If individuals wish to reduce the detrimental effects of external costs they are required to allocate their own resources to deal with the spill-over effects. This gives rise to the notion ‘social costs’. In the example of industrial fumes the social costs of production are the sum of the costs to the producer of hiring inputs (i.e. private costs) plus the costs due to the negative externality which are borne by the third party (i.e. external costs.) Since property rights to the environment are not well defined and because the externality is non-excludable individuals are unable to internalise the effects of the externality through private trade; adjust marginal cost so the market sale of the item results in the efficient output. External effects, therefore, influence the behaviour of individuals. Negative externalities will result in the over-production of the good associated with the externality such that allocative, productive and social inefficiency will arise. The price of the product will not equal marginal social cost; the firm will not be operating at lowest possible cost or its technical optimum if social costs are not reflected by the price of its product; marginal social benefit will not equal marginal social cost.
Externalities provide an allocative role for the government. The problem is to allocate the external effect optimally. With regards to the pollution of the environment, the government could arrange to sell property rights to individuals who wish to use the environment for that purpose. This additional cost, reflecting society’s evaluation of the environment, would be borne by the polluter, thereby forcing him to modify his production decisions by reducing the level of output and hence the level of pollution. Since an optimal level of externality is not usually zero, the revenue raised from the sale of the property rights could then be used to reduce that damage which is actually done to the environment. Other policies used by governments include pollution taxes and emissions standards.
These general principles can be illustrated by means of the following example:
Consider the case of a firm which generates, in addition to its marketable output, acid rain as a negative externality. The firms demand curve, representing the marginal social benefits consumed by those who purchase the marketable output is given by D in the figure below. The private costs to the firm from producing its output are shown as MPC. In addition to these costs there are the external costs due to the acid rain, which are borne by society and which are not taken into account by the firm when it makes it output decision. If it is assumed that these costs are £E per unit of output, the marginal external/environmental costs are shown as MEC.
For the external costs to be positive it means that there must be an alternative use for the environment such as the use of the environment to support life and for recreation. That is, either there are competing uses for the environment, or consumers have to spend resources returning it to its previous state.
If marginal environmental costs are taken into account then society would prefer an output of Q1 rather that Q. To achieve this result the government can either regulate the firm by setting standards that will constrain the firm to produce Q1, or sell property rights to the environment at a price that covers the marginal environmental costs. In the latter case, the firm internalises its external costs and take them into account when making its output decision. An alternative means of internalising the environmental costs is for the government to make the polluter pay by imposing a pollution tax equal to the MEC.
