K Gupta and Aseem Prakash

PRESENTED BY – GROUP 15
•Harsh Tamboli (PGPSM09015)
•Rajat Kumar Dalai (PGPSM09030)
Introduction
1 2 3 4 5

Externalities The paper No Framework As a criterion

Analysis of for choosing
can be recommends: is available to externalities'
internalized the match the optimal
incidence, effect, method to
through – institutional institutional and other factors
route, which solutions to the internalize an
1.Market is necessary. externality,
mechanism minimizes the Historical and It could be minimize
total cost ecological
2. Government necessary for the overall cost to
(sum of context of the
regulation solution to be the company.
technology, society in
3.Self- stage- and
management, which it has
governing location-specific.
and transaction emerged
institutions costs) to the
4.Mix of these firm
institutions
 Emergence of Externality
● Baumol & Oates have identified two conditions for terming an event an externality.

Condition 1: An externality is present whenever any
individual’s (say ‘A’) utility or production function
includes a real variable (non-monetary) whose value
is chosen by others (say ‘B’) without particular
attention to A’s welfare
Condition 2: `A’ does not compensate (receive
compensation from) `B’ with an amount equal in
value to the resultant benefit to (cost to) `A’.

Meade views: an Pigou: Externalities Externalities arise due To have a socially

externality arises cause a divergence to incomplete efficient allocation of
when `A’ confers a between private costs delineation of resources,
benefit (incurs a cost) and social costs. property rights over externalities need to
to `B’ without `B’ public resources. be internalized
being a fully
consenting party.
Attribute of an Externality

Grouped ten attributes under five categories -

Occurrence Polluter Spatial Time Technological

Occurrence: An externality's occurrence may be certain (like the smoke released

when coal burns) or uncertain (nuclear leak in a reactor).

Space, time, and creatures are all areas of certainty and doubt (will
it affect a particular set of human and other living beings).

Measurability of an externality depends on the availability of

technology and on institutional factors
 Attribute of an Externality
Polluter:
Identifiable / Non-Identifiable
• Can the source/s of
pollution be identified
(thermal plant in the
hinterland causing air
pollution) or not identified
(undifferentiated and large
number of emitters of a
pollutant)
Single/Multiple Source
• If the source/s of pollution
can be identified, how
many are they
Spatial:
Localized/Non-Localized
• Is the effect of the
externality limited to a
specified geographical
area or not?
• The definition of `local’
would depend on the
perspective of the decision
maker e.g. a national
externality becomes local
in a global perspective.
Time:
Regular/Sporadic
• Is the pattern of occurrence
regular (effluents discharged by
a chemical factory at a fixed
time every day) or sporadic
(radiation leaks in a nuclear
plant)?
If it is sporadic, is it catastrophic
(Bhopal disaster), or is it within
the `tolerable permissible’ range
(unexpected seepage from the
water treatment tank of a
fertilizer factory)?
Attribute of an Externality
Technological:
• Preventable/ Non-Preventable -
1.Externality can/cannot be prevented partially/ totally from occurring by modifying input mix,
machine design, or process e.g. treating sewage before release in a water body can
substantially reduce its ill effect on aquatic life.
2.To prevent an externality at a certain stage, we may transfer it to another stage, area, or
constituent e.g. we may `wash’ coal, and reduce its ash content.
• Unidirectional/Reciprocal -
1.Unidirectional externality arises when the agent of externality imposes an externality on
others e.g. Prof. Coase’s confectioner generating noise with his mortars and pestles and
disturbing the doctor.
2.When each agent imposes an externality on all others, a reciprocal externality arises e.g.
several fishing trawlers polluting the same water body and decreasing catch for each other.
• Insulable/ Non Insulable -
1.Polluters may or may not be able to insulate themselves from the externality e.g. workers of
a nuclear power plant may completely insulate themselves from radiation leaks by using
special radiation-proof clothing.
Internalizing Externalities
• Internalizing externalities through
• State intervention - Pigou; State intervention is either through state-imposed taxes
or `command and control’
• Through a process of bargaining between the `polluter’ and the `victim’ – Coase
• Through the evolution of self-governing institutions; impose a code of conduct on
their members without necessarily requiring the support of the state of the market

● Process of Internalizing Externalities

a. Recognition of the externality
b. Identifying the `perpetrator’ and the `victim’.
c. Evaluation of the costs and the benefits of internalizing externality by each party
d. Assignment of the costs and the benefits of internalizing externality
 Role of non-governmental third parties about the `perpetrators’ and the `victims of the externality

Often the `victims are poor and illiterate who

Citizen groups, environmental groups,
consumer groups etc., which (traditionally)
have had no locus standi, can be an important
influence in all four stages for internalization of
externalities.
do not understand when their interests are
being hurt. Hence the necessity for third party
intervention on behalf of such citizens.
Recognition
Identification
Evaluation and Assignment
What Will happen in self-governing
Institutions
• If the factories decide to self-govern their behaviour to eliminate the appearance
of the externality. The following could be done:

• Set a maximum aggregate limit of discharge so that nature is able to absorb

the pollutants, and citizens do not feel its effect. A process of mutual
bargaining shall decide on the distribution of discharge quotas, monitoring,
penalties for violation, conflict resolution mechanism etc.

• Install and operate a common effluent treatment facility themselves or

through a contractor.
 How to Internalize?
Policymakers must decide:
• Which route/s to take to internalize externalities?
• What should be the criterion/criteria to decide the route/s?

How to Choose?
We propose that the criterion for identifying the right route should be the minimization of total cost to
the firm of internalizing externalities. The total cost has three components:
● Cost of Technology
● Transaction Costs
● Cost of Management/Organization
Cost of Technology

•Internalizing externalities would call for modified/new process design and

production equipment. This would entail adoption of modified/ new technology in
the production, distribution, and disposal process. The cost has two components:
• Cost of buying the technology
• Cost of using the technology
•Transaction Costs: Transaction costs are costs associated with transfer, capture and
protection of property rights. Transaction costs can arise before contracting for the
technology (ex ante) and subsequent to it (ex post).
Ex Ante Costs & Ex Post Costs

•Ex Ante Costs

• Information collection
• Search for supplier
• Negotiating with the supplier
• Framing the contract
•Ex Post Costs
• Monitoring and enforcement
• Conflict resolution
• Renegotiating with the supplier
Institutions and Stages of the Externality?

Choice of the institution also depends on the stage of environmental

stress.

In many situations, command and control action have the fastest

response time. Hence their appropriateness to prevent a major disaster or
for emergency measures to combat a disaster e.g. a major oil spill.

However in the long term, policies may not be the most efficient
(therefore fail on the basis of `total cost approach’).
 Externality Attributes and Institutions

In terms of transaction If occurrence of an Self-governing In externalities, where Government

costs, administration externality is not institutions both the damage is regulations can
costs, response times to measurable, (typically) require a irreversible and quick result in quick
internalize externalities, markets and long time to action is necessary, such corrective action
and other factors, bureaucracies emerge though institutions may not work to change the
institutions vary. As a cannot function. they may bring e.g. for sporadic behaviour of the
result, externality about durable catastrophic externalities actors (irreversible
characteristics changes in the (Chernobyl disaster); for externalities,
frequently favor behaviour of the certain almost irreversible sporadic-
particular institutional participants. externalities (Ozone catastrophic
configurations. hole); and when the externalities).
polluter is not identifiable.
Should All Externalities be Internalized?

Communities and societies must decide how much externality will be internalised. The civilizations
may place different values on the same externalities because social utility functions vary.

The choice of the time frame and discount rate to identify the least cost option to internalize
externalities, is also society specific.

Time frame indicates the horizon of our costing and discount rate enables us to bring multi-phased
costs on a single base.

Cost of technology (specifically the cost of using as opposed to buying the technology) needs a
multi-period analysis since the technology will be in use for more than one time period.