Core Concept
Externalities occur when economic activities impose costs or benefits on third parties not reflected in market prices. This causes a divergence between private and social costs/benefits, leading to market failure and inefficient resource allocation.
Types of Externalities
Negative Externalities (e.g., Pollution):
- Social cost (MSC) exceeds private cost (MPC)
- Market overproduces relative to social optimum
- Creates deadweight loss from excessive production
- Examples: Industrial pollution, traffic congestion, antibiotic resistance
Positive Externalities (e.g., Vaccination):
- Social benefit (MSB) exceeds private benefit (MPB)
- Market underproduces relative to social optimum
- Creates deadweight loss from insufficient production
- Examples: Education, R&D, vaccination, tree planting
Policy Solutions
1. Pigouvian Tax/Subsidy
- Tax negative externalities equal to marginal external damage
- Subsidize positive externalities equal to marginal external benefit
- Internalizes externality, aligning private and social incentives
- Optimal when tax = marginal external cost at efficient quantity
2. Cap-and-Trade (Quantity Regulation)
- Set total quantity limit (cap) on externality-generating activity
- Issue tradeable permits that add up to cap
- Market determines permit price through trading
- Achieves quantity target; price uncertain but efficient allocation
3. Standards and Mandates
- Direct regulation: emission limits, technology requirements
- Simpler to implement but less cost-effective
- Doesn't exploit differences in abatement costs across firms
- Useful when monitoring/enforcement easier than pricing
4. Coasean Bargaining
- Assign clear property rights to affected parties
- Enable private negotiation to internalize externality
- Works with low transaction costs and small numbers
- Often impractical in development contexts (high costs, many parties)
Development Context Applications
Environmental: Industrial pollution in clusters (Tirupur textiles, Kanpur leather), deforestation spillovers, groundwater depletion
Health: Sanitation externalities, infectious disease control, antibiotic overuse
Agriculture: Pesticide runoff, fertilizer pollution, land degradation affecting neighbors
Key Insights
- Market equilibrium ≠ social optimum when externalities present
- Optimal policy depends on information, enforcement capacity, transaction costs
- Price instruments (taxes) vs quantity instruments (permits) have different properties under uncertainty
- In practice, combination of policies often needed (e.g., tax + standards)
- Political economy considerations crucial: who bears costs, distributional impacts