Externalities are one of the factors leading to market failure, causing inefficiency in

the economy.
Market failure occurs when the market mechanism fails to achieve desired outcomes
or ensure efficiency and fairness criteria in resource allocation, production decisions, and
the marketing of goods and services. In market failure, there is no external intervention to
regulate or modify the situation, leading to suboptimal or undesirable results.
I. WHAT ARE EXTERNALITIES?
Externalities refer to the condition where production or consumption affects third
parties, but these effects are not reflected in the prices of goods and services in the market
(not considered in production or consumption decisions). Externalities can be positive or
negative and may arise from the production or consumption of goods or services.
They can be private, affecting individuals, or social, impacting the entire society.
Because externalities occur in market transactions, they often affect parties other than
those directly involved and are sometimes referred to as spillover effects.
Example: A business decides to invest in an education and training program. If this
program helps improve the education and skills of individuals, it becomes a positive
externality. The community benefits from the high quality of individuals, and the
economy may also experience growth. However, this activity may not be accounted for in
the business's economic balance sheet but creates value for society.
Example: Air pollution - A company producing goods using excessive fossil energy
may cause air pollution. People living near this company may suffer the consequences of
this pollution by inhaling polluted air, but they do not benefit from the production of that
company.
II. CLASSIFICATION
There are two types of externalities: negative externalities and positive externalities.
- Negative Externalities: These are the costs (negative consequences) of an economic
activity that a third party unrelated to the activity must bear.
Example: When buying and selling cigarettes, buyers and sellers only think about
their own benefits, while smokers affect the health of others and society.
- Positive Externalities: These are the benefits provided to a third party (not the buyer
or seller), and these benefits are not reflected in the selling price.
Example: Consuming educational goods creates positive externalities for society.
When an individual is well-educated, both the individual and society benefit, such as
improved social behavior. Businesses also benefit from having high-quality labor,
increasing efficiency.
Through the impact of negative and positive externalities, we can observe two
subcategories: pecuniary externalities and technological externalities.
1. Pecuniary Externality (Monetary Externalities): This impact on a third party occurs
through the price system, whereas technological externality affects a third party outside
the price system.
Example: Opening a McDonald's restaurant next to a Burger King may reduce the
profit of the current Burger King. Since this occurs through the market price system, it is
considered a pecuniary externality. Some companies participating and competing with
existing companies (causing these pecuniary externalities) are necessary for market
efficiency.
2. Technological Externality: This only exists in cases where there is market
imperfection, unclear property rights, or undervalued shared resources. Examples include
air pollution, water pollution, and excessive use of common resources.
Example: McDonald's, during its business operations, emits pollution into the air
that affects the production of Burger King's hamburgers. This would be a case of
technological externality, which can be positive (external benefits) or negative (external
costs).
In cases where technological externalities exist, there is a difference between social
marginal benefits (or costs) and private marginal benefits (or costs).
Steel manufacturing is often very polluting as the lowest cost method of production is
to burn lots of coal to provide the energy needed in the steel manufacturing process.
In Figure 5 above, it is assumed that there are only external costs associated with
producing steel, and no external benefits. Each tonne of steel produced adds to the
surrounding air pollution. Thus, MSB = MPB. The firm producing the good aims to
maximise profits and as such does not take into account any external costs associated
with producing the next unit of output. The profit maximising firm sets quantity to Qe
where the MSB = MPC.
This is not the socially optimum level of output because this is where MSB = MSC,
and factors of production are being misallocated (e.g., more labour and capital are being
used to produce steel, and less labour and capital is being used to produce, say, education
and health services).
Figure 5 illustrates this. In the free market the price of steel is too low – Pe instead of
P* – and the output of steel is too high – Qe instead of Q*. Thus, between Q* and Qe,
MSC > MSB. The value of the resources used to make additional tonnes of steel (MSC)
is greater than the satisfaction gained from society buying and consuming another tonne
of steel (MSB).
Thus, MSC > MSB in regards to steel production and consumption. On and every unit
of output (tonnes of steel produced) between Q* and Qe, a loss of social welfare occurs.
The MSC is less than private benefit of steel consumption because of the negative
externalities associated with the production of that good. The yellow triangle shows the
total welfare loss.
Let's consider a case of positive externality.
When people use healthcare services, they create positive externalities for society. If
individuals are healthier, they are less likely to transmit diseases, and a healthier
workforce implies higher productivity in the economy.
The assumption here is that only positive externalities are related to the consumption
of healthcare services, and there are no external costs. Here, MSC (Marginal Social Cost)
represents the overall social cost of consuming healthcare services. This cost does not
affect the society's benefit, so MSC = MSB (Marginal Social Benefit).
In a free market, the price of healthcare services is determined by the balance of
supply and demand, and thus equals MPB (Marginal Private Benefit). This leads to the
quantity of healthcare services being provided at Qe.
However, this quantity is not the socially optimal level. The socially optimal quantity
is Q*. At this quantity, MSB = MSC.
The difference between Q* and Qe is due to the positive externality of consuming
healthcare services. At the quantity Qe, MSC < MSB. This means that the overall social
benefit of consuming an additional unit of healthcare service is greater than the overall
social cost of consuming that additional unit of healthcare service.
The analysis above applies to the case where external costs (or benefits) are a fixed
number per unit of goods produced (thus representing parallel and vertical shifts on the
supply and demand graphs). When this condition is violated, it can be observed that the
outcome of a competitive market can still be efficient, especially in the case of
differences in external costs. This is illustrated through an example: suppose external
costs are, for instance, $5 for the first unit produced, $4 for the second unit, $3 for the
third unit, and so on, until external costs decrease to $0 for the sixth unit and subsequent
units.
 In the case of water pollution from a company dumping waste into a lake, after a
certain level of production, additional units of production and pollution do not generate
additional marginal loss.
In the case of external benefits, such as an individual's education choice, there may be
a situation where external benefits arise in the initial years of education but eventually
decrease to zero at certain education levels.
If external costs or benefits decrease to zero before the level of production that the
private market competition provides, then there is no significant externality at the margin,
and thus, there is no market failure.
In the case of "inframarginal externalities" illustrated in Figures 7a and 7b.
As described in Figures 7a and 7b, when externalities are inframarginal, the private
market outcome is efficient because externalities are not significant at the margin (i.e., at
the equilibrium quantity). To distinguish from cases where externalities are significant at
the margin, as depicted in Figures 6a and 6b, they are often referred to as "Pareto-relevant
externalities" to differentiate them from the case of inframarginal externalities. However,
it can occur in the case of inframarginal externalities that, if the demand (or supply)
decreases, externalities may become Pareto relevant.
Based on the work of A.C. Pigou, for many decades, the prevailing thought was that
in the case of Pareto-relevant externalities, government intervention through taxes or
subsidies would be necessary to bring the market to an efficient outcome.
Taxation is one solution to address negative externalities. To help mitigate the
negative impacts of certain externalities like pollution, the government may impose taxes
on goods causing externalities. This tax, known as a Pigovian tax—named after the
economist Arthur C. Pigou—is considered equivalent to the value of the negative
externalities.
This tax aims to deter activities causing net costs to unrelated third parties. This
means that applying such a tax would reduce the market outcome of externalities to a
level considered efficient.
Using the example of negative externalities as shown in Figure 6a, the government
can impose a per-unit tax equal to the external cost. The private market supply curve will
shift upward by the amount of the per-unit tax (T), and as long as the tax per unit (T)
equals the amount of the external cost (EC) generated per unit, the new private market
supply curve will accurately reflect the marginal social cost curve, and the market
equilibrium quantity will shift to the efficient output level Q*.
 In the case of positive externalities, as depicted in Figure 6b, the government can
provide a per-unit subsidy (S) equal to the amount of the external benefit (EB) created
per unit. This will shift the private market demand curve upward by the amount of the
subsidy. The resulting equilibrium demand curve including the subsidy will accurately
reflect the marginal social benefit curve, and the market equilibrium quantity will shift to
the efficient output level Q*. Subsidies can also address negative externalities by
encouraging positive external consumption. An example is subsidizing fruit orchards to
create positive externalities for beekeepers.
This incentive has the potential to influence economic behavior, as additional
motivations in one way or another will determine the choices made. Subsidies are often
applied to a substitute item to discourage a specific activity. For instance, government
initiatives to upgrade energy-efficient renovations have discouraged consumers from less
environmentally friendly choices.
The imposition of "Pigovian" taxes and subsidies in practice is challenging. However,
correct policies require that government officials are responsible for determining the
exact quantity of taxes and subsidies needed based on the actual quantity of external costs
or benefits in the market. Furthermore, individuals may have an incentive to inaccurately
report their true preferences if the information they must provide to the government
affects their tax or subsidy amounts. Finally, even if the actual external costs or benefits
can be known, one must ask what incentive the government has to impose taxes or
subsidies in those quantities. If the government is allowed to tax (or subsidize) a specific
market, the imposed tax (or subsidy) may reflect many political factors beyond
externalities.
A real government might, for example, impose taxes per unit to maximize revenue or
increase subsidies beyond the amount of external benefits in an effort to secure votes for
the upcoming re-election. Additionally, because a business or individual would lobby
strongly to avoid or mitigate a $100 technical externality as well as a $100 pecuniary
externality, a politician seeking votes may try to impose policies to address or
compensate for both types of externalities. As Holcombe and Sobel (2001) point out,
government intervention to prevent or rectify pecuniary externalities leads to less market
efficiency rather than more.
The government can also implement regulations to offset the impacts of externalities.
Regulations are considered a common solution. The public often relies on the
government to pass and enforce laws and regulations to limit the negative effects of
externalities. Examples include environmental regulations or laws related to health.
A fundamental issue in government regulation of externalities is the need for
consistent and reliable information to monitor and manage the externalities being
regulated or addressed. Reviewing pollution control regulations, the government allocates
resources to ensure that the laws are actually adhered to, including forcing wrongdoers to
be accountable for not adequately addressing their externalities.
Coase's pioneering work (1960) changed how economists think about externalities. A
key insight of his analysis is that all externalities stem from poorly defined or undefined
property rights. The apparent remedy is straightforward, to minimize market failure; all
that is needed is to assign property rights so that they can be priced and traded in the
market.
However, Coase's insight goes further. As long as the number of participants is small
enough, voluntary negotiations between parties, without government involvement, will
reduce externalities. Returning to the previous example, Burger King could propose to
pay
McDonald's to cease air pollution, impacting Burger King's production. Assuming for
the sake of the example that for the benefit involved, Burger King would be willing to
pay up to $1,000 to prevent McDonald's from causing pollution, while McDonald's could
install pollution control equipment and eliminate the pollution it emits for $800.
According to the Coase Theorem widely known today, if transaction costs (impeding
the negotiation process) are not significant, voluntary negotiations among parties, without
government participation, will minimize externalities. Going back to the example, if there
are no significant transaction costs, the final distribution of resources will be efficient and
will also be independent of assigning initial rights. This means that the same efficient
outcome will prevail regardless of whether the government intervenes and assigns the
pollution right to McDonald's (in which case Burger King could then propose to pay
McDonald's $900 to stop pollution, which they would accept since pollution control
equipment costs only $800) or if the government intervenes and assigns the clean air right
to Burger King (in which case McDonald's would then propose to pay Burger King up to
$800 to have the right to cause pollution, which Burger King would refuse, leading to
McDonald's installing pollution control equipment).
However, it is important to emphasize once again that there is no need for government
intervention to establish property rights because the two businesses would have the
incentive to negotiate towards a Pareto-improving solution without government
intervention.
Perhaps the most significant impact of Coase's work is that transaction costs are the
fundamental source of unresolved market failures. In cases where a large number of
people have to participate in the negotiation process, high transaction costs can prevent
successful negotiations. In the case of a large number of people, where negotiations may
not take place, the ultimate outcome will depend on the initial assignment of rights
because it will remain in the hands of the assigned right.

agents (e.g., global warming), determining ownership rights is challenging. ⇒ Coasian

solutions are likely more effective for small, narrowly scoped externalities compared to
large, globally related externalities affecting many people and businesses.
The problem of resistance: Joint ownership gives power to each owner over all others
(because joint owners must agree on Coasian solutions). As with the problem of
assigning rights, the resistance problem will be exacerbated with externalities involving
many parties.
Based on the insights provided by Coase's analysis, government intervention in the
case of externalities is then necessary (in the case of an unresolved technical externality,
Pareto-relevant) should be limited only to establishing or defining private property rights.
In some cases, like air and oceans, this may not be feasible, but innovative methods such
as pollution permits can achieve the same objective. A modern approach in the case of
market failure due to externalities is often for the government to create or establish
additional.