CORRECTING EXTERNALITIES ( INTERNALIZING EXTERNALITIES)

We know that externality occurs when the benefits or cost to society differs from the benefits of cost to the decision-maker.

As a result of this, the market fails. But, how can be corrected so that the market doesn't fail? Or if you like, How can externalities be internalized? 

We are going to be looking at some possible ways of correcting externalities in this post.

Ok, let get started. 

Provision of adequate information and persuasion.

This is perhaps the most underestimated method of correcting externality. Some consumption of goods with negative externality can be avoided through persuasion.

Take the case of second-hand smokers for example. Research has suggested that the majority of second-hand smokers are not adequately aware of the threat posed by their actions on third parties.

Perhaps if they are adequately informed, second-hand smoking could have reduced dramatically. 

It is for this reason that governments around the world are now placing compulsory warnings on every pack of cigarettes.

Government can also reduce cases of positive externalities by encouraging people to consume more goods with positive externalities.

In developed countries, this can be easily by massive awareness campaigns. However, this is not always in developing countries as people may not be able to afford these goods.

Use of indirect tax and subsidy

Indirect tax and subsidy can also be used to correct externalities. An indirect tax corrects negative externalities while a subsidy corrects positive externalities.

Now, let's start with negative externalities. The accompanying diagram illustrates the situation when there are negative externalities.


Negative externalities

As can be visualized, the supply curve is S when the only private cost is considered. 

To correct externalities, the government might impose a corrective tax. The OP goal of the corrective tax is to shift the supply curve from S to MSC curve and reduce the output to the socially optimum of $Q_2$(recall that more tax, less supply).

Positive externalities can be corrected via subsidy. When government grant subsidy, more of the goods associated with positive externalities will be made available at a much lower price.

This will, in turn, shift the demand curve from D to the socially optimum of MSB. This is represented below.

Positive externality

Assigning property rights

property rights are exclusive rights for the ownership and possession of the property.

When goods and services do not have a property right, anyone can over-exploit them because no one can sue them for damages.

Air pollution is, in fact, very rampant because no one can claim a property right over the air. Hence, everyone emits as much pollution as they could knowing that they can not be sued for damages.

Now assume that property rights are given to air so that individuals can claim ownership, then negative externalities will decrease.

The reason being that the wrong use of his property will certainly come with a price or charge. 

Otherwise, the owner can sue for damages if his property is misused Thus, we see that property rights can decrease negative externalities.

Government regulation and legislation

Externalities can also be corrected via regulation and legislation.

Legislations restraining people from smoking in public places are an example of legislative action taken by the government to externalities.

There is also strict legislation in many countries that put noise and time restrictions on when aircraft can take off and land.

In most countries, state-funded education is made compulsory by the government. 

All of these are aimed at reducing externalities.

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In the same vein, the government can also reduce production externalities through regulation.

One way of government achieve this is by restricting the amount of pollution that can be emitted by a particular firm.

Once this restriction is set, the government then monitors this firm and ensures that the ideal amount of pollution is emitted.

All firms are expected to obey pollution restrictions, otherwise, they would be fined.
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