Principles for Private and Public Internalisation

of Externalities. A Synoptic View

n

Tatiana Moºteanu
The Bucharest Academy of Economic Studies
tatiana_mosteanu@yahoo.com
Mihaela Iacob
The Bucharest Academy of Economic Studies
miuiacob@yahoo.com

Abstract. Externalities represent a market failure situation and they ap-

pear when one person´s activities influence other person´s welfare in a way
that is outside the market mechanism. In contrast to the effects transmitted by
market prices, externalities negatively affect the economic efficiency. They arise
in everyday life and are noticed only if the effects are obvious. Ronald Coase´s
approach started from the premises that externalities can be internalized. His
model provides private sector means to defend against market failure. Coase´s
solution to internalize externalities based on negotiation between the involved

Principles for Private and Public Internalisation of Externalities. A Synoptic View

parties, given the property rights, has influenced the free market approach of
market failures and today many economists consider that governments should
work with the market and not against it using taxes and regulations. In the
mainstream literature it is said that if for small local externalities the private
sector can find solutions to solve problems, big scale externalities, such as
global warming, need government intervention. As far as the last ones are
concerned, we can talk about: a) the Pigouvian tax, which is a tax levied on
polluting activities; b) the Pigouvian subsidy, given to those who suffer from
negative externalities; c) the subsidy paid to individuals or firms to conduct
activities with positive externalities; d) legal regulations, such as limits for
emitting polluters and restrictions regarding the time of day or year when nega-
tive externalities can be legally produced.

Keywords: market failure; externalities; Coasean Theorem; Pigouvian tax;

Pigouvian subsidy.

n
JEL Codes: H23.
REL Codes: 7D.

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Theoretical and Applied Economics

1. The nature and characteristics is the one in which the public authority
of externalities grants the universal allowance to delimit
through homesteading of previously
Externalities appear every time a unowned “public” resources to good faith
person´s action influences another person, first users (the universalization of
in a negative or positive way, without the privatization principle) (Rothbard, 1982,
first person to bear a cost or to receive a pp. 55-99).
benefit from the undertaken action If a river has no owner, there is no
(Moºteanu, Iacob, 2007, p. 13). So, the fact market for it and everybody would use it
that some persons´ actions influence other´s without payment.
welfare does not generally generate market But if this resource would have an
failure, as long as the effects are transmitted owner, the price would reflect its value in
through price. alternative use, so it would be efficiently
Negative externalities cause market used. If the person that fishes in the river
goods overproduction, while positive would own it, the one who has the factory
externalities lead to an underproduction of should pay her a tax for polluting, that
goods, in both cases being induced different expresses the damage done, taking into
types of damages. account these changes in her production
If a person has a factory that dumps its decisions, and therefore not wasting the
garbage in a river without an owner and water. But if the one who has the factory
another one makes her living fishing in that were the owner, he should ask a tax for the
river, then the first person´s activities privilege to fish in the river, tax that
negatively influence the second person in depends on the pollution level. Hence, the
a way that is not caught in a price change, factory´s owner would have an incentive
therefore the damage done is not included not to excessively pollute the river, because
in market decisions. For the first person, the it will trigger a smaller tax.
clean water is an input. But the clean water Externalities have the following
is also a scarce resource that could enter in characteristics (Rosen, 2008, pp. 72, 73):
alternative use, like fishing. The efficiency n Externalities can be generated by
principle (Rosen, 2008, p. 72) states that both consumers and producers. Not all
for the water the first person should pay a externalities are generated by companies.
price that reflects its value as a scarce If a person smokes in a crowded space, she
resource which can be used for other will diminish the welfare of the people
activities. But there isn’t any price paid and breathing the polluted air. Smoking has also
the water is inefficiently used. other negative effects, both physical and
Externalities are the result of the financial, such as labour productivity
incapacity to set property rights, therefore decrease, the risk of generating fire, but, in
there are some opinions holding that the some degree, we can talk about a few positive
most proper solution to externality problem effects that smokers have on non-smokers.

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There is an interesting approach of person nor people around it take into
externalities (Gruber, 2005, pp. 160-161) account such external effects which
represented by the (cynical) positive measure the costs and benefits of this kind
externalities for tax payers, generated by of activity, in the absence of government
smokers´ premature death. Smokers pay intervention.
taxes for social security programs, but don’t n Public goods can be referred as a
live long enough to benefit from them, particular type of externality. When a
leaving more money in the government person generates a positive externality, with
budget that can be used for the non- effects for everyone in the economy, the
smokers. externality is a pure public good. Most of
n Externalities are reciprocal. If we the time, the distinction between public
return to the previous example, the one with goods and externalities isn’t very clear. For
the river and the two persons managing their example, if a person installs in his garden a
activities based on it, the individual device for electrocuting flies, it is
dumping garbage in the river is instinctively considered that a pure public good has been
considered the polluter. But the other person created if it had killed the flies from his
can also be considered as polluting the river whole community. In case only a fraction
with fishermen, increasing the social cost of the neighbours has been affected, then
of the factory´s owner. From the social point an externality has been generated.
of view, as alternative to fishing, using the Taxonomically speaking, the most

Principles for Private and Public Internalisation of Externalities. A Synoptic View

river for dumping garbage is not necessarily popular way of classifying externalities is
more damaging, everything depending on between negative (external costs) and
the costs of alternatives for each of the two positive (internal costs) ones.
activities. On another account, using as the main
n Externalities can be positive. elements producers and consumers, there
Vaccinating against smallpox is an example can be identified four possible combinations
of positive externality. In the process of of externalities (Moºteanu, 2005, p. 21):
vaccinating there are some costs, such as from consumer to consumer, from producer
the vaccine price, discomfort and small risk to producer, from consumer to producer
of inducing a disease. In case of a biological and from producer to consumer.
terrorist attack, the vaccinated persons Externalities from consumer to consumer
would benefit, meaning that their are known a pure consumption externalities,
probability to get sick would be very low. those from producer to producer as pure
On the other hand, from a person´s production externalities, those from
vaccination, other members of the consumer to producer mixed consumption
community will benefit, meaning there is a externalities and the externalities from
small chance they will get the disease from producer to consumer are known as mixed
that person. Yet neither the vaccinated production externalities.

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Theoretical and Applied Economics

Another way of classifying externalities smoking, alcohol consumption, drug

is based on the scale criterion. In this consumption. There are also worldwide
respect, there are externalities of small externalities, the most relevant example
dimension and produced at local level. In being global warming.
this category, there is, for example, the In the table below there are syntheti-
impact loud music on a roommate, cally displayed some types of externalities.

Table 1
Example of different types of externalities
Types of externality External costs External benefits
Pure production externalities Acid rain pollution discharged by a A farmer benefiting from drainage
(generated and received in power station which harms a nearby undertaken by a neighbouring farmer
production) commercially run forest
Mixed production externalities Dust polluting discharged by a Commercially owned bees pollinating
(generated in production but received brickwork, breathed by asthmatic fruit trees in neighbouring gardens
in consumption) children living nearby
Pure consumption externalities Noisy music at a party disturbing Households benefiting from the beauty of
(generated and received in neighbouring households neighbouring gardens
consumption)
Mixed consumption externalities Congestion caused by private Commercial bees keepers benefiting
(generated in consumption but motorists increasing firms´ transport from private gardens of nearby houses
received in production) and delivery costs
Source: Powell, Ray, Advanced Economics, Raithby, Lawrence&Co.Ltd, Leicester, p. 152.

2. Internalising externalities creating externality and the party affected

by it determine reaching social equilibrium.
Internalising externalities requires Because parties’ negotiations end with
actions where private negotiations or internalising externalities, it is revealed that
government intervention lead to a price that externalities don’t automatically generate a
reflects the total external costs and benefits market failure. The government intervenes
of a person’s decision. only to rigorously set property rights, the
rest of the problems being the private
2.1. Private solutions to internalising sector’s responsibility.
externalities The second part of the theorem states
a) In order to solve the problem with that the efficient solution doesn’t depend
externalities, Ronald Coase (1960) on which party receives the property rights,
suggested direct compensations to those as long as these are given to one party.
affected, in this respect releasing a theorem Coase used as example (Powell, p. 157)
that carries his name, consisting of two locomotives which used wood as fuel and
parts. generated fires on farmers’ fields. If farmers
The first part of Coase theorem states had “property rights to prevent crops’
that when property rights are adequately destruction”, they could sell those rights to
defined, negotiations between the party railways companies, as long as the price

38
paid was higher than the damage done. But externalities. For example (Rosen, 2008,
if the railway companies had the “property p. 81), children are taught that throwing
right to emit sparks” farmers could pay the garbage on the ground is an irresponsible
companies to reduce them, the companies and not nice gesture, inflicting costs for
accepting this deal only if the payment was other persons. Certain moral values make
higher than the foregone earnings. people coordinate each other and therefore
The Coase theorem makes two internalise externalities their behaviour
assumptions: the costs of negotiation might create.
(transaction costs) between parties are low
and the resources’ owners can identify the 2.2. Government’s solution to
source for the damage done to their property internalising externalities
and can legally prevent these damages. The a) A solution for internalising
theorem is relevant for situations where only externalities, given by the economist A.C.
a few parties are involved, externalities are Pigou, is to levy o tax on the polluter to
of a small scale, produced locally and their compensate for the fact that some inputs
sources are well defined. have prices too low. The Pigouvian tax
However, in some situations represents a tax levied on each unit the
negotiation is impossible or it could be production that generates externalities, until
done, at least in theory, with higher costs, the price paid by the consumer equals the
as is the case of air polluting, where millions social marginal cost of the production.

Principles for Private and Public Internalisation of Externalities. A Synoptic View

of people are affected. Moreover, even if Corrective taxes compensate for the
property rights for air could be set, it should fact that there isn’t a market for externalities.
be difficult for the owners to identify those It has to be noted that the purpose of
responsible for polluting the air and to what the corrective tax is to reduce the actions
extend each person is responsible for her generating externalities to an optimal level
share (Rothbard, 1982). and not to directly compensate those
b) Another way to internalise affected. This because if it was common
externalities is merger of the involved firms. knowledge that people affected by
In this situation each would take into externalities were to receive a certain sum
account the damage he could produce to of money, then more people would be
the other party and so, based on activities’ tempted to expose themselves to
coordination the profit of the new entity will externalities, in comparison with the
be greater than the sum of individual profits, situation where no compensation was given
when each would independently take (moral hazard).
decisions. A problem with this approach is that
c) Individuals can’t merge, but no incentives are given to search for ways
sometimes social conventions can be to reduce pollution, others besides reducing
considered an attempt to determine people production. Since taxation is levied on each
to take responsibility for their own unit of production, the company is not

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motivated to install a pollution reduction elimination of the negative externalities is

technology to reduce emission of pollutants impossible to achieve because it would
on each production unit, because this mean elimination of some goods vital for
wouldn’t diminish its total tax burden. To survival.
solve this problem, there can be levied a d) The traditional regulations can be
Pigouvian tax on each polluting emission improved by adding a flexibility element,
unit, called emission fee. For each emission such as negotiable emission rights, that
unit reduced, the company bears a cost, but, allow reaching a certain level of production
due to the emission tax, the total amount of and have as feature their transferability
money owed to the government diminishes between parties. Companies or countries
with every unit of pollution reduced. capable of reducing pollution more than the
Reducing pollution is done as long as tax law permits can sell the remaining emission
economy for each unit exceeds the cost of rights to those companies or countries
reducing pollution with another unit. which, for various reasons, can’t or don’t
b) An efficient level of production can want to reduce pollution below the
be obtained paying the polluter to reduce maximum limit. According to the Kyoto
his activity. Treaty(1), Romania, which was also the first
The subsidy is paid to the polluter for country to sign the protocol, can sell other
each unit of production he foregoes. states the right to emit greenhouse gases
Furthermore, subsidies can be money within the limit of the legal quota of 250
paid by government to individuals or firms mil tones of gases carbon dioxide equivalent
to take up activities with positive external less how much pollutes today.
effect. Subsidies for producers move the Choosing a type of instrument for
supply curve to the right, increasing both internalising externalities can be done
the quantity of the good and the positive according to the objective set by the
externality generated by its production. government, which can be reducing
Subsidies for consumers, paid directly to pollution and lower the costs with
consumers in order to spend them on a reducing pollution. As a relevant example,
certain good, move the demand curve to Poland and Sweden have used taxes for
the right. For example (Powell, p. 161), to polluting combined with regulation
encourage public transport, the government regarding waste water treatment, whose
gives subsidies for railway or municipal discharge in the Baltic Sea have generated
transport or can provide subsidised tickets considerable damage. Moreover, London
for passengers. uses a congestion charge, levied on
c) Regulations, as a means to reduce motorists who want to go through the
externalities, can take the form of limits for centre of London, for the purpose to avoid
pollutants emission or restrictions regarding road traffic, considering that for reducing
the time of day or year when negative environment pollution fuel taxes are more
externalities can be legally produced. Total appropriate.

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 Quantity approach of externalities 3. Conclusions
(Gruber, 2005, pp. 140-141) (regulations)
sets to reduce pollution as much as Externalities appear when a person´s
possible, regardless of the costs, being the activity influences another person, actions
best method to obtain a maximum benefit not included in the price mechanism. In
when the pollution effects are big both for general, externalities have their roots in the
the environment and for people’s health. absence of property rights.
In the case of the price approach (taxes Negative externalities cause market
and subsidies), costs with reducing pollution goods overproduction, while positive
will never exceed taxes, letting the externalities lead to an underproduction of
pollutions production to a level that is not goods, in both cases being induced different
optimal with respect to the pollution level. types of damages.
If marginal costs prove to be greater than If the government appoints property
expected, they will apply a smaller rights, its intervention being limited only to
reduction. this job, Coase believes that the involved
If an environment protection is desired, parties can negotiate to obtain an efficient
then it is best to choose the quantity output. This solution for internalising
approach and leave the price approach for externalities asks for inconsiderable
when the emphasis is on cost rather than negotiating costs, small scale externalities and
fighting pollution effects. exact identification of externalities’ source.

Principles for Private and Public Internalisation of Externalities. A Synoptic View

If theoretically the government In case market fails to solve the
corrective role for solving externalities externalities’ problem, government
defines itself by setting certain intervention intervention can be justified. The
measure, such as taxes, subsidies, government has two types of instruments
regulation, to lead to a private cost close to to intervene: the approach based on price
the social cost, in practice this internalising (taxes, subsidies) and the approached based
operation is not so simple due to difficulties on quantity (regulations), which it can
in measuring external costs. manage depending of its objectives.

Note

(1)
Forces the sighnig countries to reduce greenhouse between 2008-2010. EU engaged itself in a 8%
gases by at least 5% below the 1990 emissions, reduction.

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Theoretical and Applied Economics

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