Externalities and Transactions Cost
The existence of private property rights allows the law
to deal with externality problems. A person who is harmed by
someone's actions can ask the courts to decide about
compensation. The court's decision will depend on whether or
not he has a right to some good or service. Courts have
established property rights for clean air, clean water,
scenic views, sunshine, and quiet. If a person is not due
compensation, then he does not have the property rights but
the other party may have them. In this case he can pay the
party harming him to stop the offending activity.
Victims of pollution seldom band together and sue the polluter, nor do they band together and pay him not to pollute. The difficulty with legal action is that there are serious problems (and thus large costs) in contracting and organizing large groups for legal action. One of these problems is the free-rider problem. Ronald Coase pointed out
that pollution problems would not exist if there were no
difficulties and expenses in making contracts between
polluter and victim. (See the Explore problems to work through the logic of Coase's argument.) An implication of Coase's work is that externalities should not be a serious small-group problem.
If only a very few people are involved, they can usually organize to negotiate or to seek legal remedies. On the other hand, the costs of organizing and negotiating when large groups are involved make non-governmental solutions very difficult.
Coase shows that private-property rights are not always a
feasible way to solve the externality problem of "free"
resources. Another solution is for the government to act as
if it were the owner of these resources. The government does
this when it regulates the number of ducks that hunters can
kill. It says in effect that the government owns the ducks and that people cannot kill them without the permission of the government.
Government can charge for the use of its resources. It
could, for example, charge polluters for the use of clean
water and air. This charge would make polluters take into
account the side effects of their activities (or in the
jargon of economists, they would internalize the
externalities), and would move the marginal cost curve in
the graph upward. There is some user fee (pollution
tax) that would make the decision-makers' marginal cost
curves coincide with the marginal-cost-to-society curve, and
thus correct the efficiency problem.
Government policy dealing with pollution and negative
externalities has largely been one of regulation. Most
economists believe that this is a less-desirable (efficient)
method of dealing with the problem than a policy of a
Finally, there may not be a good solution to the problem
of "free" resources for two reasons. First, the cost of a
solution may be greater than the benefits of the solution.
Most economists believe that there is some "optimal level"
of pollution. Many productive processes produce waste
products. These waste products, when considered damaging to
people, are pollution. To remove them or to transform them
into a form that no one considers damaging requires
resources, and the use of those resources means that fewer
other products can be produced. Thus the reduction of
pollution involves the weighing of costs and benefits as
does virtually all other activity that economists discuss.
The optimal level of pollution becomes that level at which
the marginal benefit of any more reduction just equals the
marginal cost of any more reduction. If removing pollution
that causes $1.00 worth of harm costs $10.00, it is
economically inefficient to remove it. It is extremely
unlikely that the optimal (economic efficient) level will
ever be zero.
Second, there may be externality problems within the
government just as there can be externality problems in the
market. When there are externality problems in the market,
we can call on the government as an outside agent to solve
them. But if these problems exist in the government, there
is no one to turn to. For example, suppose that the citizens
of a country are split into fifty special interest groups,
and each group gets special benefits from the government. To
pay for those benefits, the government must tax the
citizens. The citizens end up paying a dollar in taxes to
get eighty cents of special benefits. (Bureaucracy eats up
the other 20%.) Although all would be better off getting rid
of all special benefits, no one group will want to give up
its special benefits, and the costs of organizing the fifty
different groups to come up with an agreement may be very
large. There may be no solution to this problem of the
We finish by looking at mousetraps.