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A negative externality occurs when economic activity benefits whoever is doing it but inflicts harm on other, uninvolved parties. Air pollution is a classic example. If a firm has no incentive to clean up its manufacturing processes, and if other firms are in the same situation, then the air will soon be fouled and everyone (including the firms) will suffer. Resource misuse presents a similar problem. Imagine a cattle rancher whose herd grazes on a “commons,” a pasture also used by others. If the pasture is overgrazed, it will be ruined for everyone, but no one rancher has an incentive to limit their herd’s grazing. On the contrary, if the pasture will soon be ruined, it makes all the more sense to let one’s herd graze freely now. That reasoning by everyone only hastens the pasture’s ruin, a phenomenon called the tragedy of the commons.
The dynamic in both the pollution case and the ruined commons is that of the prisoner’s dilemma, previously discussed on the Imperfect Markets chapter: multiple parties all end up worse off by each making individually rational, payoff-maximizing choices. When the result is lower prices in a competitive market, the firms may be unhappy but the overall result is socially beneficial. However, when the result is pollution or resource ruin, it would be good to know whether that outcome can be avoided.
Nonexcludable goods
If we think of clean air and sustainable common pastures as goods, the problem is that the goods are rival, meaning that there’s a limit to how many people can use them before they become degraded or depleted, and nonexcludable, meaning that there is no mechanism in place to restrict people’s use. Rival, nonexcludable goods are called common goods. A similar problem arises with public goods, which are nonexcludable but nonrival, when there’s a cost associated with supplying the goods. Lighthouses are a classic example: they do not get used up, but they’re costly to maintain. If any ship at sea can rely on them without paying a fee, where does the money to maintain lighthouses come from? This problem, like the tragedy of the commons but involving public goods instead of common goods, is called the free-rider problem. (Public transport that people use without paying is another example.)
Soft solutions
The simple, obvious solution to the problem of nonexcludable goods is direct government intervention. Local authorities might install some sort of monitoring and enforcement mechanism that regulates behavior. Firms are allowed to emit only so much pollution, grazing time on the commons is rationed, and so on. With some public goods, like lighthouses, it may be more practical for the government to fund the good using revenues raised elsewhere.
However, all such measures can be expensive. There are more nuanced ways of tackling the problem. A government can, for example, tax an activity in proportion to the associated externality. A firm that emits air pollution is then allowed to continue but pays a tax proportional to the amount of the pollution. The point of such a Pigouvian tax (named after economist A. C. Pigou) is to internalize the externality—that is, to turn the cost previously borne by society into a cost borne by the polluting firm. This arrangement has two effects: it creates an incentive for the firm to reduce its pollution output, and it provides tax revenue that can used to fight pollution by various other means, or to compensate society in some other way for however much pollution the firm continues to emit. Cap-and-trade systems are a variation of this idea: firms can buy and sell permits that grant the right to emit a certain amount of pollution. With cap-and-trade, firms are able to make money by polluting less and selling off the pollution rights they no longer need.
The Coase theorem
Yet another option is to privatize the good in question. According to the Coase theorem (named after economist Ronald Coase), when certain conditions apply, bargaining between private parties is an efficient solution to the problem of negative externalities. Using this approach, the tragedy of the commons would be averted by allowing one or more parties to take personal ownership of the pasture. If a township originally owned the land, it could auction it off, either as a single large property or in smaller chunks. Suppose a single owner took possession of the entire pasture. This need not be to the other ranchers’ disadvantage, since the proceeds of the sale could be divvied up among them, and they could use those to pay the new owner for permission to graze cattle on the pasture just as before. This way, the ranchers could all still use the land. The key difference is that the new owner, now collecting usage fees, would have an incentive to keep the pasture from being overgrazed, because the overgrazing externality is now internalized to them.
