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Effect of externalities and suggested solutions
The efficiency and inefficiency of free markets and an association of resource allocation to agents in an economy continues to be a widely debated topic within political an economic groups. In reality, markets are destined to be inefficient as bunch of factors arise, and probably the most important one is externalities. This paper analyses how externalities cause deviation between social and marginal costs in association of resource allocation and discusses the creative actions and techniques that can be adapted in order to reduce inefficiencies that are generated by externalities.

To begin with, in economics externality is defined as benefit or cost that affects a third party that did not wanted or had no control to acquire that benefit or cost (Buchanan and Stubblebine, 1962). In transaction, customer and producer are firsts and second parties while third party includes any organization, property owner, individual or some resource that is indirectly affected. For example, when a factory is emitting its toxins into surrounding environment people get health problems this is called negative externality. A positive example of externality would be an individual who maintains his attractive house and there for is increasing a market value of his neighbours’ properties. Externalities in general can cause deviation between marginal private cost and marginal social cost therefore the markets fail, as equilibrium of output is greater or less than social optimal level of output. It means that market is producing either too much of a good or too little (Bator, 1958). The best way to explain how externalities cause deviation between social and marginal costs is to take an example of the factory. Lets assume that this factory is making product X. The private costs to the factory owner will include things like raw materials, rent and wages. The external cost, or externality will be the cost of third party, which is a pollution and waste produced by factory. As a result the total cost to society will include the private costs because resources of society are being used and external costs since society has to us its resources to clear up the spill over costs of product X factory.


In diagram 1.1 above Y-axis represents price of product X while X-axis represents the quantity of product X produced. Furthermore, in this diagram, supply is illustrated by two upward sloping lines and demand is illustrated by downward sloping red line. The green upward slopping curve is marginal private cost curve that represents the supply curve of product X firm and the blue one is marginal social cost curve that represents true supply curve for society as a whole. The vertical distance between two supply curves (AB) represents the external costs or in other words externalities. These external costs might include pollution or health costs of employees that work in this industry.

If product X firm was not interested in its own pollution and owners of this company were only concerned about maximizing profits, the equilibrium price would be in the point where demand equals marginal private cost curve at point B and the level of output would be at Q1 and price at P1. This would result in product X being over-produced at the price that is too low for society. In addition, marginal benefit curve that represents the demand of the consumers for product X it is downwards slopping because the more product X is bought by customers the less additional benefit the society receives (Mallard, 2012). When marginal benefit intersects with marginal social cost in point C a lower quantity is demanded in supply of product X Q2. If product X firm would take into account external costs than the actual equilibrium of output would be lower than the equilibrium of output. In this case product X would be produced in lower quantity at the optimal prices to society. Since X firm doesn’t care about external costs and leaves it to society a deadweight loss occurs that is shown by CBD triangle. A deadweight loss is a cost to society created by an inefficient allocation of resources (Investopedia, 2003). In order to reduce this inefficiency government needs to intervene into this free market. The particular type of government intervention that increases the cost of production of firms includes: taxes, subsidies, direct regulations, permits and Coase theory.

The first and probably the most common way for government to intervene is to implement taxes for polluters. Arthur Pigou in his book of The Economics of Welfare recommended that taxes should be used to correct externalities.


The corrective per unit tax in figure 1.2 is EF=EH. With every unit of output produced up to Q1 the tax is being paid. The tax is determined as:

t = Social Marginal Cost (Q2)

= True Marginal Cost (Q2) – Private Marginal Cost (Q2)

By using cost –benefit analysis government can find the most efficient Q2 and then set the tax as the difference between MSC and MPC is evaluated at Q2. In this case the total revenue collected from taxing X firm would be ECFD square (Hillman, 2012).

The corrective tax helps to internalize the externality. Once the producers start to pay per-unit tax they are forced to realize that there is a cost through the externality in their production resolutions, together with privately paid costs of production. Government then uses collected revenues to clean spill overs and cover medicine expenses of people who work in that particular industry.

There are times when producers have legal rights and they can’t be taxed. In these situations governments use subsidies. The correct subsidy supports producers to produce below level of Q2. Producers get subsidies from government for every unit of output that is not produced, in this case (Q1-Q2). Like before government uses cost-benefit analysis to find optimal level of output Q2 (Hillman, 2012).

s = Social Marginal Cost (Q2)

= True Marginal Cost (Q2) – Private Marginal Cost (Q2)


In the case of product X firm, the subsidy that producers would get is CGHD Square in figure 1.3.

These two examples are called Pigovian tax and subsidy and they both are equally used by governments to affect producer incentives in order achieve optimal level of output like in this case Q2 (, 2015).

An alternative to Pigovian methods is direct regulation of externalities. This method requires less bureaucratic administration and less information, although, government still needs to know optimal levels of output and input in order to set correct regulations for producers (Hillman, 2012). Direct regulation defines what behaviour is tolerated and sets fines for those who do not obey the rules. Going back to product X example government could impose regulation on product X industry to use filtering devices or forbid using some technologies that pollute environment. Even though, direct regulations might sound like an efficient response to externalities Coase theorem suggests that it is other way round.

Coase theorem states that if there is an externality, private parties should agree on efficient outcome level without intervention of government. According Coase theorem if trade in externality is possible and no transaction costs exist, trade between these two parties would lead to efficient result despite allocation of property rights (The Coase Theorem, 2015). In this case product X firm should negotiate the amount of compensations directly with people who were affected by pollution that they caused.

Another public policy that is meant to correct problems of externality is quotas. By using quotas government sets limitations on use of input or allowable output. In example of product X firm, the government may put a quota on the amount of pollution that it can produce by using tradable permits. Tradable pollution permits are rights to buy and sell potential or real pollution in artificially created markets (Directorate, 2015). Government requires firms to hold number of permits that is equivalent to the pollution levels. There are three ways that permits are distributed. First way is when government makes an auction where firms are bidding money and the highest bidder wins. Second way is to buy permit from firms in competitive market. Final way is to get permit for free. It is important for firms to obtain the maximum amount of permits because each unit of allowable output means that competitors can’t produce that output, it is one of the ways to exclude competitors. Furthermore, tradable market for permits creates incentives for firms to reduce levels of pollution. Since cost for reducing pollution is not identical for every firm, some choose to pay more money for permits and some reduce pollution and sell their permits to others. In this way desired level of the externality can be achieved.


In conclusion, it can be said that failure of free market to adequately deal with existence of externalities has crucial implications for achieving optimal efficiency in allocation of resources within the economy. As it can be observed from this essay number of possible actions can be taken in order to correct problems caused by externalities, these solutions include Pigovian taxes and subsidies, quotas, direct regulation and Coase Theorem. Economic condition, size of external effects, industries and other factors should be taken into account when choosing right solution to eliminate external effects.


Bator, F. (1958) The anatomy of market failure. Cambridge: Centre for International Studies, Massachusetts Institute of Technology.
Begg, D., Dornbusch, R. and Fischer, S. (1994) Economics. London. McGraw-Hill.
Buchanan, J. (1987) Economics. College Station Texas: Texas A & M University Press.
Buchanan, J. and Stubblebine, W. (1962) Externality. Economica, 29(116), p.371., (2015) What is Pigovian tax? definition and meaning. Available at: (Accessed 18 Nov. 2015).
Cornes, R. and Sandler, T. (1986) The theory of externalities, public goods, and club goods. Cambridge: Cambridge University Press.
Directorate, O. (2015) OECD Glossary of Statistical Terms - Tradable pollution permits Definition. Available at: (Accessed 20 Nov. 2015).
Hillman, A. (2003) Public finance and public policy. New York: Cambridge Univ. Press.
Hillman, A. (2012) Public finance and public policy. Cambridge: Cambridge University Press, p.338.
Investopedia, (2003) Deadweight Loss Definition | Investopedia. Available at: (Accessed 18 Nov. 2015).
Mallard, G. (2012) The economics companion. Basingstoke: Palgrave Macmillan, p.144.
Pigou, A. (1932) The economics of welfare. London: Macmillan and Co., (2015) Microeconomic Definitions flashcards | Quizlet. Available at: (Accessed 16 Nov. 2015).
The Coase Theorem. (2015) Boundless. Available at: (Accessed 20 Nov. 2015).

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