Introduction to Externalities
INTRODUCTION
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.
WHAT ARE 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.
WHAT IS THE PROBLEM WITH EXTERNALITIES?
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
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.
WHAT ARE 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.
WHAT IS THE PROBLEM WITH EXTERNALITIES?
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
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