In our article in the March issue of Fraser Forum, we noted that, under certain conditions, when the free market is allowed to work, all gains from trade will be exhausted. Individuals will "truck, trade and barter" until it is impossible to make one person better off without making someone else worse off. An allocation of resources that satisfies this criterion is said to be "Pareto efficient." The Pareto criterion is the benchmark economists use to evaluate the efficiency of economic outcomes. Henceforth, the term "efficiency" will be used synonymously with "Pareto efficiency."

The traditional view of externalities

The idea that externalities might be a source of inefficiency in the free market was first articulated by the English economist A.C. Pigou. In his book entitled The Economics of Welfare (1932), Pigou noted that in order for markets to be efficient, prices must convey all costs and benefits. When prices do not convey all costs and benefits, then the market will misallocate resources and gains from trade will not be maximized. To illustrate how externalities can result in economic inefficiency, consider the following example. Suppose that a factory emits smoke as part of its production process. Furthermore, assume that a nearby laundromat hangs clothing outside to dry. Since the smoke from the factory makes it more difficult for the laundromat to dry clothes, the factory imposes costs on the laundromat. Because the factory owners do not consider these costs when they make their production decisions, they will tend to produce too much output and too much smoke. The factory will produce more output (and smoke) than it would have produced if in fact it considered these additional costs. Hence, the existence of external costs (called negative externalities) that are not reflected in market prices results in an inefficient allocation of resources.

Benefits that are not priced by the market system can also be a source of economic inefficiency. Consider, for instance, park land. In general, those who provide park land are unable to retain all of the benefits generated by it, such as the rise in the value of the surrounding real estate, the recreational benefits to the community, and its general aesthetic value. A portion of the park land's benefits will accrue to individuals who do not incur any of the costs associated with providing it. Because park land produces such positive externalities—external benefits that are not captured by the price system—it will tend to be under provided by the free market system. Hence, positive externalities are also a cause of economic inefficiency.

In order to rectify externality problems, some economists have suggested that the government impose selective taxes and subsidies. To see how these remedies work, let us return to the first example involving the factory and the laundromat. The source of the inefficiency in this scenario is that the factory owners do not consider all the costs of smoke when they make their output decisions. Because there is no market for clean air, the factory owners are oblivious to the fact that the smoke emitted from their factory imposes costs on the laundromat that hangs its clothes outside to dry. To solve this problem, some economists recommend that taxes be levied on the factory. A tax will, in effect, raise the factory's cost of production. By forcing the factory to consider these costs, or to internalize the costs it imposes on the laundromat, its output will be lower. The externality problem disappears.

In a similar vein, many economists believe that subsidies should be supplied whenever an activity generates positive externalities. Subsidization of park land encourages its suppliers to internalize all the benefits of park land—benefits that would have been under-priced by the free market system. As a result of the subsidy, the incentives are in place for suppliers to provide the "right" amount of park land.

The Coasian approach to externalities

The traditional approach to understanding and rectifying market failure was the accepted doctrine for many years. However, a growing number of economists feel that the traditional approach is incomplete. Most critics of the traditional approach to externalities take their departure from an article written by Ronald Coase in which he noted that externalities arise because of transactions costs. Transactions costs are broadly defined as the costs associated with finding a partner for exchange, negotiating a contract, and monitoring contractual performance. In other words, transactions costs are what inhibit people from engaging in mutually beneficial exchanges.

In his celebrated article, Coase noted that if there are no transactions costs, the free market outcome will be efficient. A clear definition of property rights reduces transactions costs. With well-defined property rights and no transactions costs, there is a market and a price for "everything." All externalities are automatically internalized. Returning to our first example, in the absence of transactions costs and with well defined property rights over the air, it would be much easier for the laundromat to negotiate a deal with the factory owners to reduce their smoke emissions. An efficient allocation of resources would arise as the owners of the laundromat and the owners of the factory trade rights to the air to those who value them the most.

Policy implications

The Coasian analysis has a number of policy implications. One is that a clearer definition of property rights will improve the allocation of resources. Air pollution occurs because it is unclear who owns the air. If the laundromat owners have title to the air, then they can sue the factory owners to reduce their emissions. Alternatively, if the factory owners own the air, the laundromat owners can try to negotiate a reduction in emissions. If property rights are well defined, the scope for mutually beneficial exchange is increased.

A good example of the application of the Coasian approach to externalities exists in Los Angeles. In an effort to reduce pollution, the regional government, representing the residents of L.A., defined how much total pollution was acceptable. Then it created tradable pollution rights. This had two effects. One, it reduced the residents' transactions costs in dealing with polluting firms. Citizens could now buy pollution rights and retire them. Second, it allowed businesses to either purchase or sell pollution rights. Firms could now reduce their emissions in the cheapest possible way.

Transactions costs are an inescapable fact of life. Furthermore, as noted earlier, transactions costs exacerbate externality problems. The government's role, therefore, should be to reduce the transactions costs present in the economic system in order to facilitate economic exchange. The goal of public policy should be to implement practical institutional arrangements that define property rights and reduce transactions costs. If no such institutional arrangements can be found, we may be better off simply living with certain externalities.