Secondly, a negative externality is a cost imposed on people other than those who purchase or sell a good or a service for which the recipient of the cost is not compensated. These costs are labeled “externalities” because the people who experience them are outside or external to the transaction to buy or sell a good or service. A leading example of a negative externality is pollution emitted from a factory. In this case, people who neither buy nor sell the factory’s products experience the harmful effects of pollution such as respiratory diseases, etc. Lastly, the public sector needs to be defined. The public sector refers to the government’s domain in the economy; this includes public utilities, public health, transport, regulation, etc. It is not just limited to the regulation of negative externalities.
In the neoclassical externalities theory, externalities are often sited as one of the reasons why markets fail. It has been conventionally argued that externalities cause a divergence between “private net product” and “social net product”. Firms and individuals weigh up private costs in their decision process and thus may fail to take into account external costs, thus leading to a difference between marginal private cost and marginal social cost. This gives rise to the conclusion that market activities which generate positive or negative effects will lead to less than optimal results in terms of prices charged and outputs produced, i.e. the allocation of resources is less than ideal. The market system is often touted to produce a Pareto optimal outcome. The equilibrium allocation of goods and services determined in a perfectly competitive market is shown to maximize possible net benefit to the buyers and sellers in the market, that is to give the socially optimal outcome. It is impossible to increase anyone’s net benefit without reducing someone else’s welfare, thus the market gives a Pareto optimal outcome. In this perfectly competitive market, marginal social benefit, given by price, equals marginal social cost thus social efficiency is maximized with a Pareto optimal outcome. However, this rests on a number of highly restrictive conditions one of which is the absence of externalities among others such as perfect information, no transaction costs, all economic agents are price takers etc. The presence of externalities result in a deviation from this standard and consequently, the resulting output level is greater than Pareto optimal amount and the market price is less than marginal social cost.
“The problem of ‘external costs’ is a consequence of failure to enforce fully the rights of property hence external costs (e.g. smoke damage) are failures to maintain a fully free market, rather than defects of that market,” said economist Murray Rothbard. As opposed to the proposition that market activities generate negative externalities, some economists such as Mises and Rothbard have put forth that the clear definition and strict enforcement of property rights are essential for the functioning of a market economy and thus concluded that with negative externalities, the failure is not in the market but in the failure of legal institutions to define and enforce property rights. Negative externalities are exogenous to, rather than being an endogenous part of market economy, negative externalities are not unique to the market economy. Problems that arise from negative externalities show evidence that the economic system is “failing”. This failure however is due to the fact that the market is not allowed to function properly rather than because it is. If the necessary institutional conditions for a free market process are not present then the free market can hardly be blamed. For Mises and Rothbard, in order for a market system to function properly, clearly defined and strictly enforced property rights are essential.
Hence, to blame the market for negative externalities is spurious as it is the failure to define and enforce property rights not the failure of the market that results in externalities. Ultimately, the cause of external costs lies not in the workings of the market but in the fundamental basic nature of all human beings. All economic agents in a market have a natural tendency not to feel any responsibility for anything that does not belong to us thus we do not take into account all of the costs of our actions. For example, because no one owns the atmosphere or the ocean, polluters do not take into account the costs incurred in their decision-making. Mises pointed out that “some people choose certain modes of want satisfaction merely on account of the fact that a part of the costs incurred are debited not to them but to other people”. The inherent selfish nature of people that while on one hand guides the market economy, on the other hand causes external costs. However, it is virtually impossible to define property rights for everything such as the environment. It is terribly difficult to define property rights for the air that we breathe or the oceans, this will be elaborated upon later. The fact that it is impossible to define and enforce property rights for everything coupled with human nature renders the problem of negative externalities a persistent one, one that is hard to eliminate completely.
In the neo-classical externalities theory as explored earlier, negative externalities cause a difference between marginal social cost and marginal private cost and thus the resulting output level is greater than the Pareto optimal level, there is and over production or consumption of goods with negative externalities. As shown in the diagram below, assuming no external benefits, due to the presence of external costs, the marginal private cost is less than the marginal social cost. The resulting output level of Qe is more than the ideal Pareto outcome of Q* and the deadweight loss incurred by moving from Q* to Qe is shown by the shaded triangle. Hence, negative externalities are detrimental as they result in a less than optimal allocation of resources. Too much of society’s scarce resources are diverted into the production of this good, representing a waste of society’s resources which could have been put to better use somewhere else. The resulting market price is also less than the marginal social cost, the value that society places on the last unit of goods produced is less than the opportunity cost of producing it, thus it is allocatively inefficient. As efficiency of the use of resources is of paramount importance to an economist, negative externalities should be corrected in this perspective. However, it is important to note that the term “optimal” here refers to the result that is obtained in a perfectly competitive market economy.
On the other hand, some economists view negative externalities differently using a different benchmark of efficiency. One such economist is Murray Rothbard who argues that voluntary action will always be viewed as welfare enhancing from the individual’s perspective. The determination of whether or not an exchange is voluntary or not centres around the use of private property. A coercive act according to Rothbard would always make at least one person worse off and therefore violates the Paretian rule and reduces social welfare would be one that violates the property rights of an individual. A negative externality such as pollution would reduce social welfare as pollution interferes with the use of property by it “owner”. In polluting the environment, the polluter is made better off whereas the recipient of the externality is made worse off. Kirzner believes that rather than looking at the economy from the perspective of this imaginary perfect equilibrium, a market economy should be studied as an ongoing process in which the economic agents in the market never posses perfect knowledge; and in which competition and changing market conditions supply changing information to better co-ordinate the actions and plans of a multitude of people who are interdependent in their activities. Hence, an activity that leads to an improvement of knowledge and hence co-ordinates previously uncoordinated plans, that activity is efficient. Only externalities that lead to a disruption of plans are inefficient. For example, pollution from a factory that disrupts the execution of at least some plans of a third party, the existence of the externality is deemed to be inefficient.
Thus, negative externalities are detrimental to the efficiency of a market economy no matter regardless of the benchmark for efficiency used. Efficiency, which ensures that society’s scarce resources are put to the best uses, is the argument for the correction of negative externalities. In an economist’s domain, negative externalities can only be evaluated for their impact on efficiency and judgments are made on this basic premise. In negative externalities, it is not a case of eliminating pollution, noise, etc but of attaining the optimal output level in a market economy. A society may choose to correct a negative externality not for its impact on efficiency but for other reasons. For example the value that a society places on the environment, such that they would correct air and water pollution to conserve the environment. The value that society places on different entities would be beyond the economist’s domain.
Having established that negative externalities do have an adverse effect on the allocative efficiency of a market economy and thus should be corrected, the issue that has to be examined is whether the government is necessarily the best candidate for the job. Not all negative externalities need to be corrected, according to Coase who argued that public policy should aim to maximize the value of output, which may or may not involve the “internalization” of external costs. Taking the example of a factory polluting a river and killing the fish, Coase argues that the value of the fish lost should be compared to the value of the product whose production causes the contamination of the river. In cases where the cost of the fish lost overweighs the value of the product, then the externality should be corrected.
The traditional corrective measures that can be undertaken by the government include Piguovian taxes and subsidies that would induce the market to conform to the optimal results. With respect to negative externalities, governments can impose an excise tax that is equal to the value of the external cost at the optimal output. This would force the generator of the externality to take into account all social costs associated with his production process, resulting in the equilibrium output being reduced to the optimal level. Pigou’s tax solution still allows the market to operate; it forces firms to take into account the full social costs of their actions. Furthermore, if firms are taxed for polluting, the tax acts as an incentive for firms to find cleaner and greener methods of production. On the other hand, different firms have different levels of production and thus will causes varying degrees and different negative externalities. It would not be feasible to charge each offending firm a different tax rate, as it would be expensive and time consuming. The cost of the intervention would outweigh the cost of the externality. A government also faces the problem of measuring costs and apportioning blame as no one in the real world has perfect information. The amount of information that would be required for a judge or any third party would create a very big obstacle to obtaining an efficient i.e. Coasean solution. For example, the damage caused by acid rain to lakes and forests, the problems caused by acid rain cannot be traced to specific polluters. Another problem also arises when there are large numbers of people generating an externality, each contributing a small and imperceptible amount to the problem for example urban smog caused by the activities of many people.
The government traditionally has also imposed regulation for example, banning smoking in public places or imposing quotas on the amount of pollutants that can be emitted from a firm. Legal restrictions are easy to administer as inspectors can conduct checks and the effects are readily and rapidly observable for emergency situations such as very dangerous haze or smog where the government can ban certain fuels. Conversely, regulations have been criticized for being “clumsy” as sometimes legislation is slower than technological progress and are thus not very flexible or adaptable. Regulations also do not encourage firms to find cleaner and greener production methods unlike taxes.
Since negative externalities stem from the failure to properly define and enforce property rights, it is logical that the solution lies in the extension of property rights. To many economists, the onus is on the government to provide a legal institution where there are clearly defined and strictly enforced property rights to facilitate the proper functioning of the free market. Property rights define who owns property, to what uses it can be put to, the rights other people have on nit, etc. Property rights can be extended completely such that everyone would be able to prevent others from imposing costs on them. The Coase theorem states that in a perfectly competitive market with no transaction costs, the sufferers from the externalities can make deals with the perpetrators, the externality would be internalised and the socially efficient level of output would be achieved. In practice however, this can be totally impractical. Especially in instances where a large group of people is slightly inconvenienced, it is virtually impossible to expect all the sufferers to make bargains with the perpetrators. Also, it is impossible to define property rights for entities like air or oceans as mentioned before. In this case, the state is the best to set up such an institution as the state has the legislative, executive and judicial powers to enforce property rights and thus allow the free market to function.
However the second part of the statement in the question is also fallacious, as even if the government should intervene, it does not mean that the size of the public sector, which includes everything in the public domain from public utilities to public provision of health services, should be increased.
Hence in conclusion, the existence of negative externalities should not be blamed on the free market as the failure is in defining and enforcement of property rights and while the onus is on the government to provide an institution of properly defined and enforced property rights, it does not mean that the size of the public sector should be increased. Perhaps efforts at solving the problem of negative externalities could be improved especially in the area of pollution.
Bibliography:
- Welfare economics and externalities in an open-ended universe: A modern Austrian perspective by Roy E. Cordato (Boston: Kluwer academic press, 1992)
- Free to Choose by Milton and Rose Friedman (Harvest publications, 1990)
- “Why externalities are not a case of market failure” a research paper by Brian P.Simpson, Ph.D, Assistant Professor, National University department of business, California.
- Externalities, a research paper by Erik T. Verhoef, Department of Spatial economics, Free University, The Netherlands.
