Externalities is one of the most complex issues of economic analysis. Market, by itself cannot reach a price that includes all the economic sacrifices incurred by the production unit (firm). In the case of negative externalities (environmental damage) you could imagine the firm using "environmental units" that do not belong to it, but to society. The main problem of these EUs is that ENVIRONMENT may be considered a "common property good" where in most cases there are no specific, nor identified individual property rights. The main difficulty is how you include these 'sacrifices' in the production function of the firm, i.e. how you internalize these costs.

If there are only two parties in the situation, negotiation would/could lead to an equilibrium price by compensation. Compensation paid to the one who suffered the damage is included as a cost item. This situation is detailed in Coase's paper "The Problem of Social Cost". Although, the economic analysis in it is 'inconsistent' in my opinion.

In this same paper, Coase cites Pigou and his example of the railway and the damage caused by fire due to sparks from the engine. Is it possible for the railway to negotiate a compensation with more than one owner of property damaged by the fire? Yes, but undoubtedly the process will be long and tedious, "involving higher transaction costs", which are not considered by Neoclassical Theory.

Legal doctrine has been abundant in the analysis of all these cases, there are many examples in Coase's paper, and different rulings or decisions of similar cases by courts in the US and UK. Ultimately, institutions or the institutional environment will determine the 'quantum' of transaction costs and the damage to be compensated.

The case of environmental damage is an example of a negative externality, although you also have positive externalities by production units, e.g. carbon fixation by forests or the recreational value of rural land.

Some activities that have positive externalities over society are public education, public health, public security and public research.

Coase's paper or book "The firm, the market and the law" give an original analysis of these issues, although you might not share some conclusions or methods.

I hope this has been of some value to you and helps to further understand externalities.

So many. Externalities typically mean too little of something is being produced from a social welfare perspective. A concrete example: If the government did not intervene in health care, epidemics would be a far greater problem than they are today. Private incentives to immunize clearly are lower than the public incentive. It is true for defense, airline security, education, transportation safety...

Externalities are a form of market failure. For example, lack of prices for emissions of greenhouse gases to the atmosphere results in excessive levels of emissions and global warming. A carbon tax is an example of a policy designed to internalize the externality (global warming) associated with excessive greenhouse gas emissions. A carbon tax would increase the cost of using fossil fuels that emit high levels of greenhouse gases, such as coal. If a carbon tax is imposed on significant global sources of greenhouse gas emissions, which I think is unlikely, then those emissions would decrease. Such decreases would have the social benefit of reducing future global warming. A carbon tax would increase the cost of using fossil fuels that result in high levels of greenhouse gas emissions per Btu of energy. For example, a carbon tax would significantly increase the cost of generating electricity with coal and stimulate use of less polluting substitutes, such as natural gas, wind, and solar. Another policy option for reducing greenhouse gas emissions is tradable emission permits.

Good example Tony

Thank you Dr. Debra and Dr. Tony. Is there any economic activity that does not have externalities? If the arguments are true for carbon emissions, they are also true for any other economic activity as the resources we are dealing with have a finite supply and are linked with each other in a web relations.

Very good point Dr. Siba. It is the issue of the magnitude of the difference in social and private gain. What I usually say to my health economics class is that people are not lobbying in the capital over being priced out of the yacht market, or the Starbucks market. This is why the conversation of externalities is naturally linked to "public goods". When the goods in question are public goods, than the impact to society becomes more important.

Dear Dr. Debra and Dr. Tony,

With due agreement with the concerns related to the most direct effect of the externalities, let me put the problem of global worming in the following propositions.

Statement-1: Global worming is caused largely by carbon emissions.

Statement-2: Increased use of fossil fuel is the primary cause of carbon emissions

Statement-3: Use of fossil fuels have eased our lives by facilitating communication, transportation of goods and services, production of consumable items, increased employment due to increase in energy use and increase in GDP of most advance countries where fossil fuels have so far run the machines.

Statement-4: Use of fossil fuels in certain activities have had many societal benefits for people using fuels directly (by providing a cheap source of energy where the social costs remained unaccounted due to our inability to assess externalities) or indirectly by making the goods available at cheaper price where cost remained underestimated.

Statement-5: All such benefits are difficult to assess that have accrued to society for generations in the past and for generations to come in future as long as we keep on using fossil fuel as a source of energy. An example of positive externalities arising out of use of fossil fuel.

Statement-6: Excessive carbon emissions leading to global worming has possible deleterious impacts on the welfare of generations to come. An example of negative externalities. Again difficult to quantify in terms of problem of price fixation.

Statement-7: Assuming that an intervention is needed to control carbon emissions has many possible implications. Let us broadly classify these implications in two scenarios; (a) A carbon tax is successfully imposed, agreed by all and the emissions are controlled. (b) A carbon tax is unsuccessfully imposed leading to an increase in cost prices of consumer goods in the vicinity of those centres where it is successfully imposed and still no change in the global carbon emissions levels as most do not follow the norms.

Statement 8: In scenario (a) there will be a reduction in production leading to a loss in immediate social welfare caused by lowered consumption because of price rise. There will be an increase in inequality in the distribution of net change in welfare as the marginal sacrifice of the rich who still consume the goods at higher prices will be less than the marginal lost of poor who have to purchase the goods at higher prices. I mean, the welfare loss caused by del P for the rich will be lower than the same for the poor as poor have higher opportunity cost of money spent to compensate for the price rise. Leading to a net loss for the society.

Statement 9: In Scenario (b) world prices will not remain imbalanced for a longer period. With many region still not adhering to environmental norms, producers will move out from locations where carbon tax is strictly implemented leading to a scarcity, increased cost of production due to shifting, increased concentration of polluting units in non-confirming locations and a new equilibrium price at a higher level leading to a loss of the present generation and still no substantive effect on the environmental standards.

Just to highlight some plausible implications of efforts to reduce the effect of externalities. Comments on the flaws in the discussion are most welcome.

It is indeed complex when these tradeoffs are involved. ANd of course, they always are. As you state - cost benefit analysis could be used to decide - but measurement is always an issue. And of course, decisions are ultimately based on normative objectives and priorities. I don't think we can discuss whether to have a tax or not given the ultimate consequences of global warming are devastating and outweigh any positive externalities associated with the comfort provided by carbon emissions. The question would have to be "what is the optimal tax rate" and what policy would most efficiently and equitably implement it?

This obviously involves research by experts - and measures of benefits and costs must be devised - even if imperfect. Robustness can come from sensitivity analysis.

I do not have any problem with taxes (even if it reduces welfare for some) if at all it is a possible solution. Unfortunately, having a global taxation would require a mammoth governance structure and monitoring mechanism at the global level. Of course institutions like IPCC, UNEP etc can be used as such governance mechanism. But going by the experiences we have had reg. failure of these institutions to even manage a global solidarity over the concerns. Remember, Stern Report had been officially mentioned by some representatives of the North as unduly alarming. I mean @ Dr. Tony was probably right when he mentioned a tax tool for significant sources of emission as "Unlikely". The problem probably lies in the nature of the commodity (fossil fuel) we are discussing. Its a significant source of energy and unless we have viable alternatives, any tax would result only in a rise in prices and without any significant reduction in consumption.

One thing that can be done is to use the revenues generated from carbon taxes to subsidize the development of energy sources that produce lower emissions of greenhouse gases, such as renewable energy sources. Keep in mind that many other externalities occur besides those associated with the burning of fossil fuels.

Economies around the world nowadays are very interconnected. Actions in a given country often have consequences in several other countries.

This has positive and negative points.

Primary socio- economic goal of any country is to improve the quality of life of people and also address to national challenges which affects its economy. Finding answers to substitute of fossil fuels,addressing to environment issues and creating employment opportunities are very important activities.Innovations should be seen as changes in thinking,products,processes and even organisations which have to deliver.

Dear Sukla Sir, you are very right and we are actually caught up in the trade off between quality of life of the present generation and a quality of life of the future ones. As you rightly mentioned, innovations should be seen as changes in thinking, products, processes and institutions. In case of fossil fuels, we are so much into it as our life line, that it also require a huge renovation of our life that may eat up our life time savings. Its not just about changing your existing car with a new one, but also for an expensive car at the moment without having a clear record of brand credentials. For example, a decade and half ago when I was a student, a certain brand of motor cycles called 'yo' bikes was introduced in the market and there was quite a lot of curiosity about the bike. Unfortunately, it did not click the market as it could not meet the increased non-energy efficiency expectations of the consumer class. You may agree with me that the largest selling machineries in the market are not the the ones that show energy efficiency. I believe that when we are dealing with such an issue like climate change, we can not expect a change in attitude to come up voluntarily, and not through price mechanism. I know, the users of green technology are increasing in number, but as a group, human being are also increasing in number at a much faster scale resulting in an absolute increase in the number of people using emitting technologies. Clearly, I do not have an answer than a radical ban of polluting technologies if we are in a hurry. If not, then time will take its course.

I agree to some of your points, Dr.Mohanty. Innovation triggers entrepreneurship activities bringing benefits to the people and society. Innovation also includes a new way of doing things. TQM, six sigma,quality circle,quality philosophy preached by Deming and Juran have proved to be very powerful tool for achieving excellence in quality. Concepts of rapid prototyping and concurrent engineering have revolutionised manufacturing technology.

@ Sukla Sir! Very true sir.

Only Pareto-relevant externaliites (defined as ones for which the benefit of correcting them exceeds the cost) are worthy of policy concern. Many economists seem to find externalities (and other "market failures") on every street corner.

The very concepts of externalities and market failure are incoherent. These issues should be approached by thinking of transactions costs. Your externality arises purely from transactions costs.. What does market failure mean?

Agreed Richard. What does market failure mean?

Market failure is the inability of the invisible hand to work to bring about an allocatively efficient outcome. What the people want... Imposing taxes and calling them transactions costs still means government intervention because the market fails to bring about what the people want. This is often the case when there are costs from either producing, or consuming, that are not captured accurately in the rationing mechanism - which is price.

Richard, transaction costs is one aspect, another one (which may be more important in transboundary pollution) is "property rights". If the property rights are not well-defined, market transactions tend to be difficult or impossible

Because we are talking about public goods and trying to come up with the right price is not only impossible, it is not necessarily the best rationing mechanism.

Debra, what do you favor?

I believe, even an attempt to arrive at a right price is not only a futile exercise, any effort to control socially harmful activities through a price mechanism would be grossly ineffective. I am in favour of an out and out ban of such activities or a quantity control through licensing if such banning is not readily possible.

Michael, Regulations that restrict abuse of the environment - much like what Siba is proposing. perhaps not a ban, but oversight, restrictions... I am not an environmental scientist - so I am not familiar with the literature on effective controls. A committee of experts would need to review literature and set policy.

Hi Shiba,

Market failure means that at best that some market could be more efficient that it is or could be created so it presupposes some more efficient mechanism, a mechanism to lower transactions costs, by a govt action, etc. Without specifying the supposed solution it means nothing. Often as Ronald Coase noted to me it usually is a call for some vague gvt action, sound and fury with a speculative tale.

R Zerbe, The Daniel J. Evans Distinguished Professor,

University of Washington

Market failure does exist - and as Richard said - it requires some intervention because the invisible hand alone is not bringing us where we need to be. It could be through adjusting the price that we use to ration, or it might be more than that. We are talking general economics here. If you want a solution to the global warming problem, which many still deny (despite facts), more analysis is required. Causes, consequences, cures. Alternative policies can only be devised once goals are set.

There is a huge difference between 'a market failure' and 'the failure of government interference in the market' to bring about some supposedly preferred outcome.

To some high prices are a means to reduce demand, allocate scarce resources, increase supply and increase the search for substitutes and alternatives.

For some high prices are somehow an example of market failure because high prices by definition ration demand, which may not be a socially desirable outcome, such as the availability of affordable housing to working families. The problem is that the latter has nothing to do with supply and demand or even basic economics. It is a social construct.

Where is the market failure in the following life-cycle:

Physical Reality > Economic Consequences > Social Reaction > Political Response > New Reality > Unintended Consequences > Feedback Loops > Etcetera?

The flipside to demand is the ability to pay. When applied to affordable housing, as it turns out there is more demand for single family, detached houses with yards, that are close to schools, hospitals, shops and access to public transport, as well as being within a reasonable commuting distance to high paying jobs in clean, non-polluting, sustainable industries than supply.

The problem is not demand, but supply and price, as well as expectations. And, as we all know, the first tenant of economics is the assumption that supply is finite, while potential demand is unlimited.

Some see $4 gasoline as a market failure that demands a political solution, while others see $4 gasoline as a step in the right direction to move to a lower carbon future. But we should never confuse the social reaction to the economic consequences of a physical reality to be a market failure.

A high price is not a market failure. Nobody is suggesting that. Failure of price to bring about what society wants - is a market failure. The issue is - what does society want? And does it matter? Imagine a world where there was no public education. It exists in some parts of the world. What is the consequence? Too little being produced? Maybe. Depends on what society wants - and that is normative. I, for one, would like to see the income inequality gap closed a bit in the US. I, for one, would be appalled by rationing education based on ability - or even willingness of parents - to pay. And in health care, if it does not produce profit, it won't be produced. Despite the loss in national population health or national well being. I recently read about a carbon particle therapy treatment of brain tumors and other cancers that has evidence based success - but it does not exist in the US. Europe is way ahead of us. Probably not profitable. Who would have incentives to invest in such a treatment if there is no profit to be made? What society does not know, won't harm their well-being - I guess. Ken Arrow might beg to differ.

None of those examples are market failures. They are to a certain extent desirable social outcomes where the demand for a public good outweighs the ability or willingness to pay.

Education and healthcare are not free. They cost money to deliver. Someone has to pay. Either the individual, the government, the taxpayer, the insurance company, or some combination of payers and recipients. If society wants something then it is up to society to pay for it.

The fact that Europe and the United States have chosen different public/private healthcare, and how they and their citizens choose to pay for those competing models, is not a market failure. It is a public policy choice based on perceptions of the value of collective actions versus the notion of private costs.

The Europeans may have found a better model by using public and private healthcare models to bring about competition, choice and cost control, while achieving better overall outcomes and making sure everyone, one way or another, has healthcare coverage. Whereas if you do have private healthcare in the USA you can be assured of world class care. Here the problem is access, affordability and losing one's healthcare coverage due to job loss for example.

If society wants a free lunch and does not want to pay for education, healthcare, a clean environment or whatever then that is not a market failure. That private companies do not want to invest their shareholder's money in unprofitable drugs or cures is also not a market failure. That is the role of publicly funded universities, governments and research institutes paid for by taxpayers.

I am not sure which countries you are referring to when you say in some parts of the world their is no public education because I cannot think of any? Not enough classrooms? Not enough teachers? No universal access for school girls? Yes, but again, that is not due to a market failure.

Those countries are the countries where government interference in the market is the greatest, so that the market cannot function properly due to government bureaucracy, incompetence and corruption, or what I call BIC Syndrome in emerging markets and less-developed countries.

Of course society has to pay if you want more than the market can provide. I am not sure of the point. And I just gave an example of how we do NOT have the gold standard in medicine because it requires a social commitment to paying for it. As we do in education. I don't believe I ever said these things are free. I believe I said the contrary. I agree with you - it's normative. I don't make the assumption society is not willing to pay for these things. Voters are not provided with sufficient information to know whether they are willing to pay or not. Information failures lead to market failures. I don't think private companies should want to pay for unprofitable drugs or treatments. I think private markets cannot provide unprofitable treatment. Therefore I would say that the market for carbon particle therapy to treat cancer fails. Too many priced out of the market. In fact - everyone! So are you assuming the reason we don't have it is because cancer patients, their families, and anyone at risk of cancer does not want it?

Sorry, 'there is no public education'

Answer my question: Do we not have cancer treatments that most other developing countries have because society does not want it in the US?

@ William, I too believe that no one here said that things come free of cost. Rather, the point is the non-existence of the clearing conditions. Things become normative if we want to term them as normative only.

I think what Dr. Dwyer and others are saying has a lot of sense. Let us change our location of analysis from the cost side to benefit side. Does education benefit only the individuals who receive it? No. So why should the individual alone pay for it? It is easy for us to compute the cost of providing education. But it is difficult to identify the beneficiaries. So, if we transfer the entire burden of education on the persons who receive it in a static time, it will be an injustice to the individual (overpayment by the individual) and to the society (as in the absence of cost sharing, the price will be prohibitive for a section of population) leading to lower than desired levels of provision. Same is the case with the manufacturing of certain drugs. The manufacturer expects the patients to pay for the entire cost of production and the profit premium. Under such situations if the producers quit because the demand is less than the potential demand, who is at the losing end? It is not only the patients, but also the society at large.

Regarding your surprise on lack of public education in some parts of the world, its not mere an existence of public education, but adequate availability of it. Take any country of the world, the quantum of education services available is less than the potential requirement. The gross enrolment ratio in higher education in countries like India is less than 15 percent. You can have figures from other countries from the WDI database. Let us frame the Indian problem in statements as below.

A. The Indian society would benefit if the rest 85 percent are also enrolled in education.

B. The rest 85 percent can not be enrolled without additional provisioning meaning a scaling up and additional cost.

C. The total benefit to society would be higher than the total cost incurred due to impact of productivity of the present and future workers.

D. The beneficiaries have to pay for the additional cost of provisioning.

If statements A, B, and C are true and accepted then the problem in the schema is to find the beneficiaries who have to bear the cost. The immediate beneficiaries can not as had they been capable, they would nit have remained out of the system in the beginning itself. Other beneficiaries should share the burden. Market fails to identify the beneficiaries who should pay for the cost. Therefore, an intervention is needed. A tax, a subsidy or a direct provision. If the policy maker does not intervene, then the potential benefits would be too large vis-a-vis the realised.

@Siba: Very nicely put. You should share this with students.

A typical case of externality is pollution. Imagine a factory that pours toxic material in a lake. This toxic material cause a decrease in food production of some farms that use the lake water to irrigate.

The price of food rises while the price of factory’s production remains the same, making the firm’s profits,increase. So there is a failure of market because the use of environmental resources is paid by food consumers, while the pollution costs should be paid by entrepreneurs by means of the introduction of devices for reducing pollution.

To add to Alessandro's good example, the question of what "should" be done is determined by the prevailing property rights regime (themselves a reflection of what society wants to uphold). I don't think it is difficult to identify the existence of externalities (positive and negative); the debate is over what society is willing to accept, or wants to incentivize. So if the polluting factory's dumping is somehow within its rights (say, not exceeding a specified daily load), it still causes a negative externality, but the costs to remedy this would be the responsibility of farmers. In the end, food prices rise because of either reduced supply (not addressing the externality) or because farmers pass on the costs they incur to pay for remediation or abatement. We can argue that the factory shouldn't have to pay anything, but this does not negate the fact that the full social costs of its production are not being accounted for under its product's price.

Derek - absolutely - all of this is normative. Society determines what it is willing to pay for. It would be best if central planning accounts for all of the consequential costs so that negative externalities are not borne by private parties - which is merely shifting those costs away from those who gain from them, toward innocent parties.

Externalities is one of the most complex issues of economic analysis. Market, by itself cannot reach a price that includes all the economic sacrifices incurred by the production unit (firm). In the case of negative externalities (environmental damage) you could imagine the firm using "environmental units" that do not belong to it, but to society. The main problem of these EUs is that ENVIRONMENT may be considered a "common property good" where in most cases there are no specific, nor identified individual property rights. The main difficulty is how you include these 'sacrifices' in the production function of the firm, i.e. how you internalize these costs.

If there are only two parties in the situation, negotiation would/could lead to an equilibrium price by compensation. Compensation paid to the one who suffered the damage is included as a cost item. This situation is detailed in Coase's paper "The Problem of Social Cost". Although, the economic analysis in it is 'inconsistent' in my opinion.

In this same paper, Coase cites Pigou and his example of the railway and the damage caused by fire due to sparks from the engine. Is it possible for the railway to negotiate a compensation with more than one owner of property damaged by the fire? Yes, but undoubtedly the process will be long and tedious, "involving higher transaction costs", which are not considered by Neoclassical Theory.

Legal doctrine has been abundant in the analysis of all these cases, there are many examples in Coase's paper, and different rulings or decisions of similar cases by courts in the US and UK. Ultimately, institutions or the institutional environment will determine the 'quantum' of transaction costs and the damage to be compensated.

The case of environmental damage is an example of a negative externality, although you also have positive externalities by production units, e.g. carbon fixation by forests or the recreational value of rural land.

Some activities that have positive externalities over society are public education, public health, public security and public research.

Coase's paper or book "The firm, the market and the law" give an original analysis of these issues, although you might not share some conclusions or methods.

I hope this has been of some value to you and helps to further understand externalities.

An interesting discussion of the intricacies of the notion of externality by a number of scholars may be found in

R. Backhouse et al., Economics and Methodology. Crossing Boundaries, IEA Series, Macmillan, London, 1998, pp.120-176

Laurent, you are right, Knowledge has always externalities, and is a public good, with or without Patents or specific property rights. Public good or services are so because of their intrinsic characteristics, well described in most public finance books. One attribute nobody names is that the "unit" of production and provision is bigger than the "unit" of consumption. So, once a unit has been produced, more than one consumer can use it without affecting the other. This has no relation to the "ability" to pay of consumers, it's a characteristic of these type of goods.

Let's think of a vaccine against Ebola. Imagine there is a patent or IPR belonging to certain physical or legal entity. Even though some people or a government finances its use on population, this use will avoid the "negative" externality of more people infected. So the application of the vaccine on certain members of society have a "positive" effect not only on the ones who received the doses, but also on the rest of the community.

Ultimately, the benefits of the transaction do not apply only to the members of the transaction, but also to the rest of the community. This is what Coase tried to explain in all his papers, beginning with the "The Nature of the Firm" (1937). And this makes reference to the concept "externality".

In my opinion, some of the economic analyses in Coase's papers are inconsistent, but the idea or "spirit" are immensely creative and lay the foundation for two very important issues in Economics: Transaction Costs and Externalities.

Hope this is useful.

Rgds.,

http://link.springer.com/article/10.1007/s10098-015-0923-z#/page-1