“PIGOVIAN TAX’’ By Arthur Pigou
A Pigovian tax (also spelled Pigouvian tax) is a tax levied on a market activity that generates
negative externalities. The tax is intended to correct the market outcome. In the presence of
negative externalities, the social cost of a market activity is not covered by the private cost of the
activity. In such a case, the market outcome is not efficient and may lead to over-consumption of
the product. A Pigovian tax equal to the negative externality is thought to correct the market
outcome back to efficiency.
In the presence of positive externalities, i.e., public benefits from a market activity, the market tends
to under-supply the product. Similar logic suggests the creation of Pigovian subsidies to increase
the market activity.
Pigovian taxes are named after economist Arthur Pigou who also developed the concept of
economic externalities. William Baumol was instrumental in framing Pigou's work in modern
economics.
What are Pigovian Taxes
A pigovian tax is a tax placed on a negative externality to correct for a market failure. For example, a
factory does not take financially take into account the damage their emissions cause to the air, since
there is no market for air pollution. By imposing a Pigouvian Tax a government can artifically create a
cost for such activity - ideally a cost equal to what the price would be had a market for such activity
existed. In a country like Canada with socialized medicine, the cigarette tax atcs as a Pigovian tax - it
(more than) raises the revenue necessary to offset the expense to the health care system generated by
smoking.
Why I Support Pigovian Taxes
One of the uses of taxes is to discourage activity that has negative externalities, or we believe is
otherwise economically/socially harmful. That's why these 'sin' taxes exist - they discourage people from
smoking and drinking. It's also argument often put forward by those in favour of marijuana legalization -
that a better and more cost-effective way of detering usage would be to legalize marijuana and tax it
rather heavily.
These taxes also raise revenue for the state. In 2004-2005, the Canadian government collected $16.7
billion in "other" taxes, which were largely Pigovian taxes such as energy taxes and excise taxes on
cigarettes and alcohol.
Since taxes deter the activity that is being taxed, then why in the world would we ever tax income? Don't
we want to encourage hard work and entrepreunership? Yet in Canada, over 45 percent of federal
government revenue comes from personal income taxes and 15 percent comes from corporate income
taxes.
I've been rather hard on the supporters of the FairTax, but they have the right idea. Taxing activities we
wish to encourage (work) does not make a great deal of sense when we can tax acitivities we are not as
interested in promoting (consumption). The FairTaxers take it too far - the amount of revenue needed to
finance all the government programs we value cannot be generated by simply a consumption tax alone.
But the basic idea is sound.
I live in the Southwestern Ontario region of Canada, an area with perhaps the poorest air quality in all of
the country. Each year we have a record number of smog days. Wouldn't it make sense that we try to
discourage the use of electricity generated from coal and the use of fossil fuels? Yes, this would have
negative effects on the economy in isolation, but if we used the revenue generated from such a tax to
lower employment insurance premiums or income tax rates, it's likely that the net economic effect would
be positive.
Yes, we can go too far with Pigovian taxes. For instance, we could charge a level of Pigovian tax far in
excess of the damage caused by air pollution. But can anyone claim that we have the current optimum
level of work? The optimum level of investment? The optimum level of savings? If we are forced to
overtax something, and we are given the cost of running government, air pollution seems like the best
place to start.
It's true that Pigovian taxes tend to be regressive in the sense that they cause the poor to pay a higher
proportion of their income on them than the rich. While this doesn't seem to bother many when we
discuss raising the taxes on cigarettes, the overall effect of increased use of Pigovian taxes would cause a
level of regressivity that Canadians are uncomfortable with. This regressivity effect can be eliminated
through bundling Pigovian taxes with some form of negative income tax, like the U.S. Earned Income Tax
Credit, such that average tax rates remain progressive.
With so many advantages, I full-heartedly support the increased use of Pigovian taxes in Canada or any
other country. While I'm not a famous well-respected economist like Dr. Mankiw, I would still like to ask
for a membership into his club.
Workings of Pigovian tax
A pigovian tax is considered[by whom?] one of the "traditional" means of bringing a modicum of market
forces, and thus better market efficiency, to economic situations where externality problems exist.
More recently, particularly in the United States since the late 1970s, and in other developed nations
since the 1980s, an alternative to Pigovian taxation has arisen: the creation of a market for
"pollution rights." Pollution rights markets are not generally more efficient than Pigovian taxes but
are often more appealing to policy makers because giving out the rights for free (or at less than
market price) allows polluters to lose less profits or even gain profits (by selling their rights)
relative to the unaltered market case. Markets for emissions trading have been set up to bring better
allocative efficiency and improved information sharing to the pollution externality problem.
Pollution rights markets are a part of the field of Environmental Economics generally, and Free-
market environmentalism specifically.
One difficulty with Pigovian taxes is calculating what level of tax will counterbalance the negative
externality. Political factors such as lobbying of government by polluters may also tend to reduce
the level of the tax levied, which will tend to reduce the mitigating effect of the tax; lobbying of
government by special interests who calculate the negative utility of the externality higher than
others may also tend to increase the level of the tax levied, which will tend to result in a sub-optimal
level of production.
Pigovian tax effect on output.
The diagram illustrates the working of a Pigovian tax. A tax shifts the marginal private cost curve
up by the amount of the tax. Faced with this cost increase, the producers have an incentive to reduce
output to the socially optimum level by reducing the marginal externality to the marginal tax. The
total tax revenue (which could be used to mitigate the effect of the negative externality) is equal to
the size of the tax times the new output (the shaded area).
A key problem with the Pigovian tax is the "knowledge problem" suggested in Pigou's essay "Some
Aspects of the Welfare State" (1954) where he writes, "It must be confessed, however, that we
seldom know enough to decide in what fields and to what extent the State, on account of [the gaps
between private and public costs] could interfere with individual choice." In other words, the
economist's blackboard "model" assumes knowledge we don't possess — it's a model with assumed
"givens" which are in fact not given to anyone. Friedrich Hayek would argue that this is knowledge
which could not be provided as a "given" by any "method" yet discovered, due to insuperable
cognitive limits; chaos theory argues for other cognitive limitations.
Aside from efficiency, Pigovian taxes may increase the fairness of how costs of negative
externalities are borne. For example, even if a tax on air pollution is not at the perfect level to
achieve optimal efficiency, it transfers cost associated with pollution from the public (e.g., via
reduction of other taxes or benefit from public spending of the pollution tax proceeds) to the
polluter.
Like all taxes, Pigovian taxes can encourage smuggling and black markets, especially if they create
large differences in the price of popular products in neighboring jurisdictions, yet another reason
why Global Cooperation becomes key. If lower income individuals tend to spend a greater portion
of their income on the product with external social costs, such as cigarettes or electricity, then the
corresponding Pigovian tax is regressive.
[edit] Pollution taxes
The alternative, regulation, is viewed as having a higher cost to society because Pigovian taxes raise
revenue and respond automatically to changes in the market such as lowered cost of production or
pollution mitigation. With a Pigovian tax there is always an incentive to reduce pollution, whereas
with direct regulation, a polluting company has no incentive to pollute any less than what is
allowable.
Economic theory[which?] predicts that in an economy where the cost of reaching mutual agreement
between parties is high, and where pollution is diffuse, Pigovian taxes will be an efficient way to
promote the public interest, and will lead to an improvement of the quality of life measured by the
Genuine Progress Indicator and other human economic indicators, as well as higher gross domestic
product (GDP) growth.
Economic theory[which?] predicts that, under certain conditions, a double dividend could appear. The
first is the reduction of pollution. The second consists in the recycling of the government revenue
from the green tax. If the government keeps its revenue constant, some other taxes have to be cut
(see Green tax shift). If the government chooses to cut distortional taxes, the costs of the swap to
green taxes would be negative.
Research on green taxation suggest that during the 1990s there was significant correlation between
a country's UN Human Development Index (HDI) rank per fixed amount of GDP, and its level of
green tax as a percentage of total tax revenues.[citation needed] Furthermore, over periods longer than 5
years, data suggest that countries having higher green tax rates such as Norway, Sweden and
Netherlands experience higher GDP growth and higher HDI growth rate.[citation needed] However, these
studies only show a correlation between green tax rates and higher GDP/HDI growth, not a causal
effect.
[edit] Negative Pigovian tax (Pigovian subsidy)
If there are positive externalities instead of negative externalities, one would want to encourage
these behaviors by subsidizing them instead of taxing them. For instance, education is often
subsidized by government because it is believed to have positive externalities. Such subsidies of
goods with positive externalities can be considered a "negative Pigovian tax".
The motivation for such a subsidy is trying to reach economic efficiency. When a positive
externality is present, a firm's solution of its utility maximization problem does not account for the
additional utility (to another agent) produced as a by-product (the externality), thus causing the firm
to produce less than the pareto-efficient level. The Pigovian subsidy thus internalizes the externality
into the agent's utility function, by giving the firm incentive to produce more than it otherwise
would.
An example would be a central government transfer that accounts for interjurisdictional spillover
(usually in the form of matching grants).
[edit] Prohibition
Sometimes Pigovian analysis leads to the conclusion that the socially efficient level of consumption
is zero, when marginal social cost exceeds marginal private benefit from the outset. This analysis
has been used by some researchers to rationalize prohibition of drugs. However, the validity of such
claims has been disputed, as many factors make the calibration of external cost of drug use
uncertain.[2] Even if the most efficient level of consumption were zero, such a level may not be
practically achieved with prohibition, and prohibitions can generate their own social costs as well.
In economics, an externality (or transaction spillover) is a cost or benefit, not transmitted through
prices[1], incurred by a party who did not agree to the action causing the cost or benefit. A benefit in
this case is called a positive externality or external benefit, while a cost is called a negative
externality or external cost.
In these cases in a competitive market, prices do not reflect the full costs or benefits of producing or
consuming a product or service, producers and consumers may either not bear all of the costs or not
reap all of the benefits of the economic activity, and too much or too little of the good will be
produced or consumed in terms of overall costs and benefits to society. For example, manufacturing
that causes air pollution imposes costs on the whole society, while fire-proofing a home improves
the fire safety of neighbors. If there exist external costs such as pollution, the good will be
overproduced by a competitive market, as the producer does not take into account the external costs
when producing the good. If there are external benefits, such as in areas of education or public
safety, too little of the good would be produced by private markets as producers and buyers do not
take into account the external benefits to others. Here, overall cost and benefit to society is defined
as the sum of the economic benefits and costs for all parties involved.
Standard economic theory states that any voluntary exchange is mutually beneficial to both parties
involved in the trade. This is because either the buyer or the seller would refuse the trade, if it won't
benefit both. However, an exchange can cause additional effects on third parties. From the
perspective of those affected, these effects may be negative (pollution from a factory), or positive
(honey bees that pollinate the garden). Welfare economics has shown that the existence of
externalities results in outcomes that are not socially optimal. Those who suffer from external costs
do so involuntarily, while those who enjoy external benefits do so at no cost.
A voluntary exchange may reduce societal welfare if external costs exist. The person who is
affected by the negative externality in the case of air pollution will see it as lowered utility: either
subjective displeasure or potentially explicit costs, such as higher medical expenses. The externality
may even be seen as a trespass on their lungs, violating their property rights. Thus, an external cost
may pose an ethical or political problem. Alternatively, it might be seen as a case of poorly defined
property rights, as with, for example, pollution of bodies of water that may belong to no-one (either
figuratively, in the case of publicly-owned, or literally, in some countries and/or legal traditions).
On the other hand, a positive externality would increase the utility of third parties at no cost to
them. Since collective societal welfare is improved, but the providers have no way of monetizing
the benefit, less of the good will be produced than would be optimal for society as a whole. Goods
with positive externalities include education (believed to increase societal productivity and well-
being; but controversial, as these benefits may be internalized), public health initiatives (which may
reduce the health risks and costs for third parties for such things as transmittable diseases) and law
enforcement. Positive externalities are often associated with the free rider problem. For example,
individuals who are vaccinated reduce the risk of contracting the relevant disease for all others
around them, and at high levels of vaccination, society may receive large health and welfare
benefits; but any one individual can refuse vaccination, still avoiding the disease by "free riding" on
the costs borne by others.
There are a number of potential means of improving overall social utility when externalities are
involved. The market-driven approach to correcting externalities is to "internalize" third party costs
and benefits, for example, by requiring a polluter to repair any damage caused. But, in many cases
internalizing costs or benefits is not feasible, especially if the true monetary values cannot be
determined.
The monetary values of externalities are difficult to quantify, as they may reflect the ethical views
and preferences of the entire population. It may not be clear whose preferences are most important,
interests may conflict, the value of externalities may be difficult to determine, and all parties
involved may try to influence the policy responses to their own benefit. An example is the
externalities of the smoking of tobacco, which can cost or benefit society depending on the
situation. Because it may not be feasible to monetize the costs and benefits, another method is
needed to either impose solutions or aggregate the choices of society, when externalities are
significant. This may be through some form of representative democracy or other means. Political
economy is, in broad terms, the study of the means and results of aggregating those choices and
benefits that are not limited to purely private transactions.
Laissez-faire economists such as Friedrich Hayek and Milton Friedman sometimes refer to
externalities as "neighborhood effects" or "spillovers", although externalities are not necessarily
minor or localized.
Private and social costs: Social costs are the spillover costs to society (society pays off the costs),
while private costs are the costs given to the individual firms or producer.
[edit] Examples
[edit] Negative
A negative externality is an action of a product on consumers that imposes a negative side effect on
a third party; (aka- Social Cost). Many negative externalities (also called "external costs" or
"external diseconomies") are related to the environmental consequences of production and use. The
article on environmental economics also addresses externalities and how they may be addressed in
the context of environmental issues.
Systemic risk describes the risks to the overall economy arising from the risks which the
banking system takes. That the private costs of banking failure may be smaller than the
social costs justifies banking regulations, although regulations could create a moral hazard.[4]
Anthropogenic climate change is attributed to greenhouse gas emissions from burning oil,
gas, and coal. The Stern Review on the Economics Of Climate Change says "Climate change
presents a unique challenge for economics: it is the greatest example of market failure we
have ever seen."[5]
Water pollution by industries that adds poisons to the water, which harm plants, animals,
and humans.
Industrial farm animal production, on the rise in the 20th century, resulted in farms that were
easier to run, with fewer and often less-highly-skilled employees, and a greater output of
uniform animal products. However, the externalities with these farms include "contributing
to the increase in the pool of antibiotic-resistant bacteria because of the overuse of
antibiotics; air quality problems; the contamination of rivers, streams, and coastal waters
with concentrated animal waste; animal welfare problems, mainly as a result of the
extremely close quarters in which the animals are housed." [6][7]
The harvesting by one fishing company in the ocean depletes the stock of available fish for
the other companies and overfishing may be the result. This is an example of a common
property resource, sometimes referred to as the Tragedy of the commons.
When car owners use roads, they impose congestion costs on all other users.
A business may purposely underfund one part of their business, such as their pension funds,
in order to push the costs onto someone else, creating an externality. Here, the "cost" is that
of providing minimum social welfare or retirement income; economists more frequently
attribute this problem to the category of moral hazards.
Consumption by one consumer causes prices to rise and therefore makes other consumers
worse off, perhaps by reducing their consumption. These effects are sometimes called
"pecuniary externalities" and are distinguished from "real externalities" or "technological
externalities". Pecuniary externalities appear to be externalities, but occur within the market
mechanism and are not a source of market failure or inefficiency.[8]
The consumption of alcohol by bar-goers in some cases leads to drinking and driving
accidents which injure or kill pedestrians and other drivers.
Shared costs of declining health and vitality caused by smoking and/or alcohol abuse. Here,
the "cost" is that of providing minimum social welfare. Economists more frequently
attribute this problem to the category of moral hazards, the prospect that a party insulated
from risk may behave differently from the way they would if they were fully exposed to the
risk. For example, an individual with insurance against automobile theft may be less vigilant
about locking his car, because the negative consequences of automobile theft are (partially)
borne by the insurance company.
The cost of storing nuclear waste from nuclear plants for more than 1,000 years (over
100,000 for some types of nuclear waste) is included in the cost of the electricity the plant
produces, in the form of a fee paid to the government and held in the Nuclear Waste Fund.
Conversely, the costs of managing the long term risks of disposal of chemicals, which may
remain permanently hazardous, is not commonly internalized in prices. The USEPA
regulates chemicals for periods ranging from 100 years to a maximum of 10,000 years,
without respect to potential long-term hazard.
[edit] Positive
Examples of positive externalities (beneficial externality, external benefit, external economy, or
Merit goods) include:
A beekeeper keeps the bees for their honey. A side effect or externality associated with his
activity is the pollination of surrounding crops by the bees. The value generated by the
pollination may be more important than the value of the harvested honey.
An individual planting an attractive garden in front of his or her house may provide benefits
to others living in the area, and even financial benefits in the form of increased property
values for all property owners.
A public organization that coordinates the control of an infectious disease preventing others
in society from getting sick.
An individual buying a product that is interconnected in a network (e.g., a video cellphone)
will increase the usefulness of such phones to other people who have a video cellphone.
When each new user of a product increases the value of the same product owned by others,
the phenomenon is called a network externality or a network effect. Network externalities
often have "tipping points" where, suddenly, the product reaches general acceptance and
near-universal usage, a phenomenon which can be seen in the near universal take-up of
cellphones in some Scandinavian countries.
Knowledge spillover of inventions and information - once an invention (or most other forms
of practical information) is discovered or made more easily accessible, others benefit by
exploiting the invention or information. Copyright and intellectual property law are
mechanisms to allow the inventor or creator to benefit from a temporary, state-protected
monopoly in return for "sharing" the information through publication or other means.
Sometimes the better part of a benefit from a good comes from having the option to buy
something rather than actually having to buy it. A private fire department that only charged
people that had a fire, would arguably provide a positive externality at the expense of an
unlucky few. Some form of insurance could be a solution in such cases, as long as people
can accurately evaluate the benefit they have from the option.
A family member buying a movie or game will provide a positive externality to the rest of
the family, who can then watch the movie or play the game.
An organization that purchases a large screen and projector will give benefits to those who
may use the screen for various purposes.
Home ownership creates a positive externality in that homeowners are more likely than
renters to become actively involved in the local community. For this reason, in the US
interest paid on a home mortgage is an available deduction from the income tax.[9]
Education creates a positive externality because more educated people are less likely to
engage in violent crime, which makes everyone in the community, even people who are not
well educated, better off.
As noted, externalities (or proposed solutions to externalities) may also imply political conflicts,
rancorous lawsuits, and the like. This may make the problem of externalities too complex for the
concept of Pareto optimality to handle. Similarly, if too many positive externalities fall outside the
participants in a transaction, there will be too little incentive on parties to participate in activities
that lead to the positive externalities.
[edit] Positional
Positional externalities refer to a special type of externality that depends on the relative rankings of
actors in a situation. Because every actor is attempting to "one up" other actors, the consequences
are unintended and economically inefficient.
One example is the phenomenon of "over-education" (referring to post-secondary education) in the
North American labour market. In the 1960s, many young middle-class North Americans prepared
for their careers by completing a bachelor's degree. However, by the 1990s, many people from the
same social milieu were completing master's degrees, hoping to "one up" the other competitors in
the job market by signalling their higher quality as potential employees. By the 2000s, some jobs
which had previously only demanded bachelor's degrees, such as policy analysis posts, were
requiring master's degrees. Some economists argue that this increase in educational requirements
was above that which was efficient, and that it was a misuse of the societal and personal resources
that go into the completion of these master's degrees.
Another example is the buying of jewelry as a gift for another person, e.g. a spouse. For Husband A
to show that he values Wife A more than Husband B values Wife B, Husband A must buy more
expensive jewelry than Husband B. As in the first example, the cycle continues to get worse,
because every actor positions him or herself in relation to the other actors. This is sometimes called
keeping up with the Joneses.
One solution to such externalities is regulations imposed by an outside authority. For the first
example, the government might pass a law against firms requiring master's degrees unless the job
actually required these advanced skills.
[edit] Supply and demand diagram
The usual economic analysis of externalities can be illustrated using a standard supply and demand
diagram if the externality can be monetized and valued in terms of money. An extra supply or
demand curve is added, as in the diagrams below. One of the curves is the private cost that
consumers pay as individuals for additional quantities of the good, which in competitive markets, is
the marginal private cost. The other curve is the true cost that society as a whole pays for
production and consumption of increased production the good, or the marginal social cost.
Similarly there might be two curves for the demand or benefit of the good. The social demand curve
would reflect the benefit to society as a whole, while the normal demand curve reflects the benefit
to consumers as individuals and is reflected as effective demand in the market.
[edit] External costs
The graph below shows the effects of a negative externality. For example, the steel industry is
assumed to be selling in a competitive market – before pollution-control laws were imposed and
enforced (e.g. under laissez-faire). The marginal private cost is less than the marginal social or
public cost by the amount of the external cost, i.e., the cost of air pollution and water pollution. This
is represented by the vertical distance between the two supply curves. It is assumed that there are no
external benefits, so that social benefit equals individual benefit.
Supply & Demand with external costs
If the consumers only take into account their own private cost, they will end up at price Pp and
quantity Qp, instead of the more efficient price Ps and quantity Qs. These latter reflect the idea that
the marginal social benefit should equal the marginal social cost, that is that production should be
increased only as long as the marginal social benefit exceeds the marginal social cost. The result is
that a free market is inefficient since at the quantity Qp, the social benefit is less than the social cost,
so society as a whole would be better off if the goods between Qp and Qs had not been produced.
The problem is that people are buying and consuming too much steel.
This discussion implies that negative externalities (such as pollution) is more than merely an ethical
problem. The problem is one of the disjuncture between marginal private and social costs that is not
solved by the free market. It is a problem of societal communication and coordination to balance
costs and benefits. This also implies that pollution is not something solved by competitive markets.
Some collective solution is needed, such as a court system to allow parties affected by the pollution
to be compensated, government intervention banning or discouraging pollution, or economic
incentives such as green taxes.
[edit] External benefits
The graph below shows the effects of a positive or beneficial externality. For example, the industry
supplying smallpox vaccinations is assumed to be selling in a competitive market. The marginal
private benefit of getting the vaccination is less than the marginal social or public benefit by the
amount of the external benefit (for example, society as a whole is increasingly protected from
smallpox by each vaccination, including those who refuse to participate). This marginal external
benefit of getting a smallpox shot is represented by the vertical distance between the two demand
curves. Assume there are no external costs, so that social cost equals individual cost.
Supply & Demand with external benefits
If consumers only take into account their own private benefits from getting vaccinations, the market
will end up at price Pp and quantity Qp as before, instead of the more efficient price Ps and quantity
Qs. These latter again reflect the idea that the marginal social benefit should equal the marginal
social cost, i.e., that production should be increased as long as the marginal social benefit exceeds
the marginal social cost. The result in an unfettered market is inefficient since at the quantity Qp, the
social benefit is greater than the societal cost, so society as a whole would be better off if more
goods had been produced. The problem is that people are buying too few vaccinations.
The issue of external benefits is related to that of public goods, which are goods where it is difficult
if not impossible to exclude people from benefits. The production of a public good has beneficial
externalities for all, or almost all, of the public. As with external costs, there is a problem here of
societal communication and coordination to balance benefits and costs. This also implies that
vaccination is not something solved by competitive markets. The government may have to step in
with a collective solution, such as subsidizing or legally requiring vaccine use. If the government
does this, the good is called a merit good.
[edit] Possible solutions
There are at least four general types of solutions to the problem of externalities:
Criminalization: As with prostitution in some countries, addictive drugs, commercial fraud,
and many types of environmental and public health laws.
Civil Tort law: For example, class action by smokers, various product liability suits.
Government provision: As with lighthouses, education, and national defense.
Pigovian taxes or subsidies intended to redress economic injustices or imbalances.
A Pigovian tax is a tax imposed that is equal in value to the negative externality. The result is that
the market outcome would be reduced to the efficient amount. A side effect is that revenue is raised
for the government, reducing the amount of distortionary taxes that the government must impose
elsewhere. Economists prefer Pigovian taxes and subsidies as being the least intrusive and most
efficient method to resolve externalities.
However, the most common type of solution is tacit agreement through the political process.
Governments are elected to represent citizens and to strike political compromises between various
interests. Normally governments pass laws and regulations to address pollution and other types of
environmental harm. These laws and regulations can take the form of "command and control"
regulation (such as setting standards, targets, or process requirements), or environmental pricing
reform (such as ecotaxes or other pigovian taxes, tradable pollution permits or the creation of
markets for ecological services). The second type of resolution is a purely private agreement
between the parties involved.
Government intervention may not always be needed. Traditional ways of life may have evolved as
ways to deal with external costs and benefits. Alternatively, democratically-run communities can
agree to deal with these costs and benefits in an amicable way. Externalities can sometimes be
resolved by agreement between the parties involved. This resolution may even come about because
of the threat of government action.
Ronald Coase argued that if all parties involved can easily organize payments so as to pay each
other for their actions, then an efficient outcome can be reached without government intervention.
Some take this argument further, and make the political claim that government should restrict its
role to facilitating bargaining among the affected groups or individuals and to enforcing any
contracts that result. This result, often known as the Coase Theorem, requires that
Property rights be well defined
People act rationally
Transaction costs be minimal
If all of these conditions apply, the private parties can bargain to solve the problem of externalities.
This theorem would not apply to the steel industry case discussed above. For example, with a steel
factory that trespasses on the lungs of a large number of individuals with pollution, it is difficult if
not impossible for any one person to negotiate with the producer, and there are large transaction
costs. Hence the most common approach may be to regulate the firm (by imposing limits on the
amount of pollution considered "acceptable") while paying for the regulation and enforcement with
taxes. The case of the vaccinations would also not satisfy the requirements of the Coase Theorem.
Since the potential external beneficiaries of vaccination are the people themselves, the people would
have to self-organize to pay each other to be vaccinated. But such an organization that involves the
entire populace would be indistinguishable from government action.
In some cases, the Coase theorem is relevant. For example, if a logger is planning to clear-cut a
forest in a way that has a negative impact on a nearby resort, the resort-owner and the logger could,
in theory, get together to agree to a deal. For example, the resort-owner could pay the logger not to
clear-cut – or could buy the forest. The most problematic situation, from Coase's perspective, occurs
when the forest literally does not belong to anyone; the question of "who" owns the forest is not
important, as any specific owner will have an interest in coming to an agreement with the resort
owner (if such an agreement is mutually beneficial).
