Market-based policies to remove the inefficiency caused by externalities

Why externalities cause inefficiency. An externality is a benefit or a harm that a firm or a person causes to others for which it is neither paid nor penalised; no market exists in which that effect is bought or sold. Because the decision maker leaves the effect on others out of account:

• a negative externality leads to too much of the activity, since each user ignores the harm done to others;
• a positive externality leads to too little, since those who benefit without paying cannot be charged, and the activity is under-supplied.

In both cases the market quantity differs from the quantity that is best for society, which is the inefficiency the policy must correct.

What makes a policy market-based. A market-based policy does not order anyone to produce or consume a fixed amount. It changes the price, the incentive, that people face and then leaves each of them free to decide. It works because people respond to incentives: a tax discourages the production and consumption of a good, and a subsidy encourages it. The aim is to make the price each person pays include the effect of her action on others, so that her own choice takes that effect into account.

Policy 1: a corrective tax on a harmful activity.

• How it works. The government levies a tax on each unit of the activity that harms others. Certain taxes are levied precisely to discourage the production and consumption of goods such as tobacco or petrol. With the tax, buyers pay more and sellers receive less, so the quantity falls.
• Size. The tax works best when it is close to the harm one more unit does to others. The polluter then pays for that harm as if it were any other cost, and cuts back only where doing so costs less than the tax.
• Our example. Suppose Tamil Nadu charges each dyeing unit in Tiruppur a fee for every kilolitre of untreated effluent it releases into the Noyyal river. A unit that can treat its effluent cheaply does so and pays little; one for which treatment is costly pays the fee. Pollution falls, and it falls most where cutting it is cheapest.

Policy 2: a subsidy for a beneficial activity.

• How it works. Where an activity benefits others, the government pays a subsidy to its producers or consumers, which encourages more of it. Those who act are now rewarded for part of the benefit they give to others, so the activity rises towards the level that is best for society.
• Our example. A farmer who plants trees along his field boundaries in Haryana reduces dust and soil loss for his neighbours too. A grant per tree that survives three years makes planting worth his while even though the neighbours pay nothing.

Policy 3: defining property rights and charging for use.

• How it works. Many externalities arise from a shared resource that no one owns, such as a pond, a forest or the air, where each user ignores the loss he imposes on the rest. Defining property rights gives someone the authority to exclude others; once rights are clearly defined, the market itself can bring use to an efficient level. The holder of the rights can charge for use, or the right to use the resource can be auctioned.
• Why it is market-based. The government only sets the rights; the price of using the resource is then settled by buyers and sellers of those rights. Users who gain most from the resource pay for it, and others use less.
• Our example. A state that treats the right to mine sand from a river as property can auction yearly licences for a fixed tonnage. Contractors who value the sand most buy the licences, and the total taken is kept to what the river can bear.

Conclusion. Externalities make the market produce too much of harmful activities and too little of beneficial ones, because the decision maker ignores the effect on others. Market-based policies correct this through prices rather than orders: a corrective tax on harmful activities, a subsidy for beneficial ones, and clearly defined property rights, with charges or auctions for the use of shared resources. Each makes people bear, or be paid for, the effects of their actions on others, and leaves them free to decide how best to respond.