1.

0 INTRODUCTION

Private markets offer an efficient way to put buyers and sellers together and determine what
goods are produced, how they are produced, and who gets them. The principle that voluntary
exchange benefits both buyers and sellers is a fundamental building block of the economic
way of thinking.

An externality, sometimes called a spill over, arises whenever the actions of one economic
agent (such as an exchange between a buyer and seller) make another economic agent (or
third party who is not part of the exchange) worse or better off, yet the first agent neither
bears the costs nor receives the benefits of doing so. Externalities can be positive or negative.

Positive externality exists when a firm's production or an individual’s consumption increases

the well-being of others but the firm or individual is not compensated by those others.
Positive production externalities will lead to under production while Positive consumption
externalities will lead to under consumption.

Negative externality exists when a firm's production or an individual’s consumption reduces

the well-being of others who are not compensated by the firm or individual. Negative
production externalities will lead to over production while Negative consumption
externalities will lead to over consumption.

2.0 POLLUTION AS A NEGATIVE EXTERNALITY

Pollution is a negative externality. The problem of pollution arises for every economy in the
world, whether high-income or low-income, and whether market-oriented or command-
oriented. Every country needs to strike some balance between production and environmental
quality. Economists illustrate the social costs of production with a demand and supply
diagram. The social costs include the private costs of production incurred by the company
and the external costs of pollution that are passed on to society. The external costs might
occur because of injuries to human health, impact on property values, destruction of wildlife
habitat, reduction of recreation possibilities, or because of other negative impacts. Because
externalities represent a case where markets no longer consider all social costs but only some
of them, economists commonly refer to externalities as an example of market failure.

Market failure is when the market does not allocate resources on its own efficiently in a way
that balances social costs and benefits. When there is market failure, the private market fails
to achieve efficient output because either firms do not account for all costs incurred in the
production of output and/or consumers do not account for all benefits obtained, in the case of
a positive externality.

In the case of pollution, at the market output, social costs of production exceed social benefits
to consumers, and the market produces too much of the product. If firms are required to pay
the social costs of pollution, they create less pollution but produce less of the product and
charge a higher price.

3.0 MEASURES TO DEAL WITH POLLUTION AS AN EXTERNALITY

The key to dealing with pollution as an externality is to internalize external costs and benefits
to ensure that those who create the externalities include them when making decisions.
Internalizing the externality is achieved when either private negotiations or government
action lead the price to the party to fully reflect the external costs or benefits of that party's
actions. This can be done through taxes, property rights, tolls, and government subsidies.

3.1 Private-Sector Solutions to Negative Externalities: Coase Theorem

Private actors will sometimes effectively address externalities and reach efficient outcomes
without government intervention. Private solutions to externalities include moral codes,
charities, and business mergers or contracts in the self interest of relevant parties. The Coase
theorem states that when transaction cost are low, two parties will be able to bargain and
reach an efficient outcome in the presence of an externality. In practice, private parties often
fail to resolve the problem of externalities on their own.

(a) Moral codes: Moral codes guide individuals’ behaviour. Individuals know that certain
actions are simply not “the right thing to do” or would elicit disapproving reactions from
others. This is illustrated in the case of littering. The likelihood of being fined may be small,
but moral codes provide an incentive to refrain from littering.

(b) Charities: Charities channel donations from private individuals towards fighting to limit
behaviours that result in negative externalities or promoting behaviours that generate positive
externalities. The former can be seen in the case of organizations that protect the
environment, while the latter is exemplified through organizations that raise money for
education.
(c) Business mergers or contracts in the self interest of relevant parties: Two businesses
that offer positive externalities to each other can merge or enter into a contract that makes
both parties better off.

The Coase Theorem, which was developed by Ronald Coase, posits that two parties will be
able to bargain with each other to reach an agreement that efficiently addresses externalities.
However, the theorem notes several conditions in order for such a solution to occur, including
low transaction costs (the costs the parties incur by negotiating and coming to agreement) and
well-defined property rights. If the conditions are met, the bargaining parties are expected to
reach an agreement where everyone is better off. In practice, transaction costs are rarely low
enough to allow for efficient bargaining and hence the theorem is almost always inapplicable
to economic reality.

Ronald Coase's insight that externalities can sometimes be internalized was however useful
as it provides the competitive market model with a defense against the onslaught of market
failures. It is also an excellent reason to suspect that the market may be able to internalize
some small-scale, localized externalities. Although it would not help with large-scale, global
externalities, where only a “government" can successfully aggregate the interests of all
individuals suffering from externality

3.2 Public Sector Remedies for Externalities

The government can respond to externalities in two ways. The government can use
command-and-control policies to regulate behaviour directly. Alternatively, it can implement
market-based policies such as taxes and subsidies to incentivize private decision makers to
change their own behaviour.

(a) Tax

Government can play a role in reducing negative externalities by taxing goods when their
production generates spillover costs. The idea of a tax, for example, petrol tax, is to make
consumers and producers pay the full social cost of producing pollution. This is known as
“making the polluter pay”. This taxation effectively increases the cost of producing such
goods. The higher cost, then, better reflects the true cost of production because it includes the
spillover costs of, say, pollution. So, such taxation attempts to make the producer pay for
the full cost of production. This tax internalizes the externality and removes the inefficiency
of the negative externality.
As the figure above demonstrates, a tax shifts the marginal private cost curve up. In response,
producers change the output to the socially-optimum level.

The advantage of this taxation scheme is that the government raises substantial revenue,
which could be used to finance other pollution reduction schemes (e.g. subsidising
alternatives). It provides a market incentive for firms to offer more efficient engines, which
cause less pollution. Increased petrol tax has created an incentive for firms and consumers to
switch to less fuel intensive engines.

One drawback of tax is that demand may be quite inelastic and that an increase in petrol tax
may do little to reduce demand and only marginally reduce the amount of pollution. Though
in the long term, demand may become more elastic as people switch to other forms of
transport over time. Another potential problem is that it can be difficult to implement green
taxes due to administration costs or it is difficult to know how much to tax so that private cost
will exactly equate with the social cost.

In practical terms (non-economic issue), the difficulty is often political resistance – people
never like paying new taxes, even if there is a long-term goal of reducing pollution. Similarly,
If pollution taxes are raised in one country, producers may shift to countries with lower taxes
which will not effectively reduce global pollution but create problems such as
unemployment.
(b) Subsidies

An alternative to taxing activities that create negative externalities is to subsidise activities

that lead to positive externalities. This reduces the costs of production for suppliers and
encourages a higher output. As such firms and consumers will be more willing to switch. For
example, solar power is an alternative to burning coal. A government subsidy can make solar
power competitive and encourage its development. The subsidy is justified because the
development of solar power has a significant positive externality. Similarly, the government
may subsidise state healthcare; public transport or investment in new technology for schools
and colleges to help spread knowledge and understanding.

The problem of subsidies is that there is always a danger government subsidies could be
misused. Firms may take the subsidy but keep the money for extra profit rather than for
developing the alternative energy source. The government may lack the proper information
on what types of energy or firms to subsidise. This may lead to public money being wasted,
with little reduction in pollution.

(c) Regulation

The government can intervene in a market by creating regulations and laws for limiting the
amount of pollution in the air. They can come in the form of government-imposed standards,
targets, process requirements, or outright bans. Such measures make certain behaviours either
required or forbidden with the goal of addressing the externality. For example, the
government may make it illegal for a company to dump certain chemicals in a river. By doing
so, the government hopes to protect the environment or other companies or individuals that
use the river that would otherwise suffer a negative impact.

The advantage of regulation is that they create clearly defined goals and can make sure that
pollution levels are actually reduced rather than relying on market-based incentives, which
may or may not work. Regulations also act as a spur for business innovation e.g. to cut the
level of carbon emissions and may be more effective if demand is unresponsive to price
changes.

The main drawback of regulation is that they can be difficult to enforce, for example, having
regulations on air pollution levels, does not say how that will be achieved. You may still need
taxes or directives to make sure air pollution levels are reduced. Similarly, the cost of
meeting regulations can discourage small businesses and lower competition in markets