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Theory

Many economic activities generate costs or benefits for third parties that are not part of the transaction. These effects are known as externalities. Externalities can be corrected with taxes or subsidies so that their effect is accounted for in transactions 1.

Externalities

Externalities are costs or benefits of an activity that fall to parties not involved in a transaction 2. Some examples commonly given of external costs include pollution, email spam 3, systemic financial risk 4, health problems from unhealthy food 5, and secondhand smoke 6.

Some given examples of positive externalities include research and development, pollination from beekeeping 7, open source software 8, job safety training 9, historic preservation 10, and vaccination 11.

See also our analysis of externalities in environmental policy and proposals to address them.

Property Rights

Externalities often arise from poorly defined property rights, such as the lack of clear delineation of water rights leading to overusage of water 12. By the Coase theorem, if property rights are fully defined and transaction costs are zero, then private parties should be able to find an efficient solution for externalities 13.

Transaction costs cannot always be made sufficiently low for the Coase theorem to apply, nor is defining property rights always sensible when considering common resources such as the atmosphere and oceans. Such a situation is called a Tragedy of the Commons 14. Internalizing of externalities is often a solution in this case.

Regulation

Regulation is an alternative to privatization and pricing, as has been used successfully to reduce emissions of ozone-depleting substances via the Montreal Protocol, to address air pollution, and many other areas.

Regulation can be an imprecise tool with significant drawbacks, however. Zoning regulations exist to address a range of externalities of urban development 15. However, such rules are often arbitrary or crafted for narrow interests, and appropriate pricing may better serve the intended goal than regulation. An example is congestion pricing as opposed to density limits to manage traffic.

In some instances, such as the English grazing lands that were the subject of Hardin's 1968 essay, individuals can develop systems to self-regulate common resources 16.

References

  1. Baumol, W. J. "On Taxation and the Control of Externalities". The American Economic Review 62(3), pp. 307-322. June 1972. ↩

  2. Helbling, T. "Externalities: Prices Do Not Capture All Costs". Finance & Development, International Monetary Fund. February 2020. ↩

  3. Rao, J. M., Reiley, D. H. "The Economics of Spam". Journal of Economic Perspectives 26(3), pp. 87-110. Summer 2012. ↩

  4. Korinek, A. "System Risk-Taking: Amplification Effects, Externalities, and Regulatory Responses". European Central Bank, Working Paper Series, No. 1345. June 2011. ↩

  5. Institute of Medicine and National Research Council. Exploring Health and Environmental Costs of Food: Workshop Summary. Washington, DC: The National Academies Press. 2012. ↩

  6. Mason, J., Wheeler, W., Brown, M. J. "The Economic Burden of Exposure to Secondhand Smoke for Child and Adult Never Smokers Residing in U.S. Public Housing". Public Health Reports 130(3), pp. 230-244. May-June 2015. ↩

  7. Vanyi Arvane G., Csapo Z., Karpati L. "Positiv [sic.] externality of honey production". 120th Seminar, September 2-4, 2010, Chania, Crete 109313, European Association of Agricultural Economists. 2010. ↩

  8. Cheng, H. K., Tang, Q. C., Liu, Y. "The Impact of Network Externalities on the Competition Between Open Source and Proprietary Software". Journal of Management Information Systems 27(4), pp. 201-230. April 2011. ↩

  9. Ramos, D., Arezes, P., Afonso, P. "Application of the Delphi Method for the inclusion of externalities in occupational safety and health analysis". Dyna 83(196), pp. 14-20. April 2016. ↩

  10. Romero, A. M. "The Positive Externalities of Historic District Designation". The Park Place Economist 12. 2004. ↩

  11. Hinman, A. R. "Economic aspects of vaccines and immunizations". Comptes Rendus de l'Académie des Sciences - Series III - Sciences de la Vie 322(11), pp. 989-994. November 1999. ↩

  12. Demsetz, H. "Toward a Theory of Property Rights". Classic Papers in Natural Resource Economics 52(2), pp. 424-479. June 2014. ↩

  13. Coase, R. H. "The Problem of Social Cost". The Journal of Law and Economics 3, pp. 87-137. October 1960. ↩

  14. Hardin, G. "The Tragedy of the Commons". Science 162(3859), pp. 1243-1248. December 1968. ↩

  15. Lehavi, A. "Zoning and Market Externalities". Fordham Urban Law Journal 44(2): 4. 2017. ↩

  16. Fairlie, S. "A Short History of Enclosure in Britain". The Land 7. Summer 2009. ↩