Private Solutions
Although externalities tend to cause markets to be inefficient, government action is not always needed to solve the problem. In some circumstances, people can develop private solutions.
The problem of externalities is sometimes solved by moral codes and social sanctions e.g. litter.
They can also be solved by charities e.g. Greenpeace
Coase Theorem: if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities and allocate resources efficiently themselves. If the benefit exceeds cost, then it is efficient to use that good or service. According to the Coase Theorem, the initial distribution of rights does not matter for the market’s ability to reach the efficient outcome. Not always successful due to:
• Bargaining does not always work
• Transaction costs (costs in the process of agreeing and following a bargain)
• Difficulties when number of interested parties is large
• Asymmetric information (not having perfect knowledge of the costs and benefits)
• The situation may be complicated by free riders (see the Free Rider Problem page)
• This theorem assumes rational behaviour, which in reality may be clouded by all sorts of behavioural
and psychological influences.
The problem of externalities is sometimes solved by moral codes and social sanctions e.g. litter.
They can also be solved by charities e.g. Greenpeace
Coase Theorem: if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities and allocate resources efficiently themselves. If the benefit exceeds cost, then it is efficient to use that good or service. According to the Coase Theorem, the initial distribution of rights does not matter for the market’s ability to reach the efficient outcome. Not always successful due to:
• Bargaining does not always work
• Transaction costs (costs in the process of agreeing and following a bargain)
• Difficulties when number of interested parties is large
• Asymmetric information (not having perfect knowledge of the costs and benefits)
• The situation may be complicated by free riders (see the Free Rider Problem page)
• This theorem assumes rational behaviour, which in reality may be clouded by all sorts of behavioural
and psychological influences.
Public Policies
The government can respond to externalities in two ways:
1. Command-and-control policies to regulate behaviour directly.
An example of a command-and-control policy is when the government dictates a maximum
level of pollution that a factory may emit.
2. Market-based policies that provide incentives for change.
Pigovian tax, a tax enacted to correct the effects of a negative externality, is an example of
a market-based policy. Pollution permits, like Pigovian taxes, are increasingly being viewed
as a cost-effective way to keep the environment clean.
1. Command-and-control policies to regulate behaviour directly.
An example of a command-and-control policy is when the government dictates a maximum
level of pollution that a factory may emit.
2. Market-based policies that provide incentives for change.
Pigovian tax, a tax enacted to correct the effects of a negative externality, is an example of
a market-based policy. Pollution permits, like Pigovian taxes, are increasingly being viewed
as a cost-effective way to keep the environment clean.
Public/Private Policies
One private solution to externalities which can occur but which needs legal backing is the establishment of property rights.
Property rights grant the exclusive right of an individual, group or organisation to determine how a resource is used.
Extending property rights could internalise externalities, because the threat of prosecution for pollution is a sufficient incentive to avoid doing it. It also allows the owner of the property to sell or share that property if they wish at a mutually agreeable price.
However, how do we apportion rights to things such as air, the seas and rivers? The cost of establishing property rights and getting international agreement on what they entail is considerable and may counteract the social benefits they might provide.
Property rights grant the exclusive right of an individual, group or organisation to determine how a resource is used.
Extending property rights could internalise externalities, because the threat of prosecution for pollution is a sufficient incentive to avoid doing it. It also allows the owner of the property to sell or share that property if they wish at a mutually agreeable price.
However, how do we apportion rights to things such as air, the seas and rivers? The cost of establishing property rights and getting international agreement on what they entail is considerable and may counteract the social benefits they might provide.