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Negative externalities

A negative externality is a cost that is suffered by a third party as a

result of an economic transaction. In a transaction, the producer and
consumer are the first and second parties, and third parties include any
individual, organization, property owner, or resource that is indirectly
affected. Externalities are also referred to as spill over effects, and a
negative externality is also referred to as an external cost.

Some externalities, like waste, arise from consumption while other

externalities, like carbon emissions from factories, arise from

Market-based solutions try to manipulate market forces to
reduce the externality, by exploiting the price mechanism. One
such market-based solution is to extend property rights so that
third parties can negotiate with those individuals or
organizations that cause the externality. British economist and
Nobel Prize winner, Ronald Coase argued that the establishment
of property rights would provide an efficient solution to the
problem of externalities. As long as one party can establish a
property right, there will be a bargaining process leading to an
agreement in which externalities are taken into account.
If property rights cannot be established, such as with the air, sea, or
roads, then the only two options are:
We learn to live with externalities, or:
Government intervenes on our behalf through taxes or direct controls
and regulations, such as:
Taxing polluters, such as carbon taxes, or taxes on plastic bags.
Subsidizing households or firms to be non-polluters, such as giving
grants for home insulation improvements.
Selling permits to pollute, which may become traded by the polluters.
Forcing polluters to pay compensation to those who suffer, such as
making noise polluting airports pay for double-glazing.
Road pricing schemes, such as the Electronic Road Pricing
(ERP) system in Singapore, which is a pay-as-you-go, card-
based, road-pricing scheme.
Providing more information to consumers and producers, such
as requiring that tickets to travel on polluting forms of transport,
especially air travel, should contain information on how much
CO2 pollution will be created from each journey.
The adoption of policies emerging from research
by behavioural economists - often shortened to 'nudge' theory.
This type of approach looks at influencing choices individuals
make by nudging them towards more effective decison making.
In 1920, Arthur C. Pigou wrote The Economics of Welfare which is an early
exposition of this concept of externalities.
Pigou noted that private business pursued their own
marginal private interests. However, industrialists were
not concerned with any external costs to others in
society. In other words, they had no incentive to
internalize the full social costs of their actions, and this
led to a deadweight welfare loss.
“In general industrialists are interested, not in the social,
but only in the private, net product of their operations.
They (externalities) are rendered, again, when the owner
of a site in a residential quarter of a city builds a factory
there and so destroys a great part of the amenities of the
neighboring sites; or, in a less degree, when he uses his
site in such a way as to spoil the lighting of the houses
opposite …”
Pigou used an example of a contractor building a factory
in the middle of a neighborhood. The factory leads to
external costs faced by those living in the locality. These
external costs includes: Pollution, Congestion, Damage to
health, Loss of light
Pigou’s solution as seen by Coase Coase’s solution
The essence of the problem of externality:
One person A in the course of rendering services The problem is reciprocal in nature: An
to B incidentally renders services or disservices externality issue is actually about the use of a
also to C. Hence, there is only one direction of the resource – the party that uses the resource always
effect – from A to C. harms the other party.
The solution to the problem of externality:
The government (the central planner) should The government (the central planner) should
intervene directly through centralized define and allocate entitlements and then, if
instruments: reallocation is beneficial, net of associated costs,

– Quantity regulation (bans) – Either the market will operate through Coasean
– Monetary tools (taxes or subsidies) – Or a firm (or another entity, e.g. an association)
will internalize the externality.

Pigovian solutions Coasean market solutions (Coasean bargaining)

Main feature: aimed at establishing centralized Main feature: aimed at defining property rights
rules and monetary (fiscal) instruments (e.g. that should be (re)allocated by the market by
taxes and fees) means of Coasean bargaining
1.The solution to the externality problem is 1.The solution to the externality problem is
defined by the central body. defined by decentralized agents
2.Who should provide compensation and who 2.Who should provide compensation and who
should be compensated are defined in advance – should be compensated are defined by Coasean
before the specific problem has emerged? bargaining in the course of the negotiations.
3.The parties concerned cannot choose between 3.The parties concerned can choose between
alternative uses of re sources alternative uses of resources
4.There is no competition between agents and 4.There is a direct and indispensable connection
alternative uses of resources between benefits and responsibilities due to
5.The connection between benefits and private entitlements
responsibilities exists only as defined by rules
and regulations.
The Pigovian theory/solution has some limitations.

First, the Pigou theory presupposes there is a function of the

existence of the so-called social welfare, and the government is
the natural representative of public interest, and the government
can perceive the public interest and then choose the right policy
to reduce the externalities in economic activity through
intervention. However, the fact is that public policy itself maybe
Second, the use of Pigovian solution is based on the premise that
the government knows the cause of externalities can calculate
all marginal costs or benefits, however it is impossible for any
government to obtain all information to make a Pareto optimal
allocation of resources. In theory, Pigouvian solution is perfect,
but the actual implementation maybe largely constrained.
Third, government intervention also makes
costs. If the cost of Government intervention
is more than the losses caused by
externalities, then there is no reason for use
to use government intervention .
Fourth, the Pigovian solution may cause the
rent-seeking activities, which will lead to
waste of resources and distortions of
resource allocation.
On the other hand, the Coasian solution is also
The first problem is that in order to make the
Coasian solution work, the market should be
developed, however, for many developing
countries, the whole economy system is still in
transforming, I don’t think Coasian solution
can work very well without a certain
protection level toward property right.
Second, the costs of voluntary negotiation
transaction need to be considered. The feasibility
of voluntary consultation is depending on the size
of transaction costs. If the transaction costs are
higher than the social benefits, then why should
we have such negotiation.
Third, the voluntary negotiation is based on the
premise that property rights are clearly defined.
In fact, some property rights of environmental
resources such as property rights are often
difficult to define or very costly to define.