Negative externalities also known as spillover costs

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Negative Externalities

Negative externalities, also known as spillover effects, are costs of a commodity that impact consumers that are not part of the product’s business. This is a microeconomic issue since the expense paid by the third party is not factored into the product’s price without political interference. For eg, the expense is borne by a passive smoker in the management of health conditions exacerbated by passive smoking participation.

Road Transportation in European Countries

In the case of European countries, road transportation causes a variety of negative externalities such as noise, congestion, and fatalities. As a result, policymakers in Europe resolved to impose corrective taxes on petroleum products to internalize the externalities. This way, the marginal social cost would equal marginal private costs. A twitch in the pocket led economic agents to rethink their use of fuel, and this led to a significant fall in pollution, accidents, and congestion in European cities. According to transport London, traffic in the last ten years has gone down by 10.2 percent.

Market-Based Policies for Curbing Negative Externalities

Policymakers and governments have come up with methods to curb the effects of negative externalities. The government does this in two ways; either by direct control measures such as limiting the amount of toxic wastes that can be emitted and by market-based policies such as imposing corrective taxes and introducing markets for permits to pollute. In this paper, we focus on market-based-policies.

Pigovian Taxes

Named after economist Arthur Pigou. They are also known as corrective taxes. These are taxes that internalize the externality by including it as a cost incurred during the production process. The advantage of these taxes over the regulations is that a company has the incentive only to satisfy the regulation. The Pigovian taxes when imposed tend to cause a significant increase in the cost of production forcing producers to reduce their output. They will cut their negative externalities in order to lower their cost of production. This policy goes a long way in reducing negative externalities, but it is also an opportunity since the government can collect a significant amount of revenue from the taxes.

Introducing Tradable Permits

Another efficient way to deal with negative externalities is by the government creating a market for the rights to create a specific externality that will affect the third party negatively, and this can also be referred to as the Coase theorem; named after the economist who put forward the theorem, Arthur Coase. The theory is that, “Under perfect competition, once government has assigned clearly defined property rights in contested resources and as long 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,” The Journal of Law and Economics, October 1960). The government has first to determine the levels of pollution that are safe and then sells the rights to pollute to companies. If the company finds out that polluting less than their rights to do so leads to losses, they will have to put policies in place that ensure pollution is reduced and production is increased. In this way minimizing the effects of the externality in question. This is a microeconomic issue turned into an opportunity since the government generates revenue in selling these permits.

Potential Consequences

Imposing corrective taxes and selling permits to allow for rights to create negative externalities is a good way of preventing this microeconomic issue, however, if not done correctly, they may have dire consequences.

Increasing Costs and Higher Prices

For example, although pollution is not desired in any society, the cost incurred in combating it increases considerably as the amount of pollution remaining tends to zero, and this makes the efforts to clean the environment increasingly expensive for a continuously smaller benefit.

Another disadvantage of selling permits and imposing corrective taxes on negative externalities is that most companies may decide to pass the extra cost incurred thanks to these policies to their customers leading to higher prices of commodities.

Importance of Accurate Information

Given the facts, the above ways of dealing with negative externalities may cause more harm than good if proper investigations into the opportunity to come up with the most suitable way to implement it are not done. The government and policymakers need to have information on the exact amount of externality cost that is imposed by a company to the third party. Information on the accurate price and output for the specific market is vital as well. If policymakers overestimate the cost of the externality, it may lead to an economic disaster.


Economic decisions tend to have external impacts both positive and negative on people who are not involved in the transaction. It is a microeconomic problem since if negative, the cost incurred by the third party is not taken into account when deciding how much to consume. The situation can be combated with policies such as corrective taxes and permits to pollute that ensure this cost is internalized. However, if this is not done the correct way, it may create more economic problems. The government and policymakers, therefore, need information on the level of marginal damages and also marginal cost function of the companies producing the externality.

Works cited (2017). Negative Externality - Economics. [online] Available at: [Accessed 30 Oct. 2017].

Santos, G. (2017). Road fuel taxes in Europe: Do they internalize road transport externalities?.

Spaulding, W. (2017). Externalities. [online] Available at: [Accessed 30 Oct. 2017].

 Staff, I. (2017). Externality. [online] Investopedia. Available at: [Accessed 30 Oct. 2017].

November 09, 2022

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