Question

Define the term externalities. Include both positive and negative. Discuss externalities as argued by Prof Ronald Coase in the Problem of Social cost.

Answer 1

Externality refers to a consequence of an economic activity that affects a third party but this consequence is not reflected in the market price. It can be divided Into positive and negative externality. Positive externality refers to benefits(MEB) enjoyed by the third party as a result of a firm's action but for which the party has made no payment. Example- park, inoculations. Negative externality refers to negatives costs or consequences faced by a third party due to the firm's or individual's action as induced when the MEC(marginal external cost ) is not taken into consideration. Example - smoking, noise pollution, discharge of effluents into a nearby river

According to Ronald Coase, the problem to be examined was that actions of business firms were having a harmful effect and most studies analyzed it with respect to social and private cost from the Pigovian view hence the solution was to tax the factory owner but according to Coase this is inappropriate as traditionally A causes harm to B then A is made liable but the real question is whether A should be allowed to harm B or B to harm A.Hence he uses Stigler's example of contamination of stream and stresses on the fact that is the value of the fish grater or less than the value of the product which the contamination makes possible. Hence his view on externality is that bargaining will allow parties to effectively and efficiently address externalities but this is possible only under certain conditions like low transaction cost, perfect information, and well-defined property rights. For instance, if we take an example of a farmer and rancher, now if the rancher's cattle destroy the farmer's crop then the farmer can bargain with the rancher to come up with an efficient solution hence requiring no government intervention.