Externalities: Prices Do Not Capture All Costs

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Consumption, production, and investment decisions of individuals, households, and firms often affect people not directly involved in the transactions; large indirect effects are termed externalities.
Most externalities are "technical externalities": indirect effects that impact others’ consumption and production opportunities but are not reflected in the product price.
When private returns or costs differ from social returns or costs, market outcomes may be inefficient from a welfare perspective.

Negative externalities
- Example: pollution. A polluter bases decisions on direct costs and profit opportunities and does not consider indirect costs borne by others.
- Indirect costs include decreased quality of life, higher health care costs, and forgone production opportunities (for example, harm to tourism).
- Result: social or total costs of production are larger than private costs, leading to overproduction when only private costs are considered.
Positive externalities
- Example: research and development (R&D). R&D adds to the general body of knowledge, benefiting others beyond the firm that funded it.
- Result: private returns are smaller than social returns, leading to underproduction of goods or services with positive externalities.

Differences between private and social costs or returns create inefficiencies; neoclassical economics labels these as "market failure."
Internalization principle: social returns should be maximized and social costs minimized by ensuring households and firms internalize all costs and benefits.
Pigou’s proposal: governments should tax polluters an amount equivalent to the harm cost to others, and subsidize producers of positive externalities by the amount others benefit.

Ronald Coase (1960) discussed resolving externalities through bargaining among affected parties; this work contributed to his Nobel Prize in economics in 1991.
Conditions required for feasible bargaining solutions:
- Property rights must be well defined.
- Bargaining transaction costs must be low.
- No uncertainty or asymmetric information.
Institutional frameworks that enable bargaining can be an optimal form of government intervention in some cases.
Intellectual property rights (patents) can allow firms to capture most returns from R&D, but assigning property rights is harder for basic or general research; government subsidies may be needed for basic research.

Public goods are a special class of externality: nonexcludable and nonrival.
- Nonexcludable: producers cannot prevent others from enjoying benefits.
- Nonrival: one person’s consumption does not reduce opportunities for others.
If private benefits are small relative to social benefits while private costs are large, public goods may not be supplied.
Taxes often finance government provision of public goods (Samuelson, 1955).
Environmental public goods (clean air, clean water, biodiversity, sustainable fish stocks) are largely nonrival and nonexcludable and lack well-defined property rights, creating collective action problems.

High transaction costs, uncertainty, and asymmetric information impede bargaining solutions.
Moral hazard is a form of externality where decision makers maximize private benefits while not bearing full consequences due to uncertainty or incomplete information.
Verification problems (for example, inability to verify a polluter’s promised preventive actions) make bargaining infeasible.

The atmospheric accumulation of greenhouse gases (GHG) from human activity is a major cause of global warming; without policies to curb GHG emissions, scientists expect growth in the problem leading to climate change costs such as destruction of capital and lower agricultural productivity.
Costs and risks from climate change are borne globally, while mechanisms to compel internalization by those who benefit from GHG-emitting activities are limited.
The atmosphere is a global public good, making private bargaining solutions unfeasible and international internalization policies difficult to identify and enforce (Tirole, 2008).

Externalities create wedges between private and social costs or returns that lead to inefficient market outcomes and can prevent markets from emerging.
Government intervention is often required to ensure full internalization of costs and benefits, including:
- Pigouvian taxes on negative externalities and subsidies for positive externalities.
- Establishing institutional frameworks and property rights to enable bargaining where feasible.
- Providing subsidies or direct provision for public goods and basic research where property rights are hard to define.
- Developing and coordinating policies to internalize global externalities such as GHG emissions, acknowledging enforcement and distributional challenges.

F&D Magazine — Externalities: Prices Do Not Capture All Costs (Thomas Helbling)