Public and private approaches to controlling externalities

The problem both approaches address. An externality is an effect of one party's action on others for which it is neither paid nor penalised, and no market exists in which that effect is bought or sold. Because the person acting ignores the harm (or benefit) to others, a negative externality leads to too much of the activity and a positive one to too little. Both approaches try to make the decision maker take the effect on others into account.

Public and private approaches distinguished.

Example of a public approach: a tax that discourages, a subsidy that encourages. A government that wants less of an activity can tax it, and one that wants more can subsidise it, because people respond to incentives: taxes on producers and consumers discourage goods such as alcohol, and subsidies encourage goods such as education. Applied to an externality, the tax is set on the activity that harms others. Our example: sugar mills in western Uttar Pradesh discharge waste into a river used by farmers downstream. If the state charges each mill a fee for every tonne of waste it discharges, roughly equal to the damage that tonne does, the mill now pays for the harm it causes. It cuts its discharge to the point where treating one more tonne costs more than the fee, so the externality is brought inside its own costs. On the positive side, a subsidy for vaccination or schooling pays people for the benefit their action gives to others, so more of it takes place.

Example of a private approach: defining property rights. Where an externality comes from a resource that no one owns, the problem can be solved by defining property rights, which give an owner the authority to exclude others; once rights are clear, the market itself can reach an efficient outcome. Our example: a patch of village forest in the Western Ghats is open to everyone, and each household that cuts wood ignores that the trees it takes leave less for the others, so the forest is cut faster than it can regrow, the commons problem. If the forest department hands the rights over that patch to the village's forest committee, the committee bears the whole cost of overcutting and gains the whole benefit of restraint. It sets how many trees may be cut each year, and an outsider who wants wood must pay it, so the price of wood-cutting now reflects its true cost. No tax or rule from the state is needed once the right is assigned; the parties settle use among themselves.

Conclusion. The public approach corrects an externality from outside, through the state's taxes, subsidies and rules; the private approach corrects it from inside, by giving someone ownership and letting the affected parties bargain. The private route works best when rights can be defined and few parties are involved; the public route is needed when many people are affected and bargaining among them is impractical.