Smokestacks belching soot; overfishing causing depletion of fish stocks in the oceans; species made extinct by the encroachment of man; and to top it all off, a possible warming of the globe that threatens to disrupt everyone's way of life. All of these are examples of externalities. AN EXTERNALITY IS A COST OR BENEFIT EXPERIENCED BY A THIRD PARTY TO A RESOURCE TRANSFER.

For example, Harry the Hog Farmer owns a piece of land out in the country where he raises hogs for a living. As Harry is quick to confess, he's not in the hog business because it's a great way to meet interesting people. Harry's in it for the money. And, in general, hogs have been good to Harry. He's managed to make a decent living for himself and his family.

It just so happens, that Harry lives right next door to the Golden Years' Retirement Home. Each day the residents of the Golden Years' Retirement Home are subjected to the disturbing--and downright unappetizing--sound of a herd of pigs all squealing over whose turn it is to sit in the mud pit. On top of that, Harry is constantly running around the farm yelling "Soooiee" like there's no tomorrow. Some lucky residents can just turn off their hearing aids and enjoy the show. But the rest of Golden Years' inhabitants are forced to put up with this porcine noise pollution. How bad is it? If the truth were known, these residents would be willing to collectively pay $10,000 a year to silence Harry and his hogs.

Suppose Harry can earn revenues of $40,000 from raising hogs, with costs of $36,000. From Harry's perspective, this is great. The hog business is profitable. And so he keeps on raising those porkers. However, from society's perspective, all is not well. When one adds in the $10,000 of "damages" from the noise pollution suffered by the residents of the Golden Years' Retirement Home, it is seen that this resource transfer lowers society's happiness. In fact, the real (gross) Benefit to society from producing the hogs isn't $40,000, it's only $30,000. That is, the $40,000 in benefits received by the pork consumers must be diminished by the $10,000 loss of happiness resulting from the noise pollution. Once this externality of the noise pollution is counted, we see that the Cost is greater than the Benefits. Rather than increasing society's happiness by $4,000 as Harry's profits seem to indicate, this resource transfer actually lowers society's happiness by $6,000.

What happened? Society wants to say, "Let those resources go! Those hogs aren't valuable enough to justify taking those resources away from other consumers." But Harry's not getting the message. WHEN EXTERNALITIES ARE PRESENT, PROFITS FAIL TO ACCURATELY REPORT THE GAINS AND LOSSES TO SOCIETY FROM A RESOURCE TRANSFER. At its root, the externality problem is a problem of INCOMPLETE INFORMATION.

The reality is that Harry is making a resource transfer which impacts three distinct groups of consumers: (i) the consumers of pork products; (ii) other consumers who lose happiness because resources (land, Harry's time, etc.) are taken away from alternative activities; and (iii) the residents of the Golden Years' Retirement Home. The price system has done a good job of reporting the respective happinesses of Groups (i) and (ii). However, the senior citizens of Group (iii) are ignored in this resource transfer. They are a "third party" that is suffering a cost from this resource transfer. Because Harry the Hog Farmer never has to "feel the pain" of the senior citizens, he makes a socially incorrect choice. His positive profits encourage him to make a resource transfer which will lower society's happiness. And that's a shame.

Can the government intervene to make society better off? Yes it can. In fact, there are a number of avenues open to the government. Ideally, the government would like to get Harry the Hog Farmer to feel the pain he imposes on his neighbors. As things currently stand, nobody owns the "airspace." As a result, Harry can "pollute" it with impunity. In contrast, if the government conferred ownership (or "property") rights of the airspace around the Golden Years' Retirement Home to its residents, Harry would have to compensate them for filling it with unpleasant noise pollution. He could purchase the right to pollute that airspace. Does that strike you as being too weird?

If so, consider this. Suppose Harry wanted to use some of the retirement home's land to dump corn husks left by his hogs after their feedings? The price Harry would have to pay for that land would force him to think long and hard whether that property was more valuable to him or the residents. If it was really important for Harry to "pollute" that land with his refuse corn husks, he would have an incentive to buy it (and the residents an incentive to sell it). As a result, that resource would go to its highest valued use. The fact that somebody owns the land keeps Harry from doing to the land what he is doing to the air.

THUS ONE WAY GOVERNMENT CAN INTERVENE WHEN THERE ARE EXTERNALITIES IS TO ESTABLISH AND ENFORCE PROPERTY RIGHTS. This is generally the most preferred course of action when addressing an externality problem (though sometimes it is not enough to solve the externality problem). Establishing property rights to "airspace" would force Harry to internalize the costs he imposes on his neighbors. It fixes the "hole" in the price system that allows the interests of third parties to go unrepresented. We also admit that--in this case at least--establishing property rights to airspace is not very practical. But it is useful to think about; it reminds us why prices are failing to report the correct information about the gains and losses from this resource transfer. And in many cases, it is a practical solution to addressing externality problems.¹

If the government can't establish property rights, then what? A COMMON GOVERNMENT INTERVENTION FOR ADDRESSING EXTERNALITIES IS TO IMPOSE FINANCIAL PENALTIES AND REWARDS. We must remember that the problem with externalities is that they cause a misallocation of society's resources. In the case of Harry the Hog Farmer, too many hogs are being raised. Thus the government could improve the allocation of resources by discouraging farmers from raising hogs. Suppose hog farms were well recognized for being a public nuisance. Then the government could require hog farmers to buy a permit to operate a hog farm. Let the price of the permit be $7,000. Look at how this government intervention changes the Profit Table associated with this resource transfer.

The tax associated with operating the hog farm is causes Harry the Hog Farmer to feel some of the pain he is imposing on the residents of the Golden Years' Retirement Home. In this case, it is enough to drive Harry out of business. And that's good. Because society does not want this resource transfer to take place. From the perspective of society's happiness, there are only two numbers in the table that matter: $30,000 and $36,000. Harry the Hog Farmer has taken resources worth $36,000 elsewhere in the economy and directed them to an activity that produces only $30,000 of net happiness. Society's happiness is lowered. By discouraging this resource transfer, the government has made society $6,000 better off.

This example of Harry the Hog farmer illustrates the problem of NEGATIVE EXTERNALITIES. Negative externalities occur whenever third parties to a resource transfer suffer costs from that resource transfer. When negative externalities are present, too many resources are directed to an industry. Government intervention can increase society's happiness by discouraging that industry from withdrawing resources from other activities.

Less common is the problem of POSITIVE EXTERNALITIES. Positive externalities occur whenever third parties to a resource transfer experience benefits from that resource transfer. When positive externalities are present, too few resources are directed to an industry--that is, the industry does not produce enough of the good. Suppose that instead of being a public nuisance, Harry and his hogs sang four-part harmonies. Then the residents of the Golden Years' Retirement Home would be blessed by the heavenly melodies emanating from Harry's farm. In order to make sure that Harry produced the right number of hogs, we would want him to internalize the pleasure that the residents received from his hogs. Government could intervene to increase society's happiness by helping Harry to "feel their joy." Subsidies and mandates are two ways that government can accomplish this.

Before proceeding to a real life application of the externality problem, it's worthwhile to consider some of the problems that we mentioned in the beginning of this chapter. When overfishing causes depletion of fish stocks in the oceans and species are made extinct by the encroachment of man, there is an externality problem. In this case, the source of the problem is the lack of property rights. Because nobody owns the fish in the oceans, there is no incentive to save fish so that consumers can enjoy them next year. Fishermen don't "feel the pain" they impose on consumers by depriving them of fish next year. Likewise, since most animal species are not owned by humans, there is no incentive to preserve them. Again, the firms that destroy the natural habitats of these animals aren't being forced to "feel the pain" that future generations may have to experience because valuable animal species will not be around to provide happiness for them. In many cases, modern technology can provide innovative ways to establish property rights.² In other cases, such as ocean mineral rights, the problem isn't lack of technology, but lack of law. In both sets of cases, governments can make dramatic improvements in the allocation of resources by assigning and enforcing property rights.

Sometimes, as in the example of the noise pollution from Harry and his hogs, establishing property rights is not a practical solution. When smokestacks send forth plumes of soot into the atmosphere, costs are imposed on third party consumers who suffer from having to breathe polluted air. Even if households owned the "air-rights" to the air they breathed, it would be impractical to identify and prosecute those parties responsible for polluting their air. In such cases, financial penalties like punitive taxes can help firms to feel the pain they impose on others. However, how large should the government make these penalties? How can the government know the amount of third party costs being suffered by consumers? These are difficult questions which are highlighted in our next chapter on environmental mandates.

The case of a positive externality is handled analogously (see figure below). With a positive externality, the market undervalues the benefit of the good. In the absence of government intervention, Q* gets produced. However, Q** is the social optimum. The shaded area represents the corresponding welfare loss.