Introduction to Externalities

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In this essay I will explain what externalities are, why they can be problematic, how they can be addressed, the role of government and the potential effects of how governments choose to intervene, concluding that transaction costs are a major determinant of the best policy response to the issue of externalities.

Connolly & Munro (1999) describe an externality as “an action by one agent which affects directly the well-being or production possibilities of other agents, but is chosen without regard to those consequences”. Externalities can be positive or negative. I’m living in oil-rich Bahrain, with irritants such as pollution from oil production, smoke from sheesha pipes, traffic jams from excessive use of motor cars, construction noise in the new apartment block where I reside and nuisance from jet skiing activities at the beach. These negative externalities resulting from others’ activities are a nuisance, but if those who partake in these activities were to stop, they would lose out instead of me. Conversely, I don’t complain about the pleasant oudh scent in shopping malls which I can enjoy without purchasing anything, night lighting provided by our neighbouring hotel, or the agreeable views of my neighbour’s gardens, beach and marina, enjoyed from my balcony. These are all positive externalities which my neighbours would not produce unless there was some benefit to them, but they cannot prevent me from enjoying either.

In private transactions, the wider social effects are generally not taken into account. In a Pareto-efficient market, the private and social costs would be equal, but in reality, the market often fails to produce a balance. Private costs ≠ social costs in competitive markets. Private producers will continue production while it is profitable, but, if there is a social cost, such as pollution, the more they produce, the higher the social cost - the more they pollute the environment. Yet, many market activities that create a social cost are allowed to continue; and manufacturers carry on producing goods that give free benefits to others…why? The goods they produce are still valued in some way and, therefore, to eliminate them completely would not necessarily be an optimal outcome. Instead, there must be a trade-off between production and externalities – a balance must be found between the two. Private enterprises will only continue to produce goods that create a social benefit (positive externalities) to the point where they remain profitable. However, they will not voluntarily take measures to reduce social costs (negative externalities), so some form of intervention is required.

There are a number of ways of addressing social costs. A lot will depend on how ‘property rights’ are distributed in the individual situation. Do oil production companies have a greater right to pump as much oil as possible out of the ground than the local residents have to a clean and healthy environment? Morally and ethically, you’d think the answer would be “no”, but it’s not as simple as it seems. Without oil production, the Middle East would never have achieved its economic strength and resultant power, yet the region would become uninhabitable if all its resources were given over to oil production. If oil companies owned the legal right to a clean environment, the local inhabitants would have to try to induce companies to reduce production; whereas, if the inhabitants owned the legal right, the oil companies would have to pay them off in order to continue production. The costs in reaching a solution to the externality problem are called ‘transaction costs’. The Coase Economic Theorem states that “bargaining over externalities will lead to Pareto efficiency, provided property rights are well-defined” (Connolly & Munro, 1999). For example, if a fisherman has a clear...
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