Why is it important to deal with externalities and how to do this

The results of negative externalities can be pretty grim. For example, in 2006 a marine researcher Boris Worm, along with a team of scientists and economists, concluded that the ocean could be empty of fish by the year 2048. The consequences of this would be felt by many organisms around the world, including humans. And this is just one example.

Other externalities, some on a much smaller scale, also affect many people. When a parade is being organized on your street, you might have trouble finding a parking spot and will likely find a lot of litter the next morning. These are externalities of the parade. When a power station emits black fumes, it pollutes the air breathed by all the people who live and work nearby.

From the point of view of economic theory, the problem with the externalities is somewhat similar to the problem of public goods – the individual rationality is at odds with what is best from the social point of view. But an additional problem lies at the fact that the people and organizations that produce the externalities do not experience their effects directly. For parade organizers, your problems with litter are your problems that do not affect the success of the parade. Perversely, they might be viewed as proof that the parade was a success, because it had many participants. For the power station, air quality does not enter its profit and loss account. Management cares only about the prices of coal and the energy it produces.

Finding solutions

Many people have tried to find a way out of this problem. One of the solutions is to introduce laws ensuring that social costs are felt by the producers of the externalities. For example, a local government might make permission for the parade conditional on committing to cleaning the area afterwards. Some countries introduce tradable pollution rights. Companies are allowed to pollute a certain amount, but they can sell and buy pollution permits, so it becomes profitable to pollute less to save money. In the next week, we will talk more about how to solve problems in which social and individual rationalities are at odds.

If you want to read more about real-life examples of resource depletion, the related externalities, and some ideas for solving the resulting problems you can explore this website.