Define Externalities. Present a brief about types of externalities. Explain how internalisation of negative externalities could be a solution to externalities through the instruments of taxation and property rights
Externalities refer to the side effects or consequences of economic activities that affect other parties who did not choose to be involved in those activities.
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They can be either positive or negative.
Types of Externalities
- Negative Externalities: These occur when the activity of one party imposes costs on others without compensating them. Examples include pollution, noise, and traffic congestion. Negative externalities lead to overproduction of harmful goods or services because the producer does not bear the full cost of their actions.
- Positive Externalities: These arise when the activity of one party results in benefits to others, without the benefiting parties compensating the originator. Examples include education and vaccination. Positive externalities often lead to underproduction of beneficial goods or services because the producer does not receive all the benefits of their actions.
Internalisation of Negative Externalities
Internalising negative externalities means making the party responsible for the externality bear the cost associated with it. This encourages them to reduce or modify their behavior to account for the full social cost of their actions. Two common instruments for internalising negative externalities are taxation and property rights.
- Taxation:
- Pigovian Taxes: Named after economist Arthur Pigou, these are taxes levied on activities that generate negative externalities. For example, a carbon tax on companies that emit greenhouse gases forces them to internalize the environmental costs of their emissions. The tax creates an economic incentive for firms to reduce pollution or adopt cleaner technologies.
- Implementation: The tax should be set at a level that reflects the estimated cost of the negative externality. This approach aligns private costs with social costs, leading to more efficient outcomes.
- Property Rights:
- Tradable Permits: Also known as cap-and-trade systems, these allocate a set number of permits for activities that cause externalities (e.g., pollution). Firms can buy and sell these permits, creating a market for reducing externalities. Companies that can reduce pollution at lower costs will sell their excess permits to those facing higher costs.
- Establishing Property Rights: By clearly defining and enforcing property rights, it becomes possible to negotiate and resolve conflicts related to externalities. For instance, if a factory pollutes a river, property rights could be assigned to those affected, allowing them to negotiate compensation or pollution reduction measures with the factory.
Conclusion
Internalising negative externalities through taxation and property rights ensures that the costs associated with negative effects are borne by those who create them. This helps align private incentives with social welfare, leading to more efficient and sustainable outcomes in the presence of externalities.