If tickets were sold for a fireworks display, who would buy them, since anyone can watch the fireworks without paying for a ticket. If a steel foundry creates polluting chemicals when it makes steel, and if it could simply dump the chemicals into the creek that runs by it, it would do so because it would be cost-free. Disposing of the chemicals in an environmentally safe way would be costly and it would not be necessary in the production of steel. Nonetheless, many people would suffer from the pollution who have no interest in buying steel. These are examples of externalities, where benefits and costs to the economy as a whole are not reflected in the market price of the good or service causing the externality.

Externalities (aka spillovers) are the benefits or costs of a product or its manufacture that affect people external to the market for the product — hence, the name. A positive externality (aka spillover benefit) has beneficial effects, such as the higher education that a segment of society attains which benefits the whole economy, while a negative externality (aka spillover cost) has negative effects, of which the most common example is pollution. The manufacture of most products creates pollution, yet, without government intervention, the cost of that pollution is not factored into the product price, harming everyone, even those not participating in the market.

Under certain circumstances, negative externalities can be remedied through private negotiations. Coase externalities are externalities that — according to the Coase theorem, named after Ronald Coase, the economist who presented the idea — can be prevented or compensated where property ownership is clearly defined, the number of people involved is small, and negotiation costs are low.

For instance, suppose a landowner puts wind turbines on his land, but the noise bothers his neighbors. The noise is a negative externality since his neighbors suffer from the noise but they are not compensated for it. Since he receives a rent for the placement of the windmills on his land, he can share some of that rent with his neighbors to compensate them for the noise. The fact that his neighbors could probably sue him for the nuisance would be another factor to increase his willingness to compensate them. This would be considered a Coase externality, since property rights are clearly defined, and the people affected are few enough so that private negotiations could lead to a settlement.

Other methods of reducing negative externalities include the support of charities, such as the Sierra Club, that can be supported by private parties with tax-deductible contributions and by allowing anyone affected by the negative externality to sue its source. For instance, the Clean Air Act allows citizens or the EPA to sue polluters.

However, most negative externalities are widespread, affecting many people, so they cannot be remedied by private parties. Instead, governments pass laws to mitigate the effects of negative externalities and have even created separate agencies to deal specifically with the problem. For instance, the federal government has the Environmental Protection Agency which promulgates rules to curb pollution and requires polluters to clean up their pollution. States also have their own environmental departments.

Promoting Positive Externalities and Reducing Negative Externalities

The people will be better off if positive externalities are promoted and negative externalities are reduced. Since private parties cannot profit from externalities, governments must use laws and taxes to achieve these goals.

Governments have several methods to reduce the effects of negative externalities and to promote positive externalities. The quantity of goods with negative externalities exceeds what the market equilibrium would be if the cost of the negative externality was factored into the product price. On the other hand, the quantity of goods with positive externalities is less than what is socially desirable, since the people who enjoy the benefits of the product but who do not participate in the market do not affect the market quantity. The government can remedy these situations by taxing products with negative externalities and subsidizing products with positive externalities.

Government intervention can be divided into 2 types of actions: command-and-control policies that regulate actions directly and market-based policies that provide incentives so that the self-interest of the market participants would achieve the socially optimized solution.

Direct controls are a type of command-and-control policy that prohibits specific activities that create negative externalities or that require that the negative externality be limited to a certain level, such as limiting emissions in smokestacks or tailpipes, or limiting toxic wastes, with specific procedures to clean it up.

The government can promote positive externalities by paying subsidies to either buyers or producers, which is a type of market-based policy. Subsidies to buyers would lower the cost of the product, which would increase demand. Subsidies to producers would lower their cost of production, thereby increasing supply. The government may also decide that the cost of an externality is great enough to make it a public good, where the government pays outright for its production, such as vaccinations against contagious diseases, like smallpox or polio.

Most government subsidies consists of tax breaks for either the buyers or the suppliers. Education, for instance, has many positive externalities, and the government subsidizes it by giving tax breaks for people who save for college. Because technology has large spillover benefits, the government sometimes forms an industrial policy that promotes specific technologies that would have the greatest benefit to society. However, industrial policies are often criticized because they require that the government pick winners and losers and, as often happens in governments where the legislators are more interested in money than in the well-being of their country, well-financed lobbyists often control how the money is allocated.

Another common market-based policy to reduce negative externalities is by assessing a corrective tax, a tax that internalizes the externality by incorporating it as a cost of production. Corrective taxes are also known as Pigovian taxes, named after the economist Arthur Pigou, an early advocate of their use. The primary advantage of corrective taxes over regulation is that companies have an incentive only to satisfy the regulation, whereas corrective taxes will incentivize companies to continually reduce their negative externalities to lower their costs.

One of the best examples to show the superiority of a market-based policy over that of a command-and-control policy is how the government has attempted to regulate the fuel economy of motor vehicles. The government has consistently used an average-miles-per-gallon goal that automobile manufacturers must obtain by a certain year. However, because the rules are often complex, they can often be circumvented, which reduces their efficacy. Such was the case when the auto manufacturers moved production to big trucks and SUVs because they were more profitable and because the efficiency standards at the time did not apply to vehicles built on a truck frame.

A better solution is simply to increase gasoline taxes, which would motivate many people and businesses to reduce their consumption of gasoline. People would find many creative solutions that would otherwise not be sought if the government simply stipulated how things should be done. Furthermore, people would continually strive to reduce their gasoline expense, whereas the auto manufacturers would just satisfy the law. Gasoline taxes would also reduce congestion, accidents, and pollution by motivating people to drive slower and to drive less — fuel economy regulations would have no such effect.

Of course, politicians will not raise gasoline taxes because it is not politically viable. However, it may be viable by offering to pay the tax back to the people. Then they can decide whether they want to put it back into their gasoline tank or cut their consumption of gasoline so that they can spend the money for other things. Over time, people will buy more fuel-efficient vehicles and find other ways to cut back on gasoline consumption so that they can keep the money.

Another benefit to taxing gasoline instead of regulating auto manufacturers to improve their fuel economy is the simplification of the legal code. The government doesn't have to pass any new laws except for the tax, and lawyers wouldn't be able to circumvent the tax. Indeed, economic efficiency would be increased because it would eliminate the economically worthless work done by lawyers to circumvent the law.

Markets for Negative Externalities

Another solution to limit negative externalities is by creating a market for the right to create the negative externality. One such market currently being created is for the right to pollute. Overall, the government first determines how much pollution it deems safe, then it issues a quantity of pollution rights for a specific price or distributes a set quantity to companies that need it. If it is too costly for a company to pollute less than what it has rights for, then it can purchase additional rights from companies with more than what they need, or they can purchase anti-pollution devices to reduce pollution. Because the quantity of pollution rights is limited, pollution rights can also be bought by people interested in conservation, forcing companies to lower the amount of their pollution.

For instance, the addition of the 1990 amendments to the Clean Air Act allowed companies to trade with what the EPA calls allowances for sulfur dioxide (SO2) pollution, which causes acid rain. Polluters are allowed so many allowances, which they can trade or sell to other utilities either through private negotiations or through EPA auctions, or they can save the allowances for the right to emit sulfur dioxide in future years. There is also an Opt-in Program that allows pollution sources that are not required to participate in the Acid Rain Program to voluntarily join, so that they can sell their allowances to other polluters. Anyone, including investors and brokers, can also purchase allowances to sell to polluters who need them.

The socially optimal amount of a negative externality is where the marginal benefit of further reducing the negative externality equals its marginal cost. Of course, it would be desirable to eliminate all negative externalities, but the marginal cost would increase exponentially as the remaining negative externality approaches zero. For instance, although pollution is undesirable, the cost of containing it or cleaning it up increases considerably as the amount of remaining pollution becomes less and less. Cleaning the environment further becomes increasingly expensive for a progressively smaller benefit.