Externalities

6.3.1. The Concept and Categories of Externalities

Externalities, or external economic impacts occur when an economic agent influences the situation of another economic agent incurring costs or bestowing benefits without market transactions between them.

Externalities are grouped by their impacts, whether they incur additional costs or bestow additional benefits, and also by the process that generates them.

 Negative externalities impose additional costs on the individual or group, who is outside, that is, external to the transaction.

 Positive externalities bestow additional benefits to the individual or group, who is outside, that is, external to the transaction.

 Production externalities occur, when the external impact – being either positive or negative – is caused by a production process.

 Consumption externalities occur, when the external impact – being either positive or negative – is caused by the consumption of a product or a service..

An example for negative production externality is the following: A factory of washing powder lets sewage into the river without filtering. Therefore the factory does not have to pay the cost of the filtering, so the costs of production, and the variable costs are lower, and the marginal costs (MC) of production are also lower. The firm can sell the washing powder at low price and still earn profits. The factory is involved in market transactions with its consumers, who are interested in buying more washing powder at lower prices, as the market demand is higher when the prices are lower. At the same time, the people living near the river find that the quality of their environment has deteriorated, because of the polluted water.

Therefore the total utility of the people living in the neighbourhood of the factory has decreased, regardless of their buying washing powder or not. The costs of the environmental damage, the clearing of the polluted water must be paid by the society, if they are unable to reclaim it from the polluter.

The case of the beekeper and the orchard is a classical example of positive producer externalities. A beekeper’s bees pollinate the blossoms of the neighbouring orchard ‘free of charge’, so the fruit yield is high. On the other hand, the bees also benefit from the blossoms in the orchard, honey production becomes more successful. Therefore both the owner of the orchard and the beekeper benefit from the ’service’ provided by the other without paying for

it, both enjoy the benefit of positive production externalities. (Farkasné Fekete - Molnár, 2007, Kopányi, 1993).

An example of a negative consumption externality is the lawnmower of our neighbour that disturbs our relaxation in a summer afternoon, and a positive consumption externality is our favourite CD played by our neighbour loudly enough for us to enjoy in our own flat.

6.3.2. Economic Theories on Externalities, the Internalisation of Externalities Welfare economists claim that the occurrence of externalities diminish the allocative efficiency of the society, and lead to welfare losses: because of externalities the social benefits differ from private benefits and social costs differ form private costs, the principles of market efficiency lead to a market equilibrium that differs from social optimum.

The British economist A. C. Pigou (1920) analysed the causes of externalities, and made recommendations on how to handle them. Pigou said that to resolve the problem of externalities, they should be internalised, that is, the external impacts should be incorporated into market valuation: the positive externalities should be transformed to a revenue measured by the market, and negative externalities should be transformed to costs measured by the market. Therefore the externalities will not disappear, but they will be built into the market processes, and will be taken into account in the market equilibrium. The process of internalisation may go through the following stages:

• Voluntary agreement: the party causing the externality and the party affected by its impacts will make an agreement by their free will about the value of the damage caused and the compensation to be paid.

• The involvement of an independent expert: when the two parties cannot agree about the impact of the externality, they call an independent expert, who will assess the damage caused and give a recommendation about the compensation.

Accepting the expert opinion the two parties can make an agreement.

• Legal procedure to force compensation: when the parties refuse to make an agreement, then the damaged party may go to court to initiate a legal procedure, that involves assessment of the situation by experts, and the court will decide about the damage and the compensation that the damager is forced to pay.

• Administrative measures: some activities that cause negative externalities – e.g.

environmental pollution – are legally prohibited, and if anyone continues such activities, a penalty will be charged. Therefore the negative externality becomes a cost for the polluter (in the form of the penalty). Activities generating positive externalities are encouraged by subsidies – e.g. a firm employing formerly unemployed people will enjoy a deduction from the payroll taxes.

Another approach to resolving the problem of externalities identifies the causes in the poorly defined laws and property rights. By this approach externalities exist because the property rights of some of the economic resources (e.g. water, air, other natural resources) are not defined clearly. The key concepts of this theory were defined by Ronald Coase. He argued that by clarifying and assigning the property rights of all resources, and making society accept these rights, externalities and the consequent problems may be resolved without the involvement of the government, by private bargains in the market. When a firm uses a natural resource, and by polluting this resource restrain others in using the same resource, the first thing to decide is to identify the ownership of the resource. The owner of the resource will decide about its use. If the owner is someone else, not the firm, then this

owner may prohibit for the firm to use and pollute the resource – or they can bargain about the price for which the owner is willing to allow the firm to use the resource. If the bargaining ends with a price acceptable for the firm, then paying it, the firm becomes the user of the resource, and pays the compensation for the pollution (Farkasné Fekete – Molnár, 2007;

Kopányi, 1993).

If the firm is the owner of the resource, then property rights mean the right of use as well, and the firm can prohibit others to use the resource, and pollution will not cause externalities. In this case the person harmed by the pollution can start bargaining with the firm, offering compensation for the firm to diminish or stop pollution – and if the firm finds the offer satisfactory, it may give up it polluting activity.

Therefore the resource will be used by the party who assigns higher value to it (if the firm pays for the damage caused, this means that the firm values the use of the resource higher than its owner), therefore efficient resource allocation is attained. All this takes place, by voluntary negotiations, without any government intervention, making the natural resource the object of private bargaining in the market. Coase argues that this procedure works if the property rights can be clearly defined and assigned, and the negotiation process, that is, the bargaining does not incur very high costs. Unfortunately, in most of the real world situations very high numbers of people are involved, and the negotiation prcedure is nearly impossible to conclude, so the resolution suggested by Coase is often impossible in practice.

Review Questions

1) Explain the notion of market imperfections. Give some examples.

2) How can you classify goods, what are private goods, public goods and mixed goods?

3) How can you describe the supply and demand of public goods? What is the free rider problem?

4) What do the terms ’marginal social benefit’ and ’marginal social cost’ mean, how does social efficiency differ from market efficiency?

5) Explain the notion of externalities, and define their main categories.

6) What is the resolution suggested by welfare economics to the problem of externalities?

7) Explain the approach of poorly defined property rights to the problem of externalities, and to its resolution?

8) Explain environmental pollution, as an externality.

Problems and Questions to Develop Competence ²¹

1) A company produces fruit pulp, and the production process generates bad smell, polluting the air. Higher outputs generate more damage to the air quality. The pollution affects mainly the residents of the area. Assume that the fruit pulp is sold in a perfectly competitive market, and its marginal cost function is linear. The marginal cost of the pollution (that is, the marginal cost of the externality) is proportional to output, and is equal to one third of the marginal cost of production.

a. Draw a diagram, in which you sketch the costs and revenues of the company, as the functions of output. Mark the output level that maximises the company’s profit.

b. Indicate the social costs of production in the diagram?

21 Source of problems: Case et al. (2009).

c. Indicate the level of output in the figure, that is optimal for the society. Is this quantity larger or smaller than your answer to a) ?

d. How could you convince the company to produce the socially optimal quantity?

2) Collect information about environmental problems, or production-related environmental disasters that occurred in the last 10 years in your place of residence. What solutions have been established since for eliminating or diminishing the negative externalities?

3) Describe a few services available in your place of residence that may be considered public goods. Explain why it is necessary to provide these services as public goods.