How Can Government Limit A Negative Externality

How does the government attempt to limit negative externalities?

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Why Government May Attempt to Limit Externalities

The government has ample recourse for limiting negative externalities. The reasons government would choose to limit negative externalities are that government may wish to act to move a market toward a socially optimal point or government may wish to correct or internalize negative externalities. Because competitive markets may be inefficient (or may not, depending on the economic philosophy in effect) and experiencing market failure in the presence of negative externalities, government may initiate policy intervention.

Two Kinds of Externalities

The steps government may take to attempt to limit negative externalities make more sense once you are clear about what a negative externality is. There are two kinds of externalities, and an externality is, according to the economic definition, something that affects a third party, an involuntary participant, in a market transaction. Externalities are, then, unintended effects that occur outside the parameters of a market transaction.

While these unintended (possibly unexpected) effects may be beneficial or harmful--positive or negative--the focus of concern for government policy is negative externalities that do harm to individuals, groups or segments of society. Negative externalities also do harm to markets by shifting supply to the right (to a greater quantity) of what is accurately reflected by true demand: if demand reflected the negative externality, it would be less than what is supplied. This effect on markets is illustrated by the difference between marginal social cost (MSC) and private marginal cost (MPC).

Third Parties and Second Parties: Negative Externalities

It might be well here to expand that definition to include third parties who also have a role as second parties. First parties are the producers. Second parties are the purchasers or consumers. Third parties are by-standers who did not produce or purchase a good or service; they did not participate in the market transaction.

In today's complex marketplace, second parties, intentional participants in a market transaction, may find themselves the victims of unexpected harm in the way of negative externalities from a market transaction. This unexpected negative harm to a second person participant renders them a role as a third person by-stander to the effects of a market transaction.

To illustrate this double role, consider for instance the negative externalities of black plastics made in China from recycled plastic electronics products. These black plastics have high levels of toxins that gas-off because the toxins cannot be eliminated from the recycled materials during the recycling process. Consequently, a second party in a market transaction, for example, the purchase of a new computer keyboard, is subjected to the negative externality of off-gasing toxins that contaminate the indoor-air environment of their home or office and affect their lungs. In this sense, a second party who willfully participated in a market transaction finds themselves in the unexpected role of a third party subjected to negative externalities because surely they did not purchase that keyboard with the expectation of suffering the effects of toxic chemicals.  

How Negative Externalities May Be Limited by Government

There are a number of overall categories of means by which government may attempt to limit negative externalities, which, again, are defined as costs to third parties resulting from negative, harmful effects of market transactions. These means are defined by separate economic theories, one of which is private agreements as defined by the Coase theorem named for economist Ronald Coase, another of which is Pigovian taxes and subsidies named for economist Arthur C. Pigou. The third option occurs in the public governmental sector and involves setting legal regulations, standards and quotas. [In addition, individuals and classes of individuals may take independent action in the private sector to redress negative externalities, such as initiating law suits, but these actions are outside of actions government takes to limit negative externalities.]  

Government may attempt to limit negative externalities through:

  • Government laws establishing regulations, standards, quotas
  • Pigovian taxes to restrict negative externalities
  • Pigovian subsidies to discourage negative externalities
  • Coasean governmental definition of property rights
  • Coasean governmental pricing reform allowing tradable pollution permits and creation of ecological markets

The most dominant of these means are:

  • Legislative Regulations, Standards, Quotas
  • Pigovian Taxes
  • Pigovian Subsidies

Coase Theorem

The Coase theorem states that private parties can bargain and pay each other for their actions to reach an efficient outcome in the market. It is based on (1) well defined property rights, such as who owns what part of which ocean, if anyone does; (2) all parties acting rationally; and (3) transaction costs being kept at a minimal. [This theorem extends traditional economic theory because it presupposes an ethical basis to human behavior in the economic marketplace notwithstanding the times that this presupposition has been proven erroneous through violence and bloodshed.]

The Coase theorem requires that government establish clear definitions of property ownership. The role of government, then, is to enforce property rights and encourage cooperative cap and trade activity and foster new markets like that for individual transferable quotas (ITQs).

In cap and trade, maximums standards are set, and shortfalls below the maximum can be traded to others with overages, such as with EPA emissions allowances. While cap and trade is market based, it must be facilitated by government regulatory statutes and agencies.

ITQs represent the division of overall allowances into quotas assigned to market participants. These can be traded in the marketplace in the same way capped maximum shortfalls can be traded and allocated to participants with overages.

In both cap and trade and ITQs, government regulatory agencies must participate, sanction and facilitate the operation of otherwise market-based programs that utilize the Coase theorem of marketplace solutions not dependent upon government command and control operations.

Pigovian Taxes and Subsidies

Pigovian theory requires the government to actively administer taxes that deter negative behavior resulting in negative externalities while equally actively administering subsidies that encourage the adoption of behavior that result in the absence of negative externalities. Taxes against emissions or pollutants restrict behavior that results in negative externalities because producers move within the economy to keep costs to a minimum, thus find alternatives to production that do not result in negative externalities. Subsidies reinforcing the absence of behavior that produces negative externalities by providing offsets to production costs through infusions of otherwise unexpected income resources.

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The most usual way for governments to attempt to limit negative externalities is by banning or regulating the practices that cause the externalities to occur.

For example, a major negative externality is pollution.  When companies dump toxic wastes into waterways, people suffer from that decision even if they do not buy the company's products.  This is an externality because it is a cost imposed on people who are not part of a particular economic transaction.  To stop this sort of externality, the government regulates companies, forbidding them from dumping toxic wastes.

Drugs are banned partly because of externalities that they cause.  Let's say you live in a neighborhood where drug dealers are common.  You don't buy or sell drugs so you are not part of that transaction.  However, your life is made more dangerous because of the violence and crime that goes along with drug dealing.  The government bans drug use and sale partly to prevent these externalities.


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