Principles of Economics: Externalities


An uncompensated impact of one person’s action on the well-being of a bystander. It is a type of market failure as it reduces the efficiency of the market. In general, it is caused by self-interested buyers and sellers neglecting the external costs or benefits of their actions. However, public policy can reduce externalities and increase efficiency.

On the one hand, positive externalities include herd immunity by vaccination, R&D or higher education. On the other hand, negative externalities include air and water pollution.


The idea is to alter incentives such that people take into account the external effects of their actions. Negative externalities are usually larger than socially desirable, whereas positive externalities are usually smaller than socially desirable. Example remedies to internalise respectively are tax and subsidise food. A tax on production may make a firm’s costs equal to social costs.

Public policies can be roughly divided in two:

  • Command-and-control policies regulate behaviour directly;
  • Market-based policies provide incentives so that private decision-makers will choose to solve the problem on their own.

Taxes and Subsidies

A corrective tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality.

Arthur Pigou (1877-1959) introduced the Pigovian tax which is equal to the external costs. Subsidies are therefore negative taxes to optimally compensate for the external benefit. Those taxes should align private incentives with society’s interests. An import fact is that Pigovian tax moves an economy toward a more efficient allocation of resources. This contrasts with other taxes and subsidies, which actually distort incentives and move an economy away from the social optimum.

The marginal damage is the increase of pollution per additionally produced unit. The marginal cost of abatement is the cost to reduce an additionally produced unit of pollution. Small (initial) reductions in pollution are cheap, however, the price to reduce pollution increases exponentially. The optimal pollution is defined as the equilibrium where the marginal abatement costs equals the marginal damage. A tax equal to the equilibrium point therefore forces companies to reduce the pollution to the equilibrium point (otherwise they pay taxes higher than the cost of abatement). For the abatement costs higher than the tax the company pays taxes as this is cheaper than abatement.

However, each company will have different costs of pollution abatement. Firms with the lowest abatement costs will reduce pollution most. Firms with high abatement costs have a greater willingness to pay the tax. This contrasts with a regulation to only emit a certain amount, as the reduction in pollution is obtained in the most efficient way.

Corrective taxes are better for the environment:

  • reduce pollution up to the level of tax
  • cleaner technology are quickly adopted to reduce tax load.

Tradable pollution permits

Tradable pollution permit systems reduce pollution at lower cost than regulation. Firms with low cost of reducing pollution do so and sell their unused permits. Firms with high cost of reducing pollution buy permits. Pollution reduction is concentrated among those firms with the lowest cost.

The permit price is set at the marginal cost of abatement. At the optimal pollution the marginal damage is gain equal to the marginal abatement cost. If the pollution is larger than the optimal pollution, additional permits need to be bought, on the other hand, if pollution is lower than the optimal pollution, permits can be sold.

However, in the example of the EU ETS, the profits of companies increased and the price for end-users as well. Pollution permits – while similar to Pigou taxes in design – are not a form of taxation.

There are limits as environmentalists argue no one should be able to buy the right to pollute and that pricing the environment is inherently impossible. However, without pricing it becomes difficult to judge the value of clean air and water. So far, market-based approaches have reduced the cost of environmental protection and therefore seem to be partially justified.

The Coase Theorem

Assuming everyone has perfect information, consumers and producers are price-takers, enforcing agreements in courts is costless, no transaction costs and no strategic behaviour. Based on those assumptions the initial assignment of property rights regarding externalities does not matter for efficiency. In this world it is a secondary issue who pays and all externalities are internalised. Property rights are merely used for gaining efficiency (not redistribution).

In reality, pollution causes potentially large transaction costs, which depend on the initial allocation of property rights. Free-riding also causes problems due to the asymmetric information on damages and costs. Lastly, no mention of any compensation for victims in conjunction with the previous points makes the Coase Theorem unrealistic.

To contain these problems (and get closer to the circumstances of the Coase Theorem) environmental damage is evaluated. Indirect methods compute affection by pollution on isolated markets, which revealed preferences. Direct methods (contingent valuation) are based survey on consumer willingness to pay for a better environment, which is based on stated preferences.