Since the extent and way how private markets can react to externalities depends from the reason, type and method for internalizing of a specific externality, it is appropriate to identify these concepts.
Externalities are internalized when the marginal value of the externality is priced, that is, when the private marginal costs of carrying out the activity are equal to the social costs caused by the activity. The lack of property rights or difficulty in enforcing them takes its cause of externalities. Property rights consist of the right to use a resource or asset, to convert the asset or resource into an alternative solution use, or to sell the resource. In the case of common property resources, it is difficult to avoid other individuals from using the resource. In the case of pollution for example, individuals cannot enforce rights to the utilization of the atmosphere.
There are three major types of externalities: producer-producer externalities, producer-consumer externalities and consumer-consumer externalities. Producer-producer externalities occur when the output or inputs used by one firm affect those employed by a different one, and the result is un-priced. For instance, the output of an upstream firm may pollute this inflatable water downstream, thereby destroying fishing resources and affecting the fishing industry. Regarding producer-consumer externalities, the utility function of the consumer is dependent on the output of the producer. This type of externality occurs regarding noise pollution by aircrafts and the effects of emissions from factories. Consumer-consumer externalities occur when the actions of 1 consumer affect the utility of another consumer without having to be priced.
We can also distinguish between pecuniary and technological externalities. Technological externalities make reference to the effects where the production function or utility function is affected. A pecuniary externality, on the other hand, refers to output or utility effects on an authorized due to changes in demand. These effects are reflected in changes in prices and profits of the producer, but do not alter technological likelihood of production. A negative pecuniary externality can become an outcome when an increase in production of 1 industry causes a rise in the price of inputs employed by other industries.
Economic theory is based on the premise any particular one wishes to change the behavior of the financial unit, one must modify the incentives facing that unit so that the preferred behavior becomes more appealing to it (i. e. , nicer, more profitable or both). That's the reason in order to cope with and respond to the above-mentioned types of externalities, private markets and separated individuals develop private answers to these problems. According to Coase, in order for these solutions to be realized, three basic conditions should be met, "First, evidently specified property rights must be assigned to either the benefiting party or the harmed party (property rights are laws that describe what people can do with their property). Second, the involved parties will need to have an equal amount of bargaining power. Third, the transaction costs of negotiation, or bargaining costs, must be low to ensure that the bargaining actually occurs. "
According to Gregory Mankiw (2008), "the private market could solve the condition of externalities by counting on the self-interest of the relevant parties". In different situations the perfect solution is takes the proper execution of integrating different kinds of businesses, getting into a contract of different business entities, verbal agreement between companies and a number of others.
The suggestion that private markets may achieve answers to externality problems is described via a Pareto-relevant externality, which is characterized by the existence of potential gains from trade between your acting and damaged parties. Surely, then, self-interest can be relied upon to ensure the realization of these potential gains through exchange between your involved parties. As always, efficient exchange requires precisely defined and rigidly enforced property rights. In the case of external diseconomies, these property rights include some specification of the laws of liability for damages associated with the diseconomy. If liability rules are specified in a specific manner - allowing a specified amount of externality to be created with impunity and this total be exceeded only when the damaged party is willing to agree - they serve as the starting point for negotiations to realize the potential gains from trade.
The two extreme examples of such liability rules are the zero liability rule and the entire liability rule. Apart from these, thousands of intermediate rules could be conceived. The zero liability rule specifies that external diseconomies in virtually any amount may be made up of impunity; under such a rule, the damaged party would have a motivation to give a bribe to induce the acting party to reduce their output of external diseconomy. Full liability specifies that zero externality may be created minus the consent of the afflicted party; under such a rule, the acting party could have an incentive to offer compensation to induce the affected party to simply accept a good amount of externality.
Ronald Coase in his works perceived that whatever the liability rule that is in procedure one or another party has an incentive to change a Pareto-relevant externality. Given perfect competition and zero transactions costs (costs of making and enforcing decisions), negotiations will continue until all gains from trade have been exhausted. Coase argued that all gains from trade will be exhausted at the same Pareto-efficient outcome, whatever the liability rule that is in operation.
The current situation in the theory of private market solutions to externality problems can be summarized the following: A Pareto-relevant externality, being characterized by potential gains from trade, will create incentives for one or the other of the involved parties to initiate negotiations targeted at modifying that externality. A solution not the same as the status quo situation may be performed and, if perfect competition prevails in all relevant industries like the transactions industry, that solution may be Pareto-efficient. However, the resource allocation and income distribution characteristics of the solution achieved are not neutral towards the choice of liability rules. In comparison with the zero liability rule, the entire liability rule will cause a higher amount of abatement associated with an external diseconomy such as pollution, reallocation of resources toward pollution control and production of commodities which is often made by low pollution processes, and income redistribution in favor of the afflicted party. The effective demolition of the doctrine of allocative neutrality of liability rules removes one of the prime advantages, which has been claimed for market answers to externality problems. The role of the body politic and the bureaucracy in setting the operative liability rule is now known to include the power to affect the allocation of resources in production and allocation of budgets in consumption. Within a macroeconomic sense, if externalities are as pervasive as is now believed, the power with which can be done to create liability rules implies also the energy to affect resource allocation in the monetary system all together, aggregate production and consumption and relative and aggregate prices.
Let us consider why most people do not litter. Nowadays many people follow generally accepted norms of behavior and moral codes, which treat littering as something unacceptable. Although there are laws and sanctions imposed on those who litter, most people do not do it because they feel that it is an incorrect thing. Such moral injunctions make private ventures take into account how their actions affect others and an environment they work in. In economic terms, moral codes tell companies and private markets to internalize externalities.
Nowadays many charities are established to cope with externalities. Such charities often include nonprofit organizations that are usually involved in actions connected with the protection of the surroundings and funded by private donations and sponsors. Charities are usually encouraged by the federal government through the tax system by allowing money tax deduction for charitable donations.
Coase theorem says: "the proposition that if private parties can bargain without cost in the allocation of resources, they can solve the challenge of externalities on their own". In other words, it shows that if trade in an externality is possible and there are no transaction costs, "private markets and separated private entities are able to solve the condition of externalities among themselves. Whatever the original distribution of rights, the interested parties can always reach a good deal in which many people are better off and the outcome is efficient".
Unfortunately, the perfect solution is found by Coase is not effective oftentimes because the negotiations between your parties can fail and, in general, even in the absence of such grounds, the Coase's solution works only where there is a tiny range of agents and in the absence of information asymmetries, or in the absence of transaction costs. The main criticism of the Coase solution, therefore related to the failure of the negotiations, are due to: High transaction costs; if the price tag on negotiations bargaining between your parties are perceived as excessive compared to the benefits extracted from the collaboration agents do not agree; Difficulty in identifying the cause of the damage, it is difficult for the owners of the resource understanding what it is, between many potential leaders, who actually causes the damage, and especially to quantify this damage; Imperfect information; if the preferences (and therefore the willingness to pay) and opportunities are recognized to all stakeholders involved in the negotiations, it would be expected that they can lead to an efficient outcome, otherwise the contract may be long and expensive and may be fail.
In spite of the number and variety of good instruments for internalizing externalities, the challenge should not be expected to be easily or quickly solved. The internalization of the key externalities in nearly all cases has its cost, which sometimes is too high for private entities. Moreover, it is doubtful that the price of internalization of all externalities of a specific economy may be assumed by its current economical system. That is why nowadays it seems that the participation of various generations will be necessary in order to assume the monetary costs of taking many externalities into account.
An important restriction is the one derived from the existing administrative structure available. Apart from companies with a robust and efficient administrative organization, which is able to detect any negative deviation and solve it immediately, none of classical solutions could be employed in the proper execution and intensity needed.
The limitations that are inherent in each kind of solution manifest themselves in real applications. In any manner of internalization necessarily influences costs therefore influences market prices. That is at odds with the need to be competitive in local and international markets, because businesses that do not internalize externalities will offer the same product at a lower price (green dumping). Any solution to the challenge is therefore easier applicable in local markets rather than international markets.