Externalities lead markets to allocate resources inefficiently but have mentioned only briefly how this inefficiency can be remedied. In practice both private individuals and public policymakers respond to externalities in various ways. All of the remedies share the goal of moving the allocation of resources closer to the social optimum. In this section we examine private solutions.
The types of Private Solutions:
Although externalities tend to cause markets to be inefficient, government action is not always needed to solve the problem. In some circumstances people can develop private solutions.
Sometimes the problem of externalities is solved with moral codes and social sanctions. Consider for instance why most people do not litter. Although there are laws against littering these laws are not vigorously enforced. Most people do not litter just because it is the wrong thing to do. The Golden Rule taught to most children says do unto others as you would have them do unto you. This moral injunction tells us to take account of how our actions affect other people. In economic terms it tells us to internalize externalities.
Another private solution to externalities are charities many of which are established to deal with externalities. For example the Sierra Club, whose goals are to protect the environment, is a nonprofit organization funded with private donations. As another example colleges and universities receive gifts from alumini corporations and foundations in part because education has positive externalities for society. The government encourages this private solution to externalities through the tax system by allowing an income tax deduction for charitable donations.
The private market can often solve the problem of externalities by relying on the self interest of the relevant parties. Sometimes the solution takes the form of integrating different types of businesses. For example consider an apple grower and a beekeeper that are located next to each other. Each business confers a positive externality on the other; by pollinating the flowers on the trees the bees help the orchard to produce apples. At the same time the bees use the nectar they get from the apple trees to produce honey. Nonetheless when the apple grower is deciding how many trees to plant and the beekeeper is deciding how many bees to keep they neglect the positive externality. As a result the apple grower plants too few trees and the beekeeper keeps too few bees. These externalities could be internalized if the beekeeper bought the apple orchard or if the apple grower bought the beehives. Both activities would then take place within the same firm and this single firm could choose the optimal number of trees and bees. Internalizing externalities is one reason that some firms are involved in different types of businesses.
Another way for the private market to deal with external effects is for the interested parties to enter into a contract. In the foregoing example, a contract between the apple grower and the beekeeper can solve the problems of too few trees and few bees. The contract can specify the numbers of trees, the number of bees, and perhaps a payment from one party to the other. By setting the right number of trees and bees, the contract can solve the inefficiency that normally arises from these externalities and make both parties better off.
The Coase theorem:
How effective is the private market in dealing with externalities? A famous result called the Coase theorem after economist Ronald Coase suggests that it can be very effective in some circumstances. According to the Coase theorem if the private market can bargain without costs over the allocation of resources, then the private market will always solve the problems of externalities and allocate resources efficiently.
Excerpts from Principles of Economics