Finance & Development

Thomas Helbling

There are differences between private returns or costs and the costs or returns to society
as a whole

Externalities: When Prices Do Not Capture All Costs

Smoking is bad for you (photo: Radius Images/Corbis)

Consumption, production, and investment decisions of individuals, households, and firms

often affect people not directly involved in the transactions. Sometimes these indirect
effects are tiny. But when they are large they can become problematic—what economists
call externalities. Externalities are among the main reasons governments intervene in the
economic sphere.

Most externalities fall into the category of so-called technical externalities; that is, the
indirect effects have an impact on the consumption and production opportunities of oth-
ers, but the price of the product does not take those externalities into account. As a
result, there are differences between private returns or costs and the returns or costs to
society as a whole.
Negative and positive externalities

In the case of pollution—the traditional example of a negative externality—a polluter

makes decisions based only on the direct cost of and profit opportunity from production
and does not consider the indirect costs to those harmed by the pollution. The indirect
costs include decreased quality of life, say in the case of a home owner near a smoke-
stack; higher health care costs; and forgone production opportunities, for example, when
pollution harms activities such as tourism. Since the indirect costs are not borne by the
producer, and therefore not passed on to the end user of the goods produced by the pol-
luter, the social or total costs of production are larger than the private costs.

There are also positive externalities, and here the issue is the difference between private
and social gains. For example, research and development (R&D) activities are widely con-
sidered to have positive effects beyond those enjoyed by the producer that funded the
R&D—normally, the company that pays for the research. This is because R&D adds to the
general body of knowledge, which contributes to other discoveries and developments.
However, the private returns of a firm selling products based on its own R&D typically do
not include the returns of others who benefited indirectly. With positive externalities,
private returns are smaller than social returns.

When there are differences between private and social costs or private and social
returns, the main problem is that market outcomes may not be efficient. To promote the
well-being of all members of society, social returns should be maximized and social costs
minimized. This implies that all costs and benefits need to be internalized by households
and firms making buying and production decisions. Otherwise, market outcomes involve
underproduction of goods or services that entail positive externalities or overproduction
in the case of negative externalities. Overproduction or underproduction reflects less-
than-optimal market outcomes in terms of a society’s overall condition (what economists
call the “welfare perspective”).

Consider again the example of pollution. Social costs grow with the level of pollution,
which increases in tandem with production levels, so goods with negative externalities
are overproduced when only private costs are considered in decisions and not costs
incurred by others. To minimize social costs would lead to lower production levels. Simi-
larly, from a societal perspective, maximization of private instead of social returns leads
to underproduction of the good or service with positive externalities.

Taxation and externalities

Neoclassical economists long ago recognized that the inefficiencies associated with tech-
nical externalities constitute a form of “market failure.” Private market–based decision
making fails to yield efficient outcomes from a general welfare perspective. These econo-
mists recommended government intervention to correct for the effects of externalities.
In The Economics of Welfare, British economist Arthur Pigou suggested that governments
tax polluters an amount equivalent to the cost of the harm to others. Such a tax would
yield the market outcome that would have prevailed with adequate internalization of all
costs by polluters. By the same logic, governments should subsidize those who generate
positive externalities, in the amount that others benefit.

The proposition that technical externalities require government regulation and taxation
to prevent less-than-optimal market outcomes was intensely debated after Pigou’s semi-
nal work. Some economists argued that market mechanisms can correct for the external-
ities and provide for efficient outcomes. People can resolve the problems through mutu-
ally beneficial transactions. For example, a landlord and a polluter could enter into a
contract in which the landlord agrees to pay the polluter a certain amount of money in
exchange for a specific reduction in the amount of pollution. Such contractual bargaining
can be mutually beneficial. Once the building is less exposed to pollution, the landlord
can raise rents. As long as the increase in rents is greater than the payment to the pol-
luter, the outcome is beneficial for the landlord. Similarly, as long as the payment
exceeds the loss in profit from lower pollution (lower production), the polluter is better
off as well.

The possibility of overcoming the inefficiencies from externalities through bargaining

among affected parties was first discussed by Ronald Coase (1960)—among the work that
earned him a Nobel Prize in economics in 1991. For bargaining solutions to be feasible,
property rights must be well defined, bargaining transaction costs must be low, and
there must be no uncertainty or asymmetric information, when one side knows more
than the other about the transaction.

Against this backdrop, optimal government intervention might be the establishment of

institutional frameworks that allow for proper bargaining among parties involved in
externalities. Property rights—specifically intellectual property rights, such as patents—
allow a firm to earn most if not all the returns from its R&D. But it is easier to assign
property rights for innovations and inventions than for basic or general research. Prop-
erty rights for such research are more difficult to define and government subsidies typi-
cally are needed to ensure a sufficient amount of basic research.

Public goods

Problems in defining property rights are often a fundamental obstacle to market-based,

self-correcting solutions, because the indirect effects of production or consumption
activity can affect so-called public goods, which are a special kind of externality. These
goods are both nonexcludable—whoever produces or maintains the public good, even at a
cost, cannot prevent other people from enjoying its benefits—and nonrival—consumption
by one individual does not reduce the opportunity for others to consume it (Cornes and
Sandler, 1986). If the private benefits are small relative to the social benefit but private
costs to provide them are large, public goods may not be supplied at all. The importance
of the public good problem has long been recognized in the field of public finance. Taxes
often finance governments’ delivery of public goods, such as law and order (Samuelson,
1955).

The public good problem is especially notable in environmental economics, which largely
deals with analyzing and finding solutions to externality-related issues. Clean air, clean
water, biodiversity, and a sustainable stock of fish in the open sea are largely nonrival
and nonexcludable goods. They are free goods, produced by nature and available to eve-
rybody. They are subject to no well-defined property rights. As a result, households and
firms do not place enough value on these public goods, and efficient market outcomes
through bargaining typically are not feasible. In other words, environmental issues often
face a collective action problem.

High transaction costs and problems related to uncertainty are other obstacles that pre-
vent parties involved in technical externalities from internalizing costs and benefits
through bargaining solutions. Uncertainty problems are far reaching. In fact, the well-
known moral hazard is a form of externality in which decision makers maximize their
benefits while inflicting damage on others but do not bear the consequences because, for
example, there is uncertainty or incomplete information about who is responsible for
damages or contract restrictions. For example, an insured entity can affect its insurance
company’s liabilities, but the insurance company is not in a position to determine
whether the insured is responsible for an event that triggers a payout. Similarly, if a pol-
luter’s promised preventive actions cannot be verified because of a lack of information,
bargaining is unlikely to be a feasible solution.

Today, the most pressing and complex externality problem is greenhouse gas (GHG)
emissions. The atmospheric accumulation of greenhouse gases from human activity has
been identified as a major cause of global warming. Barring policies to curb GHG emis-
sions, scientists expect this problem to grow and eventually lead to climate change and
its accompanying costs, including damage to economic activity from the destruction of
capital (for example, along coastal areas) and lower agricultural productivity. Externali-
ties come into play, because the costs and risks from climate change are borne by the
world at large, whereas there are few mechanisms to compel those who benefit from
GHG-emitting activity to internalize these costs and risks.

The atmosphere, in fact, is a global public good, with benefits that accrue to all, making
private bargaining solutions unfeasible. Identifying and agreeing on policies for internal-
ization of the social costs of GHG emissions at the global level are extremely difficult,
given the cost to some individuals and firms and the difficulties of global enforcement of
such policies (Tirole, 2008).

Externalities pose fundamental economic policy problems when individuals, households,

and firms do not internalize the indirect costs of or the benefits from their economic
transactions. The resulting wedges between social and private costs or returns lead to
inefficient market outcomes. In some circumstances, they may prevent markets from
emerging. Although there is room for market-based corrective solutions, government
intervention is often required to ensure that benefits and costs are fully internalized.

Thomas Helbling is an Advisor in the IMF’s Research Department.

References

Coase, Ronald, 1960, “The Problem of Social Cost,” Journal of Law and Economics, Vol. 3,
No. 1, pp. 1–44.

Cornes, Richard, and Todd Sandler, 1986, The Theory of Externalities, Public Goods, and
Club Goods (Cambridge, United Kingdom: Cambridge University Press).

Laffont, Jean-Jacques, 2008, “Externalities,” in The New Palgrave Dictionary of Econom-

ics, ed. by Steven N. Durlauf and Lawrence E. Blume (London: Palgrave Macmillan).

Pigou, Arthur C., 1920, The Economics of Welfare (London: Macmillan).

Samuelson, Paul A., 1955, “Diagrammatic Exposition of a Theory of Public Expenditure,”

The Review of Economics and Statistics, Vol. 37, No. 4, pp. 350–56.

Tirole, Jean, 2008, “Some Economics of Global Warming,” Rivista di Politica Economica,
Vol. 98, No. 6, pp. 9–42.