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Consumption Externalities and the Role of Government: The Case of Alcohol - WP 02/25

2  Solutions to Address Externalities

This section considers mechanisms to address externalities. The paper sets out a framework of factors that policy makers should take into account when considering externalities.

2.1  Property Rights

Some economists argue that externalities result only from a failure to specify or enforce rights to private property. Under this view external costs are failures to maintain a fully free market, rather then defects of the market.[2]

It is argued that externalities that do not result from unspecified or non-privately allocated property rights have no policy relevance, as they do not affect the workings of the market economy. Where property rights are fully allocated and enforced externalities are internalised, to the extent possible, through voluntary action such as trade of externalities or the charging of rental for scarce resources. In such a case only voluntary action can be expected to improve social welfare, particularly given the information constraints on government and the subjective nature of costs.[3]

An insight from this approach is that externalities may result from institutional structures (such as a public health system) that result in rights not being allocated privately. Thus, when addressing externalities the initial question should be whether it is desirable to reduce or eliminate the externalities through institutional change.

2.2  Trade and Transaction Costs

Coase (1988) also emphasises market solutions to the externality problem. Two aspects of Coase add to the discussion. The first is the emphasis on liability rather than property. The second is the role of transaction costs.

The Coase theorem argues that if liability rules with regard to the externality generating activity are established and agents can trade rights to generate the externality and bargaining is costless then an efficient allocation of resources will result if agents bargain rights to generate externalities, no matter which party is allocated the initial rights. The initial rights allocation affects the relative wealth of individuals. An example of this is neighbours bargaining over the use of property that affects both parties, such as the height of a house.

This implies that externalities themselves are not the cause of market failure. Where the conditions of the Coase theorem are met there is no rationale for government intervention.[4] Where possible the government should allow the market to internalise externalities by defining liability rules to allow trade. In relation to certain externalities social norms implicitly define rules that allow a non-government solution to the externality problem. For example people generally remove their hat in church.

A qualification to the theorem is that even when bargaining is costless, bargaining does not result in an efficient allocation of resources where the parties fail to take all costs or benefits into account. For example, if there is a specific tax on the externality generating good and the parties do not take into account the change in tax revenue when consumption changes, an efficient allocation of resources does not result from bargaining. Thus imposing a tax that would be optimal in a case where bargaining does not occur, may lead to inefficiency in a case where bargaining does occur.[5]

The focus on liability, rather than property, is preferable for two reasons. First, this means a trade approach can be used even in the case of some common resources, such as air. Second, liability defines property. For example, it is debatable whether the rights to land should include the right to absence of noise from neighbours. However, if there is a legal rule establishing liability for noise pollution there is no debate over who has the right.

Even where liability rules are defined there may be no (or little) trade in externalities due to high transaction costs associated with using the market. Transaction costs affect the final allocation of resources because they reduce the gains from bargaining. Where transaction costs are present agents do not fully take into account the externalities they generate. Transaction costs are likely to be high where it is difficult to obtain the information required to make the bargain, such as where a large number of people are affected by an externality, where there is no observable value for the externality, where it is difficult to monitor whether a bargain has been fulfilled or where it is difficult to identify people with whom to bargain.

Some economists argue that market failure occurs whenever transaction costs hinder trade, as this prevents achievement of the resource allocation that would be achieved if there were no transaction costs. Others argue that transaction costs are a cost like any other and thus never result in market failure. Where transaction costs result in action not taking place, all that one can conclude is that the benefits of such action are smaller than the costs, including transaction costs.[6]

An alternative approach is a comparative institutions approach. This approach compares the institutions of the market and the government in order to assess which institutional arrangement seems best able to cope with the economic problem. Under this approach market transaction costs and the costs of government action are distinguished from other costs such as production costs, as these are the costs associated with resource allocation. When there is a form of resource allocation that can allocate resources more efficiently (in the sense of closer to the result that would be achieved in a zero transaction cost world) than the market when all costs are taken into account, then there is market failure and the alternative form of resource allocation is preferable.[7] In order to implement this approach one must make judgements as to the size of the costs associated with each form of resource allocation. This is the approach that the remainder of this paper takes.

In summary, when considering externalities the second question policy makers should ask is whether, if liability rules were defined, transaction costs would be low enough to make a trade solution desirable. Where transaction costs are high policy makers should consider whether there is an alternative form of resource allocation that can improve on the market result, when all costs are taken into account.


  • [2]Cordato (1992).
  • [3]Brownstein (1980).
  • [4]Arrow (1970) reaches a similar conclusion in a general equilibrium setting.
  • [5]See page 4 for the definition of an optimal tax.
  • [6]Brownstein (1980) p97.
  • [7]Demsetz (1973).
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