What precisely is bad about externalities?

External question — Economics Stack Exchange Author: Craig Duncan Original post: https://economics.stackexchange.com/questions/58230 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. I'm a layperson with some (long ago) college economics under my belt who is curious about externalities. In particular, why are externalities bad? Intuitively I personally agree externalities are "market failures," but I'm wondering what precise sense can be made of this claim. Why exactly are externalities market failures? I had thought that externalities are necessarily inefficient (i.e. Pareto inefficient). But a helpful recent stack exchange discussion disabused me of that notion. Perhaps externalities are bad simply because, while they are not necessarily inefficient, they are typically inefficient? Is THAT the best that can be said in explanation of why externalities = market failures? Or can we say something more, such as the following? In an ideal economy, prices will reflect the full costs of production and the full benefits of consumption. So, if there are costs/benefits outside of the price mechanism, then this is sub-optimal, i.e. a market failure. Is that the reason externalities are market failures? (Side note: And if so, is that too demanding an ideal? Production and consumption surely have countless indirect costs and benefits, and it seems to me infeasible to dream of internalizing all of them so that they're reflected in the price of goods.) A final thought: Intuitively, when students are taught about negative externalities via the standard example of pollution, my guess is that the most students intuitively think, "Right, it's unfair of that factory to foist pollution costs on others while reaping the benefits of cheaper production for themselves." And personally, I agree that "privatize the profits, socialize the costs" is indeed unfair. But I don't think that unfairness is what economists have foremost in mind when they label externalities as "market failures." Right? In short, is there a consensus view among economists as to precisely why externalities should be deemed a market failure?

External answer — Economics Stack Exchange Author: 1muflon1 Original post: https://economics.stackexchange.com/a/58231 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. In particular, why are externalities bad? This is a non-economics question. Economics cannot say if something can be good or bad. For that you need moral philosophy. For example, if some economic policy would result in death of billions of people, can we, from pure economic perspective, say it is bad? No, we cannot do that because economics has no tools to distinguish between good or bad. We can use moral philosophy to determine if that policy is good or bad but not economics itself. Intuitively I personally agree externalities are "market failures," but I'm wondering what precise sense can be made of this claim. Why exactly are externalities market failures? A definition of market failure is a situation when (Hindriks and Myles Intermediate Public Economics 2nd ed pp 42); ... any of the assumptions underlying the competitive economy fail to be met and as a consequence efficiency is not achieved ... Externalities; violate the assumption underlaying competitive/perfect market. One of the assumptions of such market is that there are no externalities. externalities can be shown to allocative inefficiency. That is the goods in market will no longer be allocated to the people who value them most, because in case of externalities price no longer reflects the true costs of a good (e.g. environmental pollution creates cost to society, but in absence of property rights to clean air, price does not reflect this societal cost as opposed to other costs, such as use of labor or natural resources that are reflected in the price). I had thought that externalities are necessarily inefficient (i.e. Pareto inefficient). But a helpful recent stack exchange discussion disabused me of that notion. Perhaps externalities are bad simply because, while they are not necessarily inefficient, they are typically inefficient? Note pareto efficiency is not necessarily exactly the same as allocative efficiency (see this Lumen learning article for further explanation). Hence this is a moot point, something can lead to Pareto inefficient outcomes and not be market failure. A final thought: Intuitively, when students are taught about negative externalities via the standard example of pollution, my guess is that the most students intuitively think, "Right, it's unfair of that factory to foist pollution costs on others while reaping the benefits of cheaper production for themselves." No this is not correct. I do not know of any serious mainstream economics textbook that would claim that this is unfair. Economics has no tools to determine whether something is fair or unfair. Not paying for societal and environmental costs for production might be completely fair or unfair depending on various moral arguments. Economics as a subject has no special insights into the morality of such action and it can at best quantify the effects in terms of economic efficiency or lost utility compared to counterfactuals etc. But I don't think that unfairness is what economists have foremost in mind when they label externalities as "market failures." Right? Exactly, economists do not care about fairness in their professional capacity. Of course every economist is also a person and has their own moral philosophy, but a professional economist would not label something fair or unfair based on economic analysis/research per se. Economic research could be used as an input into deciding whether something is fair or unfair (e.g. when dealing with some consequentialist ethics you need to also know objective consequences of actions before deciding on their morality/fairness). In short, is there a consensus view among economists as to precisely why externalities should be deemed a market failure? Yes, as mentioned above it is because; they are violation of standard assumptions of perfect/competitive market. they lead to allocative inefficiency. This is not as much matter of consensus as matter of definition (e.g. 2 is not prime because of consensus per se but because primes are simply defined in a such a way that 2 qualifies as prime). An externality simply satisfies the commonly accepted definition of market failure. If you would change definition of market failure it might stop qualifying, but the definition I used is broadly used in economics profession.

External answer — Economics Stack Exchange Author: BB King Original post: https://economics.stackexchange.com/a/60595 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. Externalities are a market failure, because in the absence of externalities (and other market failures) then (free) markets generate efficient allocations through the price mechanism. In a perfect market, the market allocation will equal the social optimum as desired by a benevolent social planner. If I start from a perfect market in my model and introduce an externality then the market optimum no longer equals the social planner's optimum. Therefore the externality causes the market to fail to produce the socially optimal (efficient) allocation and is therefore a market failure. As an over-simplified example: take a market with two firms. The social planner wants efficiency, which means she wants the social marginal cost of actions to equal the social marginal benefit. Fun fact, each individual firm wants their private marginal cost to equal their private marginal benefit anyway when they optimize in the market. Without externalities, the social marginal cost and benefit respectively "equal" the sum of the private marginal costs and benefits of the firms, which they are equalizing anyway. So all good. If there is an externality, this is no longer the case. Assume now only one firm pollutes, which negatively affects the other firm. The social marginal cost is now each firms' marginal cost from before + the pollution. But the polluting firm only considers the effects of pollution on itself. It does not care / take into account its pollution's effects on the other firm (why would it care, this is a market where private firms are free to do what they want and maximize their own profit). Suppose the pollution effect is spread 50-50 among both firms. Firm 1 then considers its own problems, so accounts for 50% of the pollution that is affecting itself. Firm 2 is not polluting anyway and can't do anything about firm 1 polluting. So, then only 50% of the pollution is being taken into account by the "free market". So now the marginal cost that the free market is taking into account is "marginal cost firm 1 + marginal cost firm 2 + 50%*pollution". This does not equal the social optimal = "marginal cost 1 + marginal cost 2 + 100%*pollution". So the market fails to produce the social optimum. How to solve externalities: Make sure firm 1 internalizes the full cost. I.e. if firm one takes into account 100% of the pollution cost (e.g. by a tax), then all good, the market is back to the social optimum. Note: You don't really "sum" marginal costs this way mathematically, but the logic carries through.