Externalities: Implications for allocative efficiency and suggested solutions.

Number of hits Since 6 June 1996. This counter courtesy of WWW.DIGITS.COM
This page is copyright © 1996 to Heath Gibson. This page may not be reproduced for commercial gain without permission. This page and its contents may be copied for academic and study purposes provided that the contribution drawn from these pages is appropriately acknowledged.



The prevalence of externalities in consumption and production of goods and services generates a number of discussion points indicating weaknesses in the general rules relating to allocative efficiency in the market economic system. After defining and illustrating externalities this essay will discuss the implications of externalities in relation to the general rules of allocative efficiency and then critically evaluate the various methods suggested for dealing with the problems of externalities .

What is an externality?

When discussing externalities there are a number of useful definitions and descriptions of what an externality is . In basic terms an externality "is a cost or benefit arising from an economic transaction that falls on a third party and that is not taken into account by those who undertake the transaction."1 In a market economy this generally means that an externality occurs where there is "a direct effect of the actions of one person or firm on the welfare of another person or firm in a way which is not transmitted by market prices. " 2 This externality can arise from the "the effects that consumption of an item by one consumer may have on the welfare of others" 3 or from "the effects that the production of one product may have on the production possibilities of others." 4.

Externalities may take two forms. Firstly there are negative externalities. A negative externality occurs where consumption or production of a good generates a cost borne by someone outside of the production or consumption of that good. A negative externality in consumption could for example be the exhaust fumes produced by the driving of cars or the damage done to sand dunes by tourists driving 4WD vehicles in sensitive areas. The most obvious example of a negative externality in production is the pollution caused by many industries.

Positive externalities occur when a benefit accrues to someone outside of the production or consumption of a good. An example of a positive externality might be that by individuals consuming vaccine against the influenza virus , those who do not vaccinate themselves receive the benefit of a reduced prevalence of the virus in the community. When it comes to a positive externality in production the damming of rivers for electricity is a good example as the damming not only provides for flood mitigation for those living downstream of the river but also provides an area for enjoying water based recreational activities. 5

Implications of externalities for allocative efficiency

The prevalence of externalities in the market based economy suggests that the optimality rules normally assumed to lead to allocative efficiency may not in fact lead to the most socially efficient outcome. The presence of externalities thus represents an example of market failure to achieve allocative efficiency. The reason for this is that in the presence of externalities the market price of a good may not reflect the true societal cost or benefit and hence may be under or over produced. Figure EE1 illustrates the implication of negative externalities for allocative efficiency.

Figure EE1

In a free market where the optimality rules have been followed the quantity produced will occur at quantity Xp and price Pm , the point where demand (D) equals the private marginal cost (PMC). However where a negative externality exists the market fails to produce the socially optimal level of production. This is because the marginal damage (d) , generated by the negative externality, is a cost not taken in to account in the market. When a social marginal cost (SMC) curve is generated it is possible to see that socially optimal level of production is in fact X* and that the product should be sold at a higher price P* to reflect the fact that the true social cost of the product is higher than the private cost.

Positive externalities also have their own special implications for the achievement of allocative efficiency. Figure EE2 illustrates the implications for the optimality rules of a positive externality. The market equilibrium in this situation occurs at quantity Qp and price Pm where the private marginal benefit (PMB) of the item equals its marginal cost. However this item produces an external benefit (b) which is not taken in to account by the market. The socially optimal quantity of this item actually occurs where the social marginal benefit (SMB) curve derived by summing the private marginal benefit and the external benefit , equals the marginal cost of producing the item. This analysis suggests that the allocatively efficient situation occurs at quantity Q* and price P* .

Figure EE2

The conclusion which can be drawn from this is that true allocative efficiency will not be achieved unless the external benefits and costs associated with externalities are taken in to account when making economic analysis. Given the problems for allocative efficiency which are caused by the presence of externalities , what then are the possible solutions to correct these examples of market failure.

Solutions to externalities

Social Conventions

One approach to dealing with negative externalities is through social conventions and tradition. The argument here is that "certain social conventions can be viewed as attempts to force people to take in to account the externalities that they generate." 6 and through tradition " recognition of signals and appropriate responses are instilled as part of the culture." 7 The example associated with this is impressing on people from a young age that even though one bears a cost by holding on to litter until a bin is found that one should do so because of the externality which litter creates. Whilst this is an interesting suggestion it perhaps raises more problems than it answers. Will an individual be held to social conventions when there is a substantial cost in doing so ? And how does one apply a solution designed for dealing with individuals , to teaching and enforcing social conventions on large , possibly multi-national corporations? Thus whilst social convention may have appeal in dealing with some socially unpleasant , externality generating activities, its overall usefulness may be limited to low cost externalities generated by individuals.


Another possible solution to the problem of externalities may be for the parties involved to merge. For example if a fishing companies profits are being harmed by the pollution produced by a steel mill then the problem of this externality can be solved by merging the parties involved and internalising the effects. "For instance , if the steel manufacturer purchased the fishery, he would willingly produce less steel than before , because at the margin doing so would increase the profits of the fishing subsidiary more than it decreased the profits from his steel industry." 8 This suggestion too however may be seen as having a number of problems in its practical implantation.

This solution may be feasible for firms but how do individuals fit in to this scenario ? How , for example , do firms producing air pollution , merge with the multitude of people who may be affected by its pollution. And even if we attempt to suggest that the individuals should purchase the firm , which in theory would internalise the effects , how is this to be effected in practical terms. Thus again , whilst mergers suggest a theoretical solution to the problem of externalities in many instances they are not practical solutions.

Regulatory Limits

The most common approach to solving the problem of externalities , especially pollution , is the imposition of regulatory limits on the amount of the externality produced and the imposition of fines on those parties who produce externalities beyond the regulated limit. Whilst this approach appears to offer a simple solution to limiting externalities , requiring all firms to reduce their externality by the same amount or to the same level as other firms may not be efficient. This can be seen by reference to Figure ES1 below.

Figure ES1

Figure ES1 represents the situation of two firms (a and b) with identical costs but different marginal benefit curves (MBa and MBb). The free market situation with no government regulation will produce quantity Xp pollution at the point where the marginal benefit curves of the firms intersect the private marginal cost (PMC) curve. When the firms take in to account the damage (d) that is caused by their actions the optimal amounts of pollution for each firm is Xa and Xb respectively. Given different marginal benefit curves, moves by the government to have all firms reduce their pollution by the same amount or to limit pollution to a set amount such as X* may not be the efficient outcome. Therefore whilst regulatory limits and use of fines may appear a simple solution , it may not be efficient . Other problems of this approach include such things as monitoring and detection of firms breaching the pollution laws.

Pigouvian Taxes - a.k.a. - corrective taxes

Another possible solution to the problem of negative externalities such as pollution is the imposition of corrective taxes designed to induce producers to limit their production of a good to the socially allocatively efficient level of production. A Pigouvian tax is " a tax levied upon each unit of pollution in an amount just equal to the marginal damage it inflicts upon society at the efficient level of output." 9 Figure ES2 indicates the effects of a Pigouvian tax on a firm producing a negative externality such as pollution.

As Figure ES2 shows , the free market equilibrium will occur where demand (D) , equals the private marginal cost (PMC) of production. This occurs at quantity Xp. However the optimal amount of production occurs at Q* where social marginal cost (SMC) , which takes in to account the damage (d) caused by producing the item , equals D.

Figure ES2

Now observe the effect of introducing a Pigouvian tax of (t) which is equal to the marginal damage (d) of the externality at the optimal level . By implementing the tax the firms effective supply curve is raised to become its private marginal cost plus the tax. As a result there is a rise in the price of the good and a contraction in demand for it. The allocatively efficient level of production is achieved at price P1 and quantity Q*.

Pigouvian taxes therefore offer a more effective means of achieving allocative efficiency than straight out regulatory limits or fines. Pigouvian taxes however do still suffer from some of the same weaknesses as regulation of pollution. In order to tax polluting firms the government or enforcing body must be able to determine which activities produce pollution , determine which pollutants do the harm and finally come up with some estimate on the value of the damage being caused. Usually an estimate of these things will have to be made , meaning that the tax will only move us closer to the optimal position rather than onto it. However with improving technology and greater understanding of environmental cause and effect Pigouvian taxes may become increasing effective in moving us towards the optimal level of production in externality producing industries.

Property Rights

The establishment and enforcement of private property rights provide an alternate framework for the solving of externalities . "A private property right is a legally established title to the sole ownership of a scarce resource that is enforceable in the courts." 10 Private property rights offer a number of solutions to the problems posed by externalities.

Firstly , the establishment and enforcement of greater private property rights by the legal system would allow victims of negative externalities to sue the offending party for compensation for the damage caused. For example , if property rights to a section of river are assigned to a particular fishing club , then that club will be able to sue the chemical firm upstream which pollutes the river and kills the fish stock in the fishing clubs section of the river.

Coase Theorem & Bargaining

The other way in which property rights can assist in achieving allocative efficiency is by providing a framework in which bargaining may take place. Consider the situation illustrated in Figure ES3 below which builds on our fishing club example .

Figure ES5

The Coase Theorem suggests that " the efficient solution will be achieved independently of who is assigned the ownership rights , so long as someone is assigned those rights" 11 The reasoning for this is that if the chemical firm is assigned the property rights , the fishing club will be prepared to pay the chemical firm an amount up to the value of the damage being caused , to have the chemical firm reduce its output and that at any point past X* the damage being caused exceeds the firms profits from doing so . Hence the firm is willing to accept the payment to reduce its output to X* . Similarly if the fishing club has the rights , it will not allow the firm to produce past X* as the damage caused to the fishing club is greater than any payment the firm would be willing to make. The establishment of property rights thus creates a framework which allows bargaining and the achievement of the socially optimal outcome.

Property rights too have a number of problems. There may be problems for example of assigning and defining property rights and the enforcement of property rights would most likely involve a number of significant alterations to existing property law. There are also problems associated with the bargaining model such as the costs of bargaining , difference of bargaining power , and difficulty in identifying and quantifying the damage being caused. Thus whilst property rights offer an innovative solution to the problem of externalities there is still much work to be done in this area.

Tradeable Pollution Rights

Another approach which has been suggested in recent times is the creation of a market for tradeable pollution rights. This is illustrated in figure ES4.

Figure ES4

The pollution rights approach to negative externalities involves the government creating a market for pollution rights. The supply of pollution rights, and hence the quantity of pollution produced , is fixed at quantity X*. Firms not prepared to pay the market price of P* to purchase pollution rights must either cut back their pollution or adopt technologies which produce less negative externalities. Tradeable pollution rights can help achieve allocative efficiency as an increase or decrease in demand will be reflected in a change in the price of the rights ,but the amount of pollution produced will not exceed the optimal level determined by the number of pollution rights available.

Pollution rights however raise a number of problems which still need to be addressed. For example in determining the number of pollution rights to be sold the government must determine the point where "the marginal social cost of pollution equals the marginal abatement cost." 12 . This in turn creates the problem of the government having to buy back or issue more pollution rights whenever there is a change in these factors. Plus there still remains the problems of monitoring firms to ensure they are not producing more externalities than their rights allow. Again , tradeable pollution rights present a market based solution which may become more viable with improvements in technology and science.

Subsidies - to encourage positive externalities

So far we have only focussed on solutions to negative externalities however the undersupply of items producing a positive externality require their own solutions. The solution to positive externalities is through payment of subsidies , which is illustrated in figure ES5. Figure ES5 illustrates how the payment of a subsidy to the producer of a positive externality can improve allocative efficiency .

Figure ES5

By paying a subsidy (s) equal to the size of the social benefit from the production of the item , then production is encouraged to expand from Xp to the optimal level of output at X*. Subsidies thus offer a solution to the problem of underproduction of goods with a positive externality. However they can be criticised on the grounds that payment of the subsidy requires that size of the social benefit and the subsidy be precisely calculated as otherwise there will be a greater loss in efficiency in the areas where the subsidy is collected than the gain in the industry receiving the subsidy. The cost of collecting and dispensing the subsidy must also be taken in to account if true optimality is to be achieved.


In conclusion then it can thus be said that the existence of externalities and the failing of the market to adequately deal with them has serious implications for the achievement of true allocative efficiency within the economy. Whilst there are a number of possible approaches to correcting the problems caused by externalities , each of the suggested solutions entails its own problems which must be overcome before society will have an effective means of dealings with the problems caused by externalities.