Externalities 

Definitions

• Spillover Costs (Negative Externalities) - A cost imposed without compensation on third parties by the production or consumption of other parties.  Example: A manufacturer dumps toxic chemicals into a river, killing the fish sought by sport fishers

• Spillover Benefit (Positive Externalities) - A benefit obtained without compensation by third parties from the production or consumption of other parties.  Example: A bee keeper benefits when the neighboring farmer plans clover.

The following two graphs illustrate that an over-allocation of resources occurs when spillover costs are present and an under-allocation of resources occurs when spillover benefits are present.

Graph 1: When spillover costs occur (when producers shift some of their costs to the community), costs are lower.  By polluting, the firm enjoys lower production costs and the supply curve S.  This causes an overallocation

Graph 2: When spillover benefits occur, the demand curve understates total benefits.  Dt represents the direct benefits as well as spillover benefits.  Since Dt is higher, there is an underallocation.

One approach to reducing the externality or misallocation problem is the market approach of individual bargaining.

1. The Coase theorem suggests that spillover costs and benefits will not occur and government intervention is not necessary when property rights are clearly defined, the number of people involved is small, and bargaining costs are negligible

2. Government's role should be to encourage bargaining wherever possible rather than to get involved in direct restrictions or subsidies

3. Limitations exist with the Coase theorem, because many problems involving externalities affect many people and bargaining is too costly and inefficient to accomplish solutions effectively.

A second approach is through assignment of liability through lawsuits.  If one property owner damages another, a private lawsuit may settle the dispute by assessing damage liability on the violator.  Once again, however, this solution is limited to cases in which the damaged parties can afford to initiate the suit, or in the case of many people, can organize to sue.

A third approach is to apply direct government controls or taxes to reduce negative externalities or spillover costs, or to provide subsidies or government provision where spillover benefits exist.

1. direct controls place limits on the amount of offensive activity which can occur

2. specific taxes can be levied on pollution

A fourth approach is the development of markets for externality rights.  This is the latest policy innovation for dealing with pollution abatement.

1. A pollution control agency decides the acceptable amount of pollution in a particular region and creates rights that firms can purchase to allow them to pollute

2. Demand for rights should be downsloping.  At high prices, polluters will either stop polluting or pollute less by pollution-abatement equipment, which is more attractive when the rights are more expensive

3. With the given supply of rights, and a demand for rights, an equilibrium price will be established for each right to pollute

4. Advantages to this system

• it reduces society's costs because pollution rights can be bought and sold.  For example, some firms will find it cheaper to buy the rights than to acquire abatement equipment.  Others will sell their rights because they may be able to reduce pollution at a lower cost

• conservation groups as well as producers can buy rights.  These groups can acquire the rights and hold them.

• A market for air pollution rights has emerged and is expanding

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