Suppose there is a factory that makes textbooks which resides by a river. The company that owns the factory sells textbooks for 100 dollars each and people buy them for that amount. It costs 50 dollars to make each textbook at the factory. This situation would result in a 50 dollar surplus per textbook for the company assuming the people buying the textbook do not have any consumer surplus. So where is the problem? Given just this information, there is no problem. Society has a net benefit of 50 dollars per book. Let’s add some new information. In order to keep their production costs low, the company has the factory dump their waste into the river nearby. This waste causes damage to society in the form of pollution in the amount of 60 dollars per book. With this new information there is a net loss of 10 dollars to society per book created and sold.
This consequence is not reflected in the price of the product and is called an externality. Negative externalities are capable of causing inefficiency because the marginal social cost is higher than the private cost and the output level will not be the best for society. If the negative externality is not accounted for then a market failure occurs. As long as the marginal social benefit is less than the private marginal benefit, a good will be over-consumed in relation to the social equilibrium. Positive externalities also exist in situations where the social benefit is above the private benefit. While these do not need to be solved, they can be addressed and utilized as you will see shortly. So how are negative externalities solved? Both Coase and Pigou have offered solutions.
Pigou came up with a tax. (We will call these taxes by their name, Pigovian taxes) Pigou decided that to create a cost or tax equal to the cost of the negative externality the externality would correct the market back to the most efficient point. A similar yet opposite idea exists for positive externality where subsidies are given towards things that create positive externalities to increase consumption to the optimal level. An example of a Pigovian tax correcting a negative externality would be if a company causes 10 dollars in social damage a year and is taxed ten dollars so that the problem is offset. In the opposite case with a reverse Pigovian tax or subsidy, let’s say that IQ enhancing pills are sold for 100 dollars each. Each pill has a social benefit of 200 dollars and a private benefit of 100 dollars. If the government intervenes and adds a subsidy of 20 dollars per pill, more pills will be purchased and the net benefit to society will outweigh the cost.
Pigovian taxes are not the only solution however. In our original example we saw the negative externality was 60 dollars per book. If the company is taxed 60 dollars and their original cost is 50 dollars, then their total cost will be 110 dollars. People are not willing to buy the books for a higher price and the company will lose 10 dollars per book if they do not have another option for waste disposal. This is where Coase comes in. Robert Coase came up with a theorem stating that if trade is possible and of low enough transaction cost in an externality situation, bargaining will result in the efficient outcome and government simply needs to enforce property rights. He believes the main problem is transaction costs and not the externalities themselves.
Let’s go back to the original textbook factory example to further see how this works. Assume we find out more information about the scenario. The people being affected by the pollution are willing to move if bribed 50 dollars per book. (This may sound awkward, but given the fact we do not know total revenue this is how we will refer to the costs.) The company also discovers a way to dispose of their waste which costs 30 dollars per book by shipping it to a waste facility. The third option is to simply pay the 60 dollar tax and they will go out of business. If the company choose the option of bribing people to move out, they will break even so that is a possible outcome. The option to ship their waste to the waste facility is their lowest cost solution. Assuming the company is rational, they will take that option. Therefore the company eliminates the pollution at a cost of 30 dollars and saves 30 dollars avoiding the Pigovian tax. The company still has a surplus of 20 dollars per book in the end and so does society. This shows how the Coase theorem of externalities leads to the most efficient outcome using bargaining. Externalities can be dangerous and lead to market failure if not dealt with. Luckily with these solutions we can deal with them and achieve our social optimum (or somewhere close) and live life to the fullest.