![]() By the same logic, governments should subsidize those who generate positive externalities, in the amount that others benefit. Such a tax would yield the market outcome that would have prevailed with adequate internalization of all costs by polluters. In The Economics of Welfare, British economist Arthur Pigou suggested in 1920 that governments tax polluters an amount equivalent to the cost of the harm to others. These economists recommended government intervention to correct for the effects of externalities. Neoclassical economists recognized that the inefficiencies associated with technical externalities constitute a form of “market failure.” Private market–based decision making fails to yield efficient outcomes from a general welfare perspective. Similarly, from a societal perspective, maximization of private instead of social returns leads to underproduction of the good or service with positive externalities. To minimize social costs would lead to lower production levels. Social costs grow with the level of pollution, which increases as production increases, so goods with negative externalities are overproduced when only private costs are involved and not costs incurred by others. Unless all costs and benefits are internalized by households and firms making buying and production decisions, market outcomes can lead to underproduction or overproduction in terms of a society’s overall condition (what economists call the “welfare perspective”).Ĭonsider again the example of pollution. To promote the well-being of all members of society, social returns should be maximized and social costs minimized. When there are differences between private and social costs or private and social returns, the main problem is that market outcomes may not be efficient. With positive externalities, private returns are smaller than social returns. However, the private returns of a firm selling products based on its own R&D typically do not include the returns of others who benefited indirectly. This is because R&D adds to the general body of knowledge, which contributes to other discoveries and developments. For example, research and development (R&D) activities are widely considered to have positive effects beyond those enjoyed by the producer-typically, the company that funds the research. There are also positive externalities, and here the issue is the difference between private and social gains. In short, when externalities are negative, private costs are lower than social costs. Those indirect costs-which are not borne by the producer or user-include decreased quality of life, say in the case of a home owner near a smokestack higher health care costs and forgone production opportunities, for example when pollution harms activities such as tourism. The social-that is, total-costs of production are larger than the private costs. In the case of pollution-the traditional example of a negative externality-a polluter makes decisions based only on the direct cost of and profit opportunity from production and does not consider the indirect costs to those harmed by the pollution. As a result, there are differences between private returns or costs and the returns or costs to society as a whole. Most externalities fall into the category of so-called technical externalities that is, the indirect effects have an impact on the consumption and production opportunities of others, but the price of the product does not take those externalities into account. Externalities are among the main reasons governments intervene in the economic sphere. But when they are large they can become problematic-what economists call externalities. Sometimes these indirect effects are tiny. What happens when prices do not fully capture costsĬONSUMPTION, production, and investment decisions of individuals, households, and firms often affect people not directly involved in the transactions. Finance & Development, December 2010, Vol.
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