Externalities: Positive and Negative

Externalities arise when the actions of one agent affect the well-being of others, bypassing the market mechanism. This is a classic "market failure." Definition of Externality: an impact on a third party not involved in the transaction and not reflected in the price.

Negative externalities: costs borne by third parties.

Pollution
Noise
Smoking in public places

Positive externalities: benefits received by third parties.

Education
Vaccination
R&D

Inefficiency in the presence of externalities

Negative:
Private costs
Too much is produced
Market equilibrium is inefficient

Positive:
Private benefits
Too little is produced

Pigouvian taxes and subsidies

Pigou's idea: to internalize the externality through a tax or subsidy.

Pigouvian tax: tax = external costs.
Aligns private and social costs.

Pigouvian subsidy: subsidy = external benefits.
Stimulates positive externalities.

Advantages: efficiency, flexibility, creates incentives.

Examples: carbon tax, subsidies for education and R&D.

The Coase Theorem

Coase Theorem: with clearly defined property rights and zero transaction costs, private bargaining will lead to an efficient outcome regardless of the initial allocation of rights.

Implications:

Intervention is not always necessary
Clearly defining rights is important
In practice, transaction costs get in the way

For the investor

Regulatory risks: companies with negative externalities are at risk of regulation.

Carbon exposure: risk of carbon taxes and regulation.

Positive externalities: may justify subsidies — cleantech, biotech.