Externality and differences between the Pigovian and Cosian views - Essay Example

21 April Externality and Differences between the Pigovian and Cosian Views Economists provide different definitions of externality. A common definition of an externality is that it is present when the actions of one agent affect the other, in the absence of a market transaction (Wilkinson 475). Externalities can either be positive or negative. An example of a negative externality is when the fertilizer of a farmer affects downstream waters and kills some of the fishes that a fisherman seeks to gather. A positive externality occurs when a homeowner spends money on his properties, and as a result, increases property values in the neighborhood. This paper discusses externalities and compares and contrasts Pigovian and Cosian Views. Externalities can cause inefficient allocation of resources, because when a negative externality is present, we produce and consume too much of the product and consequently, over-allocate resources to production. For example, when the fisherman is not aware of the effect of the fertilizers on his livelihood, he exerts more time and energy to catch fishes that has a dwindling population. His resources are inefficiently allocated. When a positive externality is present, we produce and consume too little of the product, which leads to under-allocation of resources to production. For instance, if there is a positive externality that involves one homeowner improving his property, other homeowners might not be motivated to improve their own properties. There is under-allocation of resources. Over-allocation and under-allocation of resources evidently result to inefficient allocation of resources. Furthermore, the price system attains efficiency, if it rewards producers who can serve the customers well, mainly through providing the lowest possible prices (Baumol and Blinder 312). This system becomes faulty, when positive and negative externalities are not identified and integrated into the equation (Baumol and Blinder 312). There are diverse views on how to manage externalities. Some economists advocate for government intervention, while others want to rely on market mechanisms to correct externalities. When an externality causes the market to allocate resources inefficiently, the government can respond in one of two approaches: command-and-control policies or market-based policies (Mankiw 212). Command-and-control policies aim to regulate externalities directly by requiring or banning certain behaviors or actions (Mankiw 213). The government also uses subsidies to require positive behaviors that lead to positive externalities. Also, it is a crime to dump toxic wastes into the rivers. The costs of pollution and adversities to health and livelihood greatly exceed the benefits to the polluter. Still, it is not always easy to control and monitor all negative externalities. For instance, every transportation vehicle produces some sort of externality or pollution by-products and it will not be feasible to eradicate or ban them all. As a result, the government creates government agencies that develop and implement policies that protect the environment, such as the Environmental Protection Agency (EPA) of the U.S. Other forms of government intervention that regulates externalities are market-based policies. They seek to align private incentives with social efficiency (Mankiw 213). For instance, the government can internalize externality by taxing activities that produce negative externalities, or it can subsidize activities that generate positive externalities (Mankiw 213). Taxes that internalize negative externalities are called corrective taxes (Mankiw 213). They are also called Pigovian taxes, after the economist, Arthur Pigou, who is one of the first advocates of such taxes. An ideal corrective tax would equal the external costs of activities that lead to negative externalities, while an ideal corrective subsidy would equal the external benefit of activities that produce positive externalities (Mankiw 213). This paper proceeds to explore the similarities between Pigou and Coase, in terms of their discussions on externalities. Pigou developed an analysis of public goods and externalities and showed the importance of reallocating resources to enhance public welfare (Aslanbeigui and Medema 132). His approach to social cost is similar to Coase, but not in terminology. When the number of parties concerned is small (and so transaction costs are small), externalities could be externalized through private contracts, which both Coase and Pigou agree on (Aslanbeigui and Medema 132). But for public goods and externalities, where more people are involved and so transaction costs are large, there is a prima facie case for government intervention, according to Pigou (Aslanbeigui and Medema 132). Pigou, nevertheless, realizes that government inefficiency, corruption, administrative expenses, and distortion of market relations, should also be factored in (Aslanbeigui and Medema 132). Coase also agrees with Pigou that these factors will affect the proper reallocation of resources, when externalities are present (Aslanbeigui and Medema 132). They agree that the government has limited powers in completely handling externalities. Furthermore, even when government action is necessary, Pigou advocates taxes less heavily than his followers. For instance, he proposes public subsidies to industries that set up pollution control devices (Aslanbeigui and Medema 132). There are three main differences between Coase’s and Pigou’s views on externality. First, Coase argues that Pigou does not realize that externalities have a reciprocal nature (Aslanbeigui and Medema 133). When an externality is reciprocal, there is no need to implement government actions. Market conditions can correct externalities on its own. Second, Coase and Pigou share different policy goals. Coase argues that efficiency and maximization of the value of output are the main priorities (Aslanbeigui and Medema 132). He advocates conservative laissez-faire economics. Pigou is more interested in advancing higher output, but believes that this is part of the more important and larger social and moral agenda (Aslanbeigui and Medema 132). He believes that when efficiency is attained at the cost of lower-income groups, total welfare will be reduced (Aslanbeigui and Medema 132). Coase focuses on efficiency and only stresses that equal weights should be given to all individuals and activities; he overlooks distributional concerns (Aslanbeigui and Medema 132). He wants to concentrate on the disputes among producers and not the distribution of negative externalities across society. He agrees with other economists who are more concerned of production efficiency, unlike Pigou, who believes in the ethical responsibility of economists and the government in protecting social welfare. The third difference between Coase and Pigou lies in the policy implications of their recommendations. Coase and Pigou believe that the government is fallible and corrupt and can cause market distortions. Coase argues, on the one hand, that the market has the potential to resolve these externalities through making a market in externality rights or simply by living with market failures (Aslanbeigui and Medema 133). He argues that these solutions or actions are more superior to government interventions (Aslanbeigui and Medema 133). Pigou, on the other hand, asserts that government intervention can often, but not all the time, effectively enhance social welfare and can be designed to reduce its limitations (Aslanbeigui and Medema 133). He promotes an activist form of government intervention to enhance social welfare. Externalities, whether positive or negative, lead to inefficient allocation of resources, because negative externalities end up with over-allocation, while positive externalities promote under-allocation of resources. Pigou and Coase agree that the market can respond to externalities. However, Coase advocates the laissez-faire approach in terms of policymaking, while Pigou underscores the value of government intervention. Pigou also underlines the ethical necessity of government intervention, while Coase challenges it. Finally, Coase argues that externalities are reciprocal and can have market-based re-allocating mechanisms. Works Cited Aslanbeigui, Nahid and Steven G. Medema. Beyond the Dark Clouds: Pigou and Coase on Social Cost. Human Well-Being and Economic Goals. By Frank Ackerman. Washington, D.C.: Island Press, 1997. 132-134. Print. Baumol, William J. and Alan S. Blinder. Economics: Principles and Policy. Ohio: South-western Cengage, 2009. Print. Mankiw, N. Gregory. Principles of Microeconomics, Volume 10. 4th ed. Ohio: South-western Cengage, 2007. Print. Wilkinson, Nick. Managerial Economics: A Problem-Solving Approach. New York: Cambridge University Press, 2005. Print. Read More