Since the extent and way how private markets can respond to externalities depends from the reason, type and method for internalizing of a particular externality, it is appropriate to identify these concepts.
Externalities are internalized when the marginal value of the externality is priced, that is, when the private marginal costs of carrying out the activity are equal to the social costs resulting from the activity. The lack of property rights or difficulty in enforcing them constitutes a cause of externalities. Property rights consist of the right to use a resource or asset, to convert the asset or resource into an alternative use, or to sell the resource. In the case of common property resources, it is difficult to prevent other persons from using the resource. In the case of pollution for example, individuals cannot enforce rights to the use of the atmosphere.
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There are three major types of externalities: producer-producer externalities, producer-consumer externalities and consumer-consumer externalities. Producer-producer externalities occur when the output or inputs used by one firm affect those employed by another one, and the effect is un-priced. For example, the output of an upstream firm may pollute the water downstream, thereby destroying fishing resources and affecting the fishing industry. In the case of producer-consumer externalities, the utility function of the consumer is dependent on the output of the producer. This type of externality occurs in the case of noise pollution by aircrafts and the effects of emissions from factories. Consumer-consumer externalities occur when the activities of one consumer affect the utility of another consumer without being priced.
We can also distinguish between pecuniary and technological externalities. Technological externalities refer to the effects where the production function or utility function is affected. A pecuniary externality, on the other hand, refers to output or utility effects on a third party due to changes in demand. These effects are reflected in changes in prices and profits of the producer, but do not alter technological possibilities of production. A negative pecuniary externality can become a result when an increase in production of one industry causes an increase in the price of inputs used by other industries.
Economic theory is based on the premise that one wishes to modify the behavior of an economic unit, one must modify the incentives facing that unit so that the preferred behavior becomes more appealing to it (i.e., more pleasant, more profitable or both). That is why in order to deal with and respond to the above-mentioned types of externalities, private markets and separated individuals develop private solutions to these problems. According to Coase, in order for these solutions to be realized, three basic conditions should be met, “First, clearly specified property rights must be assigned to either the benefiting party or the harmed party (property rights are laws that describe what people can do with their property). Second, the involved parties must have an equal amount of bargaining power. Third, the transaction costs of negotiation, or bargaining costs, must be low to ensure that the bargaining actually takes place.”
Self-interest of the Relevant Parties
According to Gregory Mankiw (2008), “the private market can often solve the problem of externalities by relying on the self-interest of the relevant parties”. In different situations the solution takes the form of integrating different types of businesses, entering into a contract of different business entities, verbal agreement between business owners and a number of others.
The suggestion that private markets may achieve solutions to externality problems is described through a Pareto-relevant externality, which is characterized by the existence of potential gains from trade between the acting and affected parties. Surely, then, self-interest can be relied upon to ensure the realization of these potential gains through exchange between the involved parties. As always, efficient exchange requires precisely defined and rigidly enforced property rights. In the case of external diseconomies, these property rights include some specification of the laws of liability for damages associated with the diseconomy. If liability rules are specified in a particular manner – allowing a specified amount of externality to be created with impunity and that amount to be exceeded only if the affected party is willing to agree – they serve as the starting point for negotiations to realize the potential gains from trade.
The two extreme examples of such liability rules are the zero liability rule and the full liability rule. Aside from these, an infinite number of intermediate rules could be conceived. The zero liability rule specifies that external diseconomies in any amount may be created with impunity; under such a rule, the affected party would have an incentive to offer a bribe to induce the acting party to reduce their output of external diseconomy. Full liability specifies that absolutely no externality may be created without the consent of the affected party; under such a rule, the acting party would have an incentive to offer compensation to induce the affected party to accept a positive amount of externality.
Ronald Coase in his works perceived that regardless of the liability rule that is in operation one or another party has an incentive to modify a Pareto-relevant externality. Given perfect competition and zero transactions costs (costs of making and enforcing decisions), negotiations will continue until all gains from trade have been exhausted. Coase argued that all gains from trade will be exhausted at the same Pareto-efficient outcome, regardless of the liability rule that is in operation.
The current situation in the theory of private market solutions to externality problems can be summarized as follows: A Pareto-relevant externality, being characterized by potential gains from trade, will generate incentives for one or the other of the involved parties to initiate negotiations aimed at modifying that externality. A solution different from the status quo situation may be achieved and, if perfect competition prevails in all relevant industries including the transactions industry, that solution may be Pareto-efficient. However, the resource allocation and income distribution characteristics of the solution achieved are not neutral towards the choice of liability rules. In comparison with the zero liability rule, the full liability rule will result in a higher degree of abatement of an external diseconomy such as pollution, reallocation of resources toward pollution control and production of commodities which can be produced by low pollution processes, and income redistribution in favor of the affected party. The effective demolition of the doctrine of allocative neutrality of liability rules removes one of the prime advantages, which has been claimed for market solutions to externality problems. The role of the body politic and the bureaucracy in setting the operative liability rule is now known to include the power to affect the allocation of resources in production and allocation of budgets in consumption. In a macroeconomic sense, if externalities are as pervasive as is now believed, the power with which is possible to set liability rules implies also the power to affect resource allocation in the economic system as a whole, aggregate production and consumption and relative and aggregate prices.
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Moral Codes and Social Sanctions
Let us consider why most people do not litter. Nowadays many people follow generally accepted norms of behavior and moral codes, which treat littering as something unacceptable. Although there are laws and sanctions imposed on those who litter, most people do not do so because they think that it is a wrong thing. Such moral injunctions make private ventures take into account how their actions affect others and an environment they work in. In economic terms, moral codes tell business owners and private markets to internalize externalities.
Nowadays many charities are established to deal with externalities. Such charities often include nonprofit organizations that are usually involved in actions connected with the protection of the environment and funded by private donations and sponsors. Charities are usually encouraged by the government through the tax system by allowing an income tax deduction for charitable donations.
The Coase Theorem
Coase theorem says: “the proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own”. In other words, it suggests that if trade in an externality is possible and there are no transaction costs, “private markets and separated private entities are able to solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can always reach a bargain in which everyone is better off and the outcome is efficient”.
Unfortunately, the solution found by Coase is not effective in many cases because the negotiations between the parties can fail and, in general, even in the absence of such grounds, the Coase’s solution works only in cases where there is a small number of agents and in the absence of information asymmetries, or in the absence of transaction costs. The main criticism of the Coase solution, and so related to the failure of the negotiations, are due to: High transaction costs; if the cost of negotiations bargaining between the parties are perceived as excessive compared to the benefits obtained from the collaboration agents do not agree; Difficulty in identifying the cause of the damage, it is often difficult for the owners of the resource understanding what it is, between many potential leaders, who actually causes the damage, and especially to quantify this damage; Imperfect information; if the preferences (and therefore the willingness to pay) and opportunities are known to all stakeholders involved in the negotiations, it would be expected that they will lead to an efficient outcome, otherwise the contract may be long and expensive and may be fail.
In spite of the quantity and variety of good instruments for internalizing externalities, the problem should not be expected to be easily or quickly solved. The internalization of the main externalities in the majority of cases has its cost, which sometimes is too high for private entities. Moreover, it is doubtful that the price of internalization of all externalities of a particular economy may be assumed by its current economic system. That is why nowadays it seems that the participation of various generations will be necessary in order to assume the economic costs of taking many externalities into account.
An important restriction is the one derived from the current administrative structure available. With the exception of companies with a powerful and efficient administrative organization, which is able to detect any negative deviation and solve it immediately, none of classical solutions could be applied in the form and intensity needed.
The limitations that are inherent in each kind of solution manifest themselves in real applications. Any way of internalization necessarily affects costs and so affects market prices. This is at odds with the need to be competitive in local and international markets, because businesses that do not internalize externalities can offer the same product at a lower price (green dumping). Any solution to the problem is therefore more easily applicable in local markets rather than international markets.