By definition, an externality exists when there is either external benefit or external damage accruing to individuals not involved in the consumption or production of some good. In the case of external damage, too much of the good is being produced or consumed. There are two approaches to dealing with this problem: (a) the public approach, and (b) the private approach.

(a) The public approach occurs as government intervenes in particular situations where there are external effects. For example, government may enact certain regulations which cause firms to curtail the amount pollutants they discharge into the air.

(b) The private approach occurs as individuals form the means of solving the problems of external damage or benefit. For example, if one neighbor is inflicting external damage on other neighbors, then these neighbors can get together and agree upon how to solve this problem (i.e. without government intervention). This approach is an application of something called the Coase Theorem.

The Coase Theorem states that if property rights are well defined and transactions costs are low, private parties can internalize an externality.

Let's define some of these terms:
1) Property rights establish the legal owner of a resource and specify the ways in which the resource may be used.
2) Transactions costs are the costs of "doing business", relating to: time, communication, etc.
3) Internalizing an externality is when the (marginal) social and private costs/benefits are brought together.

Consider the following example:
A firm locates next to a lake and produces good x. Rather than pay for waste removal, the firm dumps its waste into the lake. Fishermen, who earn their livelihood in the lake, are affected because the waste kills many of the lake's fish. The cheapest way to eliminate the pollution problem is to buy pollution control equipment which costs $1000 per year to operate and maintain.

Question 1: What type of externality is this?

This is a negative externality because the waste clearly involves external damage that is inflicted upon the fishermen. The firm is not bearing the entire cost of producing good x: the firm faces the marginal cost of producing each unit of good x, but not the marginal cost of dumping the waste generated by each unit of good x. That is, the marginal cost to society of producing good x is higher than the firm's marginal cost of producing good x.

Question 2: How does the allocation of property rights affect this problem?

Assume that a judge allows the firm to continue dumping (in effect granting property rights to the firm), which lowers the fishermen's profits by $2000 per year. Assume further that the firm will allow fishing in the lake as long as the fishing doesn't affect the firm's profits.

In this setting, the fishermen must decide what they want to do. The firm will undoubtedly continue to dump their waste in the lake. If the fishermen remain in the fishing market, they must decide whether it is better to continue losing $2000 per year or whether it is better to buy pollution control equipment themselves (since the firm is not obligated to do so in this setting). The end result: the fishermen will purchase the pollution control equipment.

Suppose instead that the judge actually granted the fishermen with the property rights to the lake. In this case, changes in the allocation of property rights put the fishermen in the driver's seat. Assuming that the firm decides to remain in the good x market, they are faced with a choice between paying for pollution control of $1000 per year and compensating the fishermen at $2000 per year. The end result: the firm will purchase the pollution control equipment.

Therefore, the allocation of property rights determines who is responsible for purchasing the pollution control equipment, the firm or the fishermen.

Question 3: If the fishermen's loss were around $800 per year - instead of $2000 - then do we get other possible outcomes?

1. If the firm has the property rights to the lake, then the fishermen will either continue absorbing their $800 annual loss or else buy pollution control equipment themselves for $1000 per year. It is better to simply absorb the loss, however, the fishermen also understand that it may be possible to "bribe" the firm to reduce output. A lower output level would decrease the external cost of the pollution that affects the fishermen. Clearly, these fishermen have an incentive to bribe the firm up to the amount of the fishermen's loss. In this manner, the externality could be internalized as well.

2. If the fishermen obtain property rights to the lake, then the firm must decide whether to purchase the pollution control equipment for $1000 or compensate the fishermen for their $800 loss. It is clearly better to choose the latter.