Question

Give and example of a negative or a positive externality. What type of Pigovian solution would you propose to equalize the private and social cost or benefit? Can a private solution be reached (following the ideas of Ronald Cause?) Why or why not?

Answer 1

Example of a Negative Product Externality.

Suppose there is a steel manufacturing firm which dumps its chemical waste in a river flowing nearby. There is another fishery firm which catches fishes and sells it. The chemical which the steel firm releases into water destroys the aquatic life including the fishes. This is an apparent problem for the fishery firm whose profits are diminished by the actions of the steel manufacturing firm. This is a case of negative production externality.

Here Private Cost of the steel firm which it bears is less than the social cost of its action. Pigouvian Tax is imposed in this case of the amount equal to the difference between the social and private cost on the steel firm so that its private costs and social costs are now equal. This is how this problem of Negative Product Externality is eliminated.

If Property rights are defined and there is not bargaining and transaction cost involved, then a private solution can be reached between the two firms mentioned above through bargaining as per the Coase Theroem.