ECON1101 - Externalities

An externality is the external cost or benefit of an activity.

External Cost / Negative Externality

A cost from an activity that falls on someone other than those who pursue the activity.

External Benefit / Positive Externality

A benefit of an activity that is received by someone other than those who pursue the activity.


Consider a beekeeper. They keep bees for the honey they create.

Bees pollinate flowers (external benefit), but they also sting children (external cost). The result of these is that the beekeeper's optimal number of hives is both less and more than the socially optimal number of bees respectively.

Most problems with externalities can be solved by social norms, and those that can't have formal negotiations.


External costs and benefits mean that some consumers/producers won't bear all the costs or get all of the benefits of any activity.

It also means that too many or too few of the goods may be produced or consumed in terms of overall costs and social optimality.

Coase Theorem

The Coase Theorem states that individuals will arrive at the efficient level of production of an externality if:

  • Property rights are established and tradable
  • Negotiation is costless
  • A small number of parties are involved

And that the efficiency of the outcome does not depend upon the owner of the property rights.

Legal Remedies for Externalities

When negotiation is costly and ineffective, or property rights are unknown, legal remedies can be needed. Two forms are available:

Direct Regulation

Market-Based Instruments (MBIs)

MBIs are policy instruments that use price or other economic variables to provide incentives to reduce negative externalities. They can be split into 2 categories.

Priced-Based MBIs

Priced-Based MBIs take the form of Pigouvian Taxes.
In a situation where an activity creates a negative externality, the social and economic costs are not equal. Hence a tax of the different between the two is introduced to correct the consumption.

Quantity-Based MBIs

Quantity-Based MBIs take the form of Tradeable Permit Systems.
They create a market for the right to produce an externality. They're created with 3 steps:

  1. Set a quantity cap
  2. Define property rights and distribute them among users
  3. Set up a market for the trade of permits

Taxes vs Tradeable Permits

The two lead to the same result, but do so in different ways. Taxes can be implemented if we know the Social Marginal Cost of an externality, Permits on the other hand are useful if we know the socially optimal level of the externality.

Optimal Amount of Negative Externalities

The optimal amount of a negative externality isn't 0, it's actually the point where the Marginal Cost of abatement is less than the Marginal Benefit of doing the abating.

Common Resources

Common resources are those that are difficult to keep others from using (non-excludable), and decrease when used (create rivalry between those trying to use them).

The Tragedy of the Commons is the principle that any shared resource will be utilised (and hence depleted) until the marginal benefit for each individual falls to zero.


The problem with common resources is that they're exploited on a first-come first-served basis, meaning there's //open access/ to them. By creating different types of property rights (private, common, state) we can reduce this.


Examples of common resources include:

  • The atmosphere
  • The oceans
  • Space

Hence whales are going extinct but chickens aren't (whales are ocean are common, chickens are owned are private).