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An externality is said to exist when the well-being of a consumer or the production possibilities of a firm are directly affected by the actions of another agent in the economy.


“An external economy (diseconomy) is an event which confers an appreciable benefit (inflicts and appreciable damage) on some person or persons who were not fully consenting parties in reaching the decision or decisions which led directly or indirectly to the event in question.” It is appropriate to include in the analysis of externalities all the theory of public goods and of public taxes and subsidies. The definition above is intended to make this clear by referring to those who are external to the decision in question as those who are not fully consenting parties in reaching the decision[1].

In a world of perfect markets in which there were no real effects (such as noise) which were not the subject of transactions in perfect markets, there would be no externalities. This would be so even if all decisions were taken by single decision-makers. In order that there should be perfectly competitive markets all decision-makers would have to operate on a small scale. No decision-maker could himself make more than a marginal change in any market; and any indirect marginal change resulting from a single decision-maker’s decision could not cause any appreciable net benefit or damage to anyone.

Where an external effect takes the form of a redistribution of income due to a price effect we may call it a ‘distributional externality’. Where there are marginal divergences between values and costs due to taxes, monopolistic elements, or to externalities more narrowly defined, a change in outputs will cause an increase in total real income if the sum of the changes in quantities each multiplied by its marginal divergence is greater than zero. Any decision which leads indirectly to such a change may be said to carry with it a ‘real-income external economy’. It seems unhelpful to draw a hard-and-fast line between those cases in which there is literally no market (as for a factory’s smoke) and those cases in which there is a very imperfect market for something. A change in quantities which in either case confers a benefit or damage which is not fully requited in the market should be treated as an external economy or diseconomy. Finally, note that while no ‘real-income externality’ could occur if there were perfectly competitive markets covering all goods and services, ‘distributional externalities’ might well occur even in a complete system of perfect competition.

Externalities are sometimes narrowly defined simply as cases where the same particular variable enters into the utility function or the cost function of more than one independent decision-maker (e.g. smoke nuisance, noise, river pollution, etc.).

The bargaining solution: This involves the purely administrative costs of arranging a joint decision to which all the parties must simultaneously agree. Reaching such joint decisions also raises bargaining problems. When the number of persons becomes at all large, the administrative and bargaining problems of reaching a unanimous joint decision become so overwhelming that the realistic possibility of an actual joint decision must be ruled out. The limiting case of this is the public good. The expenditure by the government on defense may affect the utility of every citizen, but individual citizens are not directly parties to the government’s decision to spend money on defense and raise the revenue by a particular set of taxes. Public goods are clear examples of externalities.

The second set of conditions which gives rise to a real-income externality is where there is some scarce resource such that the more you use the less there is for me, but where the resource has not been ascribed to the ownership of any economic agent (e.g. deep-sea fisheries).

The third set of conditions which may lead to real income externalities is the ‘market-organization-cost’ set. Note that in practice many of the different reasons for externalities may exist at the same time. The amount of social cost involved in the use of the roads by cars – causing noise, stench, danger to life and congestion – depends on the place, the time of day, the speed, and the direction of the journey. It is a relatively easy administrative matter to charge cars by taxation according to the horse power of the engine or the amount of petrol consumed, but this does nothing to giver special discouragement to those journeys which give most hardship to others. The question arises whether by more sophisticated metering devices it would be possible, and if so whether it would be worth the additional administrative costs, to charge according to the place and time at which a journey was made. In every concern, both public and private,  the operation of the pricing system will involve a cost. In every case there is a balance to be sought between the advantages of a more accurate pricing system and the costs of its administration. Everywhere there is some element of externality due to the market-organization cost.

Taxes and subsidies may of course be set by the government on various activities in order to reduce or offset externalities.

Should governmental control of externalities arising in the private sector take the form of prohibitions and of direct quantitative regulations of certain activities or the form of taxes to discourage and of subsidies to encourage activities which create external diseconomies or economies?

Consider a factory that is polluting the atmosphere by emitting smoke. It is not necessarily in the social interest to prohibit all the pollution. The cost of complete abatement of pollution might be exceedingly high. There is an optimal level of pollution which is illustrated below. Suppose that in the absence of any control an industry would find it convenient to emit OO units of pollution. The curve OC measures the increasing marginal damage done to society as the amount of pollution increases. But pollution abatement is costly, ant the stricter the abatement the higher probably the marginal cost. The rising marginal cost of pollution abatement is shown by the curve OD. OA, determined by the point of intersection of these two curves, is the optimum amount of pollution.

While the cost of pollution abatement is a reasonably definite one, the marginal social damage curve, which must also be estimated in pounds by the governmental authority concerned presents difficulties of a different order altogether. In order to make any reasonable attempt to grapple with the problems of regulating pollution the governmental authorities concerned must make some attempt to compare in the same monetary units the cost of pollution abatement and the present value of the social damage done by pollution. However, both of these, and in particular the latter, will be a matter of considerable doubt and uncertainty; and indeed the value of the social damage done will have in many cases to be set at a figure determined in a rather arbitrary manner.

Suppose that the abatement costs and the value of the social damage have been estimated in the best possible manner. By what type of regulation should the government attempt to achieve the restriction of the amount of pollution to OA? One method would be by a direct quantitative regulation whereby the government allocated individual permits to pollute to the individual firms concerned, the total amount of pollution permitted by the sum of individual licenses being set at OA. Another method would be to impose a tax at the rate AB or OL on each unit of pollution emitted. Starting from O, each firm, by abating pollution by one more unit, would save more in the reduction of tax than it would add to the cost of abatement, so long as its marginal cost of pollution abatement were lower than the tax per unit of pollution. To reduce pollution below the amount OA would mean that the saving in tax on pollution was less than the added costs of abatement.

There are some very substantial advantages in operating by means of a tax rather than a quantitative regulation. If there are a number of different firms polluting a river and it is desirable to restrict the total amount of pollution, the imposition of a tax per unit of pollution, leaving each firm free to decide how much pollution it will cause, will produce a given reduction in pollution at a minimal cost. Those firms which find it cheap to abate pollution will restrict their pollution much more than those firms for which pollution abatement is costly. A given total reduction in pollution will thus be obtained at the lowest possible cost. Moreover, a tax on pollution will leave each polluter complete freedom of choice in the method, as well as the amount, of pollution abatement.  R&D can be devised in a quite unrestricted manner to discover new and cheaper methods of abatement.

The efficiency of using a tax-cum-price mechanism for controlling pollution becomes even clearer when there are a number of different technical methods of control all of which may be used simultaneously to contribute to the problem. By an appropriate use of taxes and prices the various methods of pollution control can be combined in the most efficient whole. The resulting system of control has all the advantages of a decentralized price mechanism.

There is another important general argument for controlling external diseconomies by charging taxes rather than by direct regulation. It is necessary for the government to raise large sums of tax revenue for the finance of expenditure on pure public goods, and for the redistribution of income. Taxes levied on particular activities for the purpose of closing the existing divergences between marginal costs and marginal revenues which would be associated with these activities, kill two birds with one stone. They directly reduce the particular externalities which they are designed to counteract, and at the same time they raise revenue for the finance of other necessary governmental expenditures, thus reducing the need to impose revenue-raising taxes which would themselves introduce or intensify certain other externalities.













The notion that the resource allocation effects of divergences between marginal social and private costs can be dealt with by imposing a tax or granting a subsidy equal to the difference now seems too simple an explanation. If the party imposing external diseconomies and the party suffering them are able and willing to negotiate to their mutual advantage, state intervention is unnecessary to secure optimum resource allocation. Moreover, the imposition of a tax upon the party imposing external diseconomies can be a very complicated matter, even in principle, so that the a priori prescription of such a tax is unwise.

Let us call A the person or group which imposes a diseconomy, and B the person or group which suffers it. How much B suffers will in many cases depend not only upon the scale of A’s diseconomy-creating activity, but also upon the precise nature of that activity and upon B’s reaction to it. Thus to ascertain the optimum resource allocation will frequently require an investigation of the nature and costs both of alternative activities open to A and the devices by which B can reduce the impact of each activity. Note that the optimum will frequently involve B suffering a loss, both in total and at the margin. A’s and B’s respective gain and loss must be measured as the amount of money they respectively would pay to indulge in and prevent A’s activity. It could also be measured as the amount of money they respectively would require to refrain from and to endure A’s activity, which will be different unless the marginal utility of income is constant. That it is constant is a reasonable assumption when the payments do not bulk large in relation to their incomes. Under this assumption, it makes no difference whether B pays A or, if the law gives B rights against A, A compensates B.

To levy a tax on A which is not received as damages or compensation by B may prevent optimal resource allocation from being achieved – still assuming that they can and do negotiate. The reason is that the resource allocation which maximizes A’s gain less B’s loss may differ from that which maximizes A’s gain less A’s tax less B’s loss.














The fundamental logic of pricing incentives is straightforward. The basic source of environmental problems is the fact that the price system is simply not applied to many resources. The economist thus suggests that our scarce and valuable natural resources (air, etc.) should be provided at an appropriate price. More specifically, the economist calls for a reorientation of the tax system – not necessarily increasing the overall level of taxes but changing relative prices to provide incentives for the conservation of environmental resources.

What are the criteria for evaluating environmental policies?

q       Dependability

q       Permanence

q       Adaptability to economic growth

q       Equity

q       Incentives for maximum effort

q       Economy

q       Political attractiveness

q       Minimal interference with private decisions

One of the fundamental differences between pricing techniques and the direct-controls approach to environmental protection is that the latter characteristically treats environmentally damaging activities as illegal acts, while the former considers them normal consequences of economic activity which should certainly be curtailed, but without the use of the police powers of the state. In this respect, the use of pricing incentives, at least in principle, differs markedly from the reality of outright prohibition. The effectiveness of prohibition clearly depends on the vigor and clout of the enforcement mechanism. Violators of a regulation must first be caught in the act. They must then be prosecuted, found guilty, and given a substantial penalty. If any of these steps fails, the violators get away virtually free despite their disregard for the law. No such problem arises in a system of fees under which polluters simply receive their monthly bills as a matter of course. 

A major problem that besets most regulatory efforts is that the effectiveness of the regulation is dependent on a high level of public concern. The effects of regulation are often transitory. In the first blush of public enthusiasm, an agency may uphold the severity of standards by relatively effective enforcement. However,  some years later, the regulatory agency takes on the characteristic bureaucratic lassitude that is compatible with self-preservation. On the other hand, fiscal incentives, once instituted, need no reinforcement. This gives a fiscal program its reliability. 

The regulatory approach is often thought to be superior to the use of pricing incentives in terms of fairness. Yet the appearance of fairness is largely illusory. There are wide variations across industries and plants in the cost of pollution abatement. Some industries can easily recycle, but for others, reductions in pollution are much more expensive. If our objective is to distribute emission quotas fairly, we might do better to require reduction quotas such as the unit of the cutbacks were the same for all polluters.  From this perspective, effluent fees may arguably be more equitable than a uniform percentage reduction in wastes.

In choosing among instruments of environmental protection, economists place heavy emphasis on the efficiency with which they can be expected to do the job. What are the possible savings in resources that the use of effluent fees can effect?


Effluent charges have met with very little success in the political arena. Yet the use of pollution taxes does have one great political virtue. Unlike most other measures of pollution control, it need not add to the financial burdens of the public sector. Charges on environmental damage can augment the flow of public revenues and introduce powerful incentives for improvements in the quality of life, by, for example, inducing reductions in emissions of various pollutants.























An externality is any indirect effect that either a production or a consumption activity has on a utility function, a consumption set or a production set. By “indirect” is meant both that the effect is created by an economic agent other than the one who is affected, and that the effect is not transmitted through prices. External effects of this sort are characterized as technological. This definition indicates that the basic notion of externality depends on the definition of economic agents and the existence of markets that coordinate transactions among these agents.

The noise from the stereo system of one’s neighbour is a typical example of a consumption externality. Meade’s famous example of the bee-keeper and the orchard is a good illustration of a mutual production externality. Since his bees pollinate his flowers, the beekeeper affects the production possibilities of the orchard in a positive way. Conversely,  by providing flowers from which nectar can be gathered, the orchard promotes the production of honey.


The policy of creating markets by specifying property rights consists of establishing a complete system of competitive markets that incorporate externalities. The competitive equilibrium of the economy in which the space of goods has been enlarged by adding markets for pollution rights is a Pareto optimum. Several remarks must be appended to this result. On the pollution rights market between agent i and agent j, there is only one buyer and one seller. Consequently, competitive behaviour in this market is unlikely and any strategic bahaviour may lead to an allocation that is less desirable than the laissez-faire equilibrium.

Until Coase’s contribution (1960), it seemed natural from the Pigouvian perspective to consider the no-externality situation as the appropriate benchmark. Thus it was implicitly assumed that every agent had a right to a clean environment so that the polluter was taxed, justifying the slogan “polluters must pay”.

The allocation of rights appears to be a political or ditributional issue because it does not affect Pareto optimality but has only redistributive consequences. A chemical firm could buy from a fishery the right to pollute, but the same outcome would pertain if the fishery bought from the chemical firm a reduction in its level of pollution. We can associate a property rights market to each externality and this include it as a transaction in the market economy. However, the thinness of this market in general makes the assumption of competitive behaviour unrealistic.










One of the major items of controversy with respect to the application of CBA to environmental management is the idea of discounting and the derivation of the discount rate. Decisions concerning whether to undertake projects with long-term benefits or with long-term costs frequently turn on the choice of discount rate. The further into the future benefit and cost streams occur, the lower their present value. In choosing the discount rate, economists take an ethical view about the claims of future generations.

Discounting is performed to calculate the present value of a stream of costs and benefits associated with a project or policy. If benefits exceed costs in every time period, the present value is positive for any discount rate. Generally, however, the choice of the social discount rate is crucial in determining whether the present value is positive or negative. Both consumers, via a positive rate of time preference, and producers, via the opportunity cost of capital, are observed to treat the future as less important than the present. Consumers lend money and expect to be rewarded for their abstinence from consumption; for example, savings accounts earn interest. 










[1] A person is a fully consenting party to any decision over which he did not exercise a power of veto which he might have exercised.

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