Actions by individuals and firms affect not only those involved, but also can create side effects for others in ways that can be either beneficial or costly. For example, suppose you share an apartment with a neat and organized person. Because your roommate always keeps the apartment clean and uncluttered, you reap the benefits of not having dishes piling up in the sink or potato chip crumbs all over the sofa. Clearly, you benefit from this situation. On the other hand, suppose the occupants of the apartment next door are members of an aspiring heavy metal band. They blast loud music all day, and occasionally have a jam session—and you’re forced to hear everything they play. Unless you enjoy that music yourself, your neighbors’ actions become a cost for you.

Externalities, often called spillovers, arise when actions or market transactions by an individual or a firm cause some other party not involved in the activity or transaction to benefit or be harmed. If the activity imposes costs on others, it is called a negative externality and it creates an external cost. If the activity creates benefits to others, this is a positive externality and it creates an external benefit. Negative externalities include air and water pollution, littering, and chemical runoff that affect fish stocks. Examples of activities that generate positive externalities include getting a flu shot, acquiring more education, landscaping, and maintaining beehives next to apple orchards.

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The presence of externalities leads to a misallocation of resources, causing a market failure to occur, when markets fail to provide a socially optimal level of goods and services. Both producers and consumers can create externalities and can feel the effects of them. Table 1 identifies the origin and impact of some common external effects.

When a market transaction harms people not involved in the transaction, negative externalities exist. Pollution of all sorts is the classic example. Firms and consumers rarely consider the impact their production or consumption will have on others. For simplicity, we focus on the pollution caused by production. Figure 1 shows a typical market.

Supply curve S_P represents the manufacturer’s marginal private cost (MPC) of production. This supply curve ignores the external costs imposed on others from the pollution generated during production. These external costs might include toxic wastes dumped into lakes or streams, smokestack soot, or the clear-cutting associated with timber harvests. Ignoring these costs, market equilibrium is at point e, at which the product is priced at $6 and 30 units are sold.

One way to measure the well-being of consumers and producers in a market is to measure the consumer surplus and producer surplus. Consumer surplus is the difference between what consumers are willing to pay for a good (shown by the demand curve) and the market price (equal to $6 in Figure 1). Therefore, consumer surplus is equal to $45 [(($9 − $6) × 30) / 2]. Producer surplus is the difference between the market price and the minimum amount at which sellers are willing to sell a product (shown by the supply curve), and is equal to $45 as well [(($6 − $3) × 30) / 2]. Summing up consumer surplus and producer surplus equals $90, which is shown as area ace in the figure.

Now let’s assume that for every unit of the product produced, pollution costs (or effluent) equal to $2 are generated. Thus, at an output level of 30 units (point e), $60 in pollution costs (or negative externalities) is generated. Subtracting this $60 in pollution from total consumer and producer surplus results in $30 of real social benefit from this output.

This means that the true marginal cost of producing the product, including pollution costs, is equal to supply curve S_S, representing the marginal social cost (MSC) of production. This new supply curve incorporates both the private and social costs of production, thus shifting supply upward by an amount equal to ef, or $2. Equilibrium moves to point g, at which 20 units of the product are sold at $7. This is the socially optimal production for this product given the pollution it creates.

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So why is it better for society than when 30 units were produced? First, notice that when output is 20, the cost of the last unit produced—including the cost of pollution—is $7 (point g). This is just equal to the value society attributes to the product. Hence, consumers get just what they want when all costs are considered. Second, notice that consumer and producer surplus at an output of 20 units is $40 [(($9 − $5) × 20) / 2]. More important, it is now higher than the $30 of consumer and producer surplus minus the pollution costs when output was 30 units (point e).

Each unit of output produced beyond 20 costs more—taking both private and social costs into account—than its value to consumers.

Imagine a situation in which external costs exceed the consumer and producer surplus from consuming the good. Such a situation might arise when an extremely toxic substance is a by-product of production. Society is better off not permitting production of this good.

What has this analysis shown? First, when negative externalities are present, an unregulated market will produce too much of a good at too low a price. Second, optimal pollution levels are not zero, except in the case just mentioned of extremely toxic agents. In Figure 1, the socially optimal production is 20 units with total pollution costs of $2 × 20. Pollution reduction as a good has no price. Even so, we can infer a price, known as a shadow price, equal to the marginal damages—$2 per unit in this case. As we will see later, prices for the “right to pollute” will provide us with better approximations of the costs of pollution.

Ronald Coase was awarded the Nobel Prize in Economics for his seminal paper “The Problem of Social Cost.” Coase has written few articles—about a dozen—but, as economist Robert Cooter noted, although “most economists maximize the amount they write, Coase maximized the amount others wrote about his work.”1 Indeed, Coase’s paper on social cost is one of the most cited works in economics.

1 Peter Passell, “Economics Nobel to a Basic Thinker,” New York Times, October 16, 1991, p. D6.

Reducing output to an optimal level results in gains to “victims” because pollution is reduced. The reduction in output, however, causes losses to producers. The presence of losses and gains to two distinct parties, Coase argued, introduces the possibility of bargaining, provided that the parties are awarded the property rights necessary for negotiation.

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The Coase theorem states that if transaction costs are minimal (near zero), the resulting bargain or allocation of resources will be efficient—output will decline to an optimal level—regardless of the initial allocation of property rights. A socially optimal level of production will be reached, that is, no matter whether polluters are given the right to pollute or victims are given the right to be free of pollution.

Even so, the distribution of benefits or income will be different in these two cases. If victims, for example, are assigned the property rights, their income will grow, but if polluters are assigned these rights, the income of victims will decline.

As Coase noted, for these efficient results to be achieved, transaction costs must approach zero. This means it must be possible for polluters and victims to determine their collective interests accurately, then negotiate and enforce an agreement. In many situations, however, this is simply not feasible. In cases involving air pollution, for instance, polluters and victims are so widely dispersed that negotiating is not practical. In other cases, individuals may be both victims and polluters, making it difficult for an agreement to be reached and enforced.

Another problem associated with assigning rights to one party or another might be called environmental mugging. Polluters might at first threaten to pollute more than they anticipate, for instance, to increase their bargaining leverage and, ultimately, their income. Victims, in like manner, might assert exaggerated environmental concerns, again to bid up their compensation. Alternatively, if negotiations should prove to be unfruitful, polluters might start lobbying for legal relief, thus devoting their money to rent-seeking behaviors rather than buying pollution-abatement equipment.

Although the private negotiations Coase proposed have their limitations, his insights proved to be a turning point in environmental policy. Coase challenged the prevailing practice of assuming that victims had a right to be pollution-free. His analysis stressed that it does not matter to whom the rights are assigned for (e.g., the polluter or the pollution victim). No matter how property rights were assigned, if information was good and transaction costs were low, efficiency would result. Given the costs of pollution, affected parties have an incentive to work out efficient agreements.

This idea was so radical when Coase published “The Problem of Social Cost” in 1960 that another Nobel Prize winner, George Stigler, wondered “how so fine an economist could make such an obvious mistake.” Coase was later invited to the University of Chicago to discuss his ideas; Stigler described what transpired2:

We strongly objected to this heresy. Milton Friedman did most of the talking, as usual. He also did much of the thinking, as usual. In the course of two hours of argument the vote went from twenty against and one for Coase to twenty-one for Coase. What an exhilarating event! I lamented afterward that we had not had the clairvoyance to tape it.

2 George Stigler, Memoirs of an Unregulated Economist (New York: Basic Books, 1988), p. 76.

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The Coase theorem has changed the way economists look at many issues, not just environmental problems. In cases in which the costs of negotiation are negligible and the number of parties involved is small, economists and jurists have begun to look more closely at legal rules assigning liability.

When private market transactions generate benefits for others, a situation opposite to that just described results. Figure 2 illustrates a positive externality. Market supply curve S and private demand curve D_P (equal to the marginal private benefit, MPB, of consumption) represent the market for college education. Equilibrium occurs at point e, with Q_e students enrolling. Society would clearly benefit, however, if more people received a college education. Tax revenues would rise, crime rates would fall, and a better-informed electorate might produce a better-operating democracy.

Taking these considerations into account, social demand curve D_S is the private demand for college education plus the external benefits that flow from it. Socially optimal enrollment would be Q₁ (point f ). How can society tweak the market so that more students will attend college? Students will demand Q₁ levels of enrollment only if its price is P₀ (point g). The public must therefore subsidize college education by fg to draw its price down to P₀.

The U.S. government recognizes that college education benefits society at large when it provides low-interest student loans, grants, and scholarships to students attending colleges and universities.

The analysis of externalities is important when determining public policy. However, some caveats need to be noted. For example, consumer surplus and producer surplus are good measures of a society’s welfare if incomes are distributed in an equitable manner. When they are not, efforts to increase efficiency can be unconvincing for public policy. Because it is difficult to reach consensus on issues of income distribution, economists generally focus on efficiency. Also, our analysis of externalities with respect to pollution does not fully take into account important aspects such as the cumulative long-term effects of pollution, the difficulty of valuing damages resulting from pollution, and the fact that there are ways to reduce pollution other than reducing output. Despite these limitations, the analysis presented here helps us focus our attention on ways of reducing the harm done to society by negative externalities.

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We now turn our attention to another type of market failure that occurs when resources are not privately owned.