Pollution Externalities, Socially Efficient Regulation of

In economics, an externality is a benefit or cost that accrues to some entity that is a third party to the market transaction. Because under an externality the market price of the good will reflect the benefits and costs of the buyers and sellers of the good but will not incorporate the costs or benefits affecting the bystanders affected by the production or consumption of the good, the market will generally fail to provide these goods in socially optimal quantities. Viewed in this manner, an externality is the difference between the public and private costs (or benefits, depending on the nature of the externality) of a market activity. In the case of positive externalities, output will be below the socially optimal level, while negative externalities will be associated with output in excess of the socially optimal level.

One classic example of a negative externality is the production of pollution. When the externality occurs on the production side, it may be that a firm generates [Page 1624]pollutive wastes in the course of producing a good. Generally, the producer will not incorporate the costs those wastes may cause on society in the price of the good. As a result, the good will be underpriced in the market, relative to the socially optimal level, and thus overconsumed. An example of a pollution externality on the consumption side might be the air pollution generated as consumers drive motor vehicles. The price of the car and the price of the gasoline, in a completely free market, are unlikely to include any costs related to this pollution.

Equilibrium output in the market occurs, and economic welfare is maximized, when output is produced at the level where marginal revenue equals marginal cost. In competitive markets, price equals marginal revenue. In both competitive and concentrated markets, the structure of supply and demand will determine the marginal revenue and price. However, the supply and demand in these cases will only reflect the private costs and values to the market participants: the buyer and the seller. A benevolent social planner would view a different set of costs or values. In the case of pollution generated during the production of a good, the planner would realize a supply schedule that reflected higher costs: costs that included both the private costs and the third-party (public) costs. As a result, a market operating under the planner's considerations would charge a higher price for the good and produce a lower quantity of output.

Mechanisms to change the level of output and the price of a good associated with a pollution externality are varied. Private solutions are occasionally possible for some externalities; and the Coase theorem implies that if private parties can bargain costlessly over the allocation of resources, they can internalize the costs and benefits and solve the problem of externalities on their own. It can be difficult to reach such agreements or enforce them without cost, especially when they involve a large number of economic agents; and the assignment of rights that often must exist for the theorem to work may also be difficult to accomplish or enforce. As a result, public solutions to externalities have often been pursued.

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