Question

What types of regulatory fixes are possible for negative externalities? Which two would economists give a thumbs up to? What is the MAIN reason that negative externalities are a problem?

Answer 1

Negative externality occurs when a third party which is not involved in business incurs damage.

Regulatory fixes for negative externality could be taxes, or the parties involved in transaction need to pay for the damages of the third party.

The economists would prefers

Internalising the third party which has incurred damages. Eg: a chemical factory releasing waste in water bodies and harming the fishes or aquatic life in water bodies should be made to include our buy the fisheries firm. In this way the chemical factory would have to bear the costs for the damages to the aquatic life and this would help reduce the negative externality.

Another example could be well defined property rights. Generally in developing countries the property rights are not well defined. This leads to negative Externalities because in absence is such rights , no one is bound to compensate the another.

Eg: if a non smoker had the right to clean air, then smoker would either compensate him for polluting the air or would not be able to pollute the air.

This would cause reduction in negative externality and establishing property rights ie who pays to whom. Other way round, if the smoker has the right to pollute, the non smoker would pay for clean air.

Another way is through taxes .The government Can tax the party causing the negative externality and could restrict the quantity produced. In this way when limited quantity is available at a higher price, the externality could reduce because less of it would be available in the market .

Main reasons negative externality is a problem

Negative externality is a problem because the costs which the society as a whole incur are not included in the costs of the firm. This leads to market distortion and inefficient outcomes .

Eg: a firm polluting the water bodies would not take into account the damages done to the aquatic life and the life of people depending on it. This causes inefficient outcomes since the whole cost is not being taken into consideration.

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