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Externalities and Transactions Cost

The existence of private property rights allows the law to deal with externality problems. A person who is harmed by someone's actions can ask the courts to decide about compensation. The court's decision will depend on whether or not he has a right to some good or service. Courts have established property rights for clean air, clean water, scenic views, sunshine, and quiet. If a person is not due compensation, then he does not have the property rights but the other party may have them. In this case he can pay the party harming him to stop the offending activity.

Victims of pollution seldom band together and sue the polluter, nor do they band together and pay him not to pollute. The difficulty with legal action is that there are serious problems (and thus large costs) in contracting and organizing large groups for legal action. One of these problems is the free-rider problem. Ronald Coase pointed out that pollution problems would not exist if there were no difficulties and expenses in making contracts between polluter and victim. (See the Explore problems to work through the logic of Coase's argument.) An implication of Coase's work is that externalities should not be a serious small-group problem. If only a very few people are involved, they can usually organize to negotiate or to seek legal remedies. On the other hand, the costs of organizing and negotiating when large groups are involved make non-governmental solutions very difficult.

Coase shows that private-property rights are not always a feasible way to solve the externality problem of "free" resources. Another solution is for the government to act as if it were the owner of these resources. The government does this when it regulates the number of ducks that hunters can kill. It says in effect that the government owns the ducks, and people cannot kill them without the permission of the government.

Government can charge for the use of its resources. It could, for example, charge polluters for the use of clean water and air. This charge would make polluters take into account the side effects of their activities (or in the jargon of economists, they would internalize the externalities), and would move the marginal cost curve in the graph upward. There is some user fee (pollution tax) that would make the decision-makers' marginal cost curves coincide with the marginal-cost-to-society curve, and thus correct the efficiency problem.

Government policy dealing with pollution and negative externalities has largely been one of regulation. Most economists believe that this is a less-desirable (efficient) method of dealing with the problem than a policy of a pollution tax.

Finally, there may not be a good solution to the problem of "free" resources for two reasons. First, the cost of a solution may be greater than the benefits of the solution. Most economists believe that there is some "optimal level" of pollution. Many productive processes produce waste products. These waste products, when considered damaging to people, are pollution. To remove them or to transform them into a form that no one considers damaging requires resources, and the use of those resources means that fewer other products can be produced. Thus the reduction of pollution involves the weighing of costs and benefits as does virtually all other activity that economists discuss. The optimal level of pollution becomes that level at which the marginal benefit of any more reduction just equals the marginal cost of any more reduction. If removing pollution that causes $1.00 worth of harm costs $10.00, it is economically inefficient to remove it. It is extremely unlikely that the optimal (economic efficient) level will ever be zero.

Second, there may be externality problems within the government just as there can be externality problems in the market. When there are externality problems in the market, we can call on the government as an outside agent to solve them. But if these problems exist in the government, there is no one to turn to. For example, suppose that the citizens of a country are split into fifty special interest groups, and each group gets special benefits from the government. To pay for those benefits, the government must tax the citizens. The citizens end up paying a dollar in taxes to get eighty cents of special benefits. (Bureaucracy eats up the other 20%.) Although all would be better off getting rid of all special benefits, no one group will want to give up its special benefits, and the costs of organizing the fifty different groups to come up with an agreement may be very large. There may be no solution to this problem of the commons.

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