When externalities exist,
market prices will not lead to an efficient allocation of resources because of
the divergence between private costs and social costs and/or private benefits
and social benefits. To achieve economic efficiency in the presence of
externalities, there is a need for collective action. This is a “legitimate”
reason for government to interfere in a market economy.
Collective action attempts to
equate the ratios of (societal) MU/MC for all goods and services. One method of
regulation is by a per unit tax imposed on firms which do not account for
external costs in their decisions. Such a tax would add to each producer’s
profit maximising price. Conversely, a subsidypaid to producers who generate
external benefits by their decisions would have the effect of lowering each
producer’s marginal cost. These taxes and subsidies simply shift the supply
curve to the left or right. If the correct amount of tax or subsidy is chosen,
this shift will result in a quantity sold and a price reflective of the full
cost and benefit to society.
Another solution involves the
clear identification and enforcement of property rights. In cases where it is
possible to identify the specific individual (or individuals) harmed by a
negative externality, that individual can sue the firm producing the externality
for damages. Alternately, the firm, knowing it could be sued, could offer
financial incentives to the property owner to allow the use of their property.
Coase’s Theorem shows that mutually beneficial trade can occur in cases where a
negative externality exists, where the bearer of the cost pays the firm causing
the cost not to do so. There is some economically efficient point where the
marginal ratios are equal, and this point can be arrived at through
negotiation.
However, property rights are
not easy to identify or enforce. Example: Air pollution. Even if you passed a
law that granted property rights to each individual to the air above their
property, the costs of getting all these individuals together with an air
polluter to negotiate a deal would be prohibitive.
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