Economics for Everyone- Economics of Externality

India Infoline News Service | Mumbai |

It is important to note that in most of the above mentioned cases the environmental minister Mr. Jairam Ramesh took a strong view against these projects.

CONTEXT 1 - Fourteen years after it had diluted charges in the Bhopal gas leak case, the Supreme Court recently decided to re-examine its own judgement that led to lighter punishment of two years imprisonment for the accused in the case.

CONTEXT -2 Two cargo ships collided near the Mumbai coast causing an oil spill from one of the vessels

CONTEXT-3 Navi Mumbai airport may take off -There is a fresh ray of hope for the new airport at Panvel in Navi Mumbai, with the environment and civil aviation ministries attempting to bridge their differences over the project.

CONTEXT-4 Recently, Environment Minister Jairam Ramesh issued a well-argued order denying forest clearance to a bauxite mining project by Sterlite Industries, a Vedanta subsidiary. It is important to note that in most of the above mentioned cases the environmental minister Mr. Jairam Ramesh took a strong view against these projects.

A better understanding of these issues can be made from understanding the important concept of Externalities in Economics


Externalities occur when any activity by an individual or organisation or any project activity affect other persons (or society) well - being and the relevant costs and benefits are not reflected in market prices.

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 positive (building a bridge or road, access to education loan) or negative (pollution from a factory).

A positive externality arises say when any project or activity (say building a bridge) creates a positive benefit for the immediate society. Thus a positive externality would increase the utility of third parties at no cost to them. Since collective societal welfare is improved. Goods with positive externalities include education (believed to increase societal productivity and well-being), public health initiatives (which may reduce the health risks and costs for third parties for such things as transmittable diseases) and law enforcement.

In the present context it also includes areas such as

  • Government programmes ( such as NREGS, SARVA SHIKHSHYA ABHIYAN, BHARATH NIRMAN, Rural electrification schemes, Mid day meals sechemes which are also known as SOCIAL OVERHEAD CAPITAL by the development economists).
  • Technology spillovers (Indian governments policy initiative on telecom and electronic sector during the mid eighties has greatly helped the telcom and the IT sector to reach its cuurent level of progress)
  • Infrastructure initiative ( for example Golden quadrilateral project)
  • Millenium Development Goals by the United Nations.

A negative externality arises when the any activity by an individual or organisation or any project imposes costs (say for example pollution, damage to environment and scarce resources) that it imposes on others (individual or society).

All the contexts stated above indicate the classic example of to be or not to be. The environmental minister’s opposition to the project comes from the perspective o negative exterality. Let us see the impact (or probable impact) in these contexts.



Bhopal gas leak case

Various estimates of number of people died range from 4000 to 15,000 (immediate and other gas related death in the long run. Various estimates of number injuries go upto 5,00,000 ( temporary and permanent))

Oil spill from the colision of cargo ships

Resultant damage to maritime fauna and flora

Building Navi Mumbai Airport

  • The proposed airport would have altered the course of two rivers, Gadhi and Ulwe, affecting the lagoons in the area
  • The project would have jeopardised the survival of a mangrove forest, which is spread over 400 acres

Building the airport would require the levelling of a 80-metre-high hill, raising coastal zone management issues

Issue of bauxite mining project by Sterlite Industries ( Vedanta group)

If allowed, Vedanta would have lopped off 7 square kilometres of the top of Orissa's Niyamgiri, a hill revered by the few thousand-strong Dongria Kondh tribes.

Thus the person who is affected by the negative externality (say 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.

Types Of Good (Or Services)

In this context it is important to understand the following concepts

  • Free good
  • Economic good
  • Public good

Free good – Goods (or services) which have no or zero economic price (air available to us as on now, rivers, lakes Servies – services of parents).

Economic good – Those goods ( or services) which command a economic price ( Water becomes a economic good as a branded packed water bottle, outdoor games such as water rafting).

Public good- Serves the common interest of the society, offered at a subsidised price to all the memebers of the society- (Air, Parks, Ponds and lakes maintained by the village panchayats and municipal corporations, roads built by the government, Light house).

In economics, a public good is a good that is non-rivalrous and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability that no one can be effectively excluded from using the good. In the real world, there may be no such thing as an absolutely non-rivaled and non-excludable good; but economists think that some goods approximate the concept closely enough for the analysis to be economically useful.

For example breathing air does not significantly reduce the amount of air available to others, and people cannot be effectively excluded from using the air. This makes air a public good, albeit one that is economically trivial, since air is a free good.

Well known economist Paul A. Samuelson developed the theory of public goods. In his classic 1954 paper The Pure Theory of Public Expenditure, he defined a public good, or as he called it in the paper a "collective consumption good", as follows: "[goods] which all enjoy in common in the sense that each individual's consumption of such a good leads to no subtractions from any other individual's consumption of that good"

Solving the Externalities:

Solution for Negative Externalities:

From the above mentioned examples, the cases of Navimumbai airport and the Vedanta groups proposed mining activity has another side to the whole story. It is evident that they have positive externalities too. The impact of these two projects interms of employment creation and their contribution to the business activity cannot be ignored.

How to solve this problem.The probable solution is found in well known economist Ronald coase work known as Coase theorem.

For example, negative externalities are a property rights problem. Who owns the air that the steel mill pollutes? Ronald Coase put forth the solution which is known as the Coase Theorem:

"Under perfect competition, once government has assigned clearly defined property rights in contested resouces and as lon as transactions costs are negligible, private parties that generate or are affected by externalities will negotiate voluntary agreements that lead to the socially optimal resource allocation and output mix regardless of how the property rights are assigned" (Ronald H. Coase, "The Problem of Social Cost").

In other words, if there are negligible transactions costs, as long as someone owns the rights to the air around the steel mill, the efficient outcome will prevail. For example, if the steel mill owns the rights, then the individuals that live around the mill will be willing to pay the steel mill not to produce--up to the cost that they are incurring from health care, reduced aesthetic appeal of the air, etc. This amount that they are willing to pay becomes an opportunity cost for the steel mill if they produce. Thus they will cut production to the optimal level. On the other hand, if the people own the air, then the steel mill would have to pay them that same amount for the right to produce. Thus the negative externality is directly added to the steel mill's marginal cost.

Another way suggested by economists to solve the negative externality problem is to simply tax the producer the amount of the negative externality. This adds to the producers marginal cost and will cause them to reduce output.

Solution for Postive externalities- (solving the free rider problem)

Public good and Externality:

It is important to note that, public goods problems are related to the broader issue of externalities.

Some economists argue about the production of public goods results in positive externalities which are not remunerated. If private organizations don't reap all the benefits of a public good which they have produced, their incentives to produce it voluntarily might be insufficient. Consumers can take advantage of public goods without contributing sufficiently to their creation. This is called the free rider problem (A positive externality arises when we benefit from our neighbors cleaning up the common living space or raising a compound wall withour charging us).

The provision of a lighthouse has often been used as the standard example of a public good, since it is difficult to exclude ships from using its services. No ship's use detracts from that of others, but since most of the benefit of a lighthouse accrues to ships using particular ports, lighthouse maintenance fees can often profitably be bundled with port fees (Ronald Coase, The Lighthouse in Economics 1974). This has been sufficient to fund actual lighthouses.

Thus the problem of the free rider could be solved by charging a minimum fee which would atleast recover the cost of providing that facility and at the same time maintaining the status quo (no Profit motive -Public goods benefit)

Now a question for the reader

  • What about TV broadcasting and Newspaper/Magazine readership (the usual debate of readership vs circulation)? - Is it not a free rider problem?
  • What about the materials posted in the internet?
  • Piracy

To some extent encryption technology, Copyrights act can solve the above issues.

Indian Policy Scenario:

The Ministry of Environment & Forests (MoEF):

The Ministry of Environment & Forests (MoEF) is the nodal agency in the administrative structure of the Central Government for the planning, promotion, co-ordination and overseeing the implementation of India's environmental and forestry policies and programmes.

The primary concerns of the Ministry are implementation of policies and programmes relating to conservation of the country's natural resources including its lakes and rivers, its biodiversity, forests and wildlife, ensuring the welfare of animals, and the prevention and abatement of pollution. While implementing these policies and programmes, the Ministry is guided by the principle of sustainable development and enhancement of human well-being.

The Ministry also serves as the nodal agency in the country for the United Nations Environment Programme (UNEP), South Asia Co-operative Environment Programme (SACEP), and International Centre for Integrated Mountain Development (ICIMOD) and for the follow-up of the United Nations Conference on Environment and Development (UNCED). The Ministry is also entrusted with issues relating to multilateral bodies such as the Commission on Sustainable Development (CSD), Global Environment Facility (GEF) and of regional bodies like Economic and Social Council for Asia and Pacific (ESCAP) and South Asian Association for Regional Co-operation (SAARC) on matters pertaining to the environment.

The broad objectives of the Ministry are:

  • Conservation and survey of flora, fauna, forests and wildlife
  • Prevention and control of pollution
  • Afforestation and regeneration of degraded areas
  • Protection of the environment and
  • Ensuring the welfare of animals

These objectives are well supported by a set of legislative and regulatory measures, aimed at the preservation, conservation and protection of the environment. Besides the legislative measures, the National Conservation Strategy and Policy Statement on Environment and Development, 1992; National Forest Policy, 1988; Policy Statement on Abatement of Pollution, 1992; and the National Environment Policy, 2006 also guide the Ministry's work.

The ministry is headed by Jairam Ramesh (Minister of State (Independent Charge), Ministry of Environment and Forests)

Since long time, policy debates in economics involve issues on externalities problems which have a profound impact on the society.





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