Why Government May Attempt to Limit
Externalities
The government has ample
recourse for limiting negative externalities. The reasons government would choose to
limit negative externalities are that government may wish to act to move a market toward
a socially optimal point or government may wish to correct or internalize negative
externalities. Because competitive markets
may not,
depending on the economic philosophy in effect) and experiencing market failure in the
presence of negative externalities, government may initiate policy
intervention.
Two Kinds of
Externalities
The steps government may take
to attempt to limit negative externalities make more sense once you are clear about what
a negative externality is. There are two kinds of externalities, and an
according to the economic definition, something that affects a third party, an
involuntary participant, in a market transaction. Externalities are, then, unintended
effects that occur outside the parameters of a market
transaction.
While these unintended (possibly unexpected)
effects may be beneficial or harmful--positive or negative--the focus of concern for
government policy is
externalities that do harm to individuals, groups or segments of society.
Negative externalities also do harm to markets by shifting supply to the right (to a
greater quantity) of what is accurately reflected by true demand: if demand reflected
the negative externality, it would be less than what is supplied. This effect on markets
is illustrated by the
between marginal social cost (MSC) and private marginal cost
(MPC).
Third Parties and Second Parties:
Negative Externalities
It might be well here
to expand that definition to include third parties who also have a role as second
parties. First parties are the producers. Second parties are the purchasers or
consumers. Third parties are by-standers who did not produce or purchase a good or
service; they did not participate in the market
transaction.
In today's complex marketplace, second
parties, intentional participants in a market transaction, may find themselves the
victims of unexpected harm in the way of negative externalities from a market
transaction. This unexpected negative harm to a second person participant renders them a
role as a third person by-stander to the effects of a market
transaction.
To illustrate this double role, consider for
instance the negative externalities of black plastics made in China from recycled
plastic electronics products. These black plastics have high levels of toxins that
gas-off because the toxins cannot be eliminated from the recycled materials during the
recycling process. Consequently, a second party in a market transaction, for example,
the purchase of a new computer keyboard, is subjected to the negative externality of
off-gasing toxins that contaminate the indoor-air environment of their home or office
and affect their lungs. In this sense, a second party who willfully participated in a
market transaction finds themselves in the unexpected role of a third party subjected to
negative externalities because surely they did not purchase that keyboard with the
expectation of suffering the effects of toxic chemicals.
How Negative Externalities May Be Limited
by Government
There are a number of overall
categories of means by which government may attempt to limit negative externalities,
which, again, are defined as costs to third parties resulting from negative, harmful
effects of market transactions. These means are defined by separate economic theories,
one of which is private agreements as defined by the Coase
theorem named for economist Ronald Coase, another of which is
Pigovian taxes and subsidies named for economist Arthur C.
Pigou. The third option occurs in the public governmental sector and involves setting
legal regulations, standards and quotas. [In addition, individuals and classes of
individuals may take independent action in the private sector to redress negative
externalities, such as initiating law suits, but these actions are outside of actions
government takes to limit negative externalities.]
Government may attempt to limit negative
externalities through:
- Government
laws establishing regulations, standards, quotas - Pigovian
taxes to restrict negative externalities - Pigovian
subsidies to discourage negative externalities - Coasean
governmental definition of property rights - Coasean
governmental pricing reform allowing tradable pollution permits and creation of
ecological markets
The most
dominant of these means
are:
- Legislative Regulations,
Standards, Quotas - Pigovian
Taxes - Pigovian
Subsidies
Coase
Theorem
The Coase theorem states that private parties
can bargain and pay each other for their actions to reach an efficient outcome in the
market. It is based on (1) well defined property rights, such as who owns what part of
which ocean, if anyone does; (2) all parties acting rationally; and (3) transaction
costs being kept at a minimal. [This theorem extends traditional economic theory because
it presupposes an ethical basis to human behavior in the economic marketplace
notwithstanding the times that this presupposition has been proven erroneous through
violence and bloodshed.]
The Coase theorem requires that
government establish clear definitions of property ownership. The role of government,
then, is to enforce property rights and encourage cooperative cap and trade activity and
foster new markets like that for individual transferable quotas
(ITQs).
In cap and trade, maximums standards are set, and
shortfalls below the maximum can be traded to others with overages, such as with
allowances. While cap and trade is market based, it must be facilitated by
government regulatory statutes and agencies.
ITQs represent
the division of overall allowances into quotas assigned to market participants. These
can be traded in the marketplace in the same way capped maximum shortfalls can be traded
and allocated to participants with overages.
In both cap
and trade and ITQs, government regulatory agencies must participate, sanction and
facilitate the operation of otherwise market-based programs that utilize the Coase
theorem of marketplace solutions not dependent upon government command and control
operations.
Pigovian Taxes and
Subsidies
Pigovian theory requires the
government to actively administer taxes that deter negative behavior resulting in
negative externalities while equally actively administering subsidies that encourage the
adoption of behavior that result in the absence of negative externalities. Taxes against
emissions or pollutants restrict behavior that results in negative externalities because
producers move within the economy to keep costs to a minimum, thus find alternatives to
production that do not result in negative externalities. Subsidies reinforcing the
absence of behavior that produces negative externalities by providing offsets to
production costs through infusions of otherwise unexpected income
resources.
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