Externalities and Missing Markets:

The observation that bargaining can generate an optimal outcome suggests a connection between externalities and missing markets. Yet another way to view the problem of externality is that there is no market for pollution. The steel firm produces two outputs, steel and pollution. If there were a price for pollution, the mill would automatically produce the right mix of its two outputs.

To see this, suppose that property rights are well defined and enforceable and that a competitive market for pollution exists. For simplicity, also suppose that steel mill has a right to pollute. Let us find out the equilibrium price ofpollutibn.

Clearly the maximum the fishery would be willing to pay for a slight decrease in pollution would be the marginal increase in its profits that such a decrease would bring. From the viewpoint of fishery, the level of pollution is exogenous. The fishery's demand function for labor will therefore depend on h. Hence, we can write the profits of the fishery as:

(Since prices p, q,  and w are assumed to be given  and unaffected by the actions of  the two economic agents, we shall suppress prices.)  

The above example shows that a market for pollution will produce a Pareto efficient allocation;  this follows directly from the first welfare theorem, once one identifies pollution  as  just another output of production. Thus, the existence of external effects is intimately  tied to the absence of markets. In fact, the absence of property rights or markets is an alternative way to define externality.

Externalities  can  also be  distinguished  as  depletable and non-depletable. The flowers falling fiom a  tree are  depletable externality because if one person takes it another cannot. The fragrance of flowers,  however,  is a non-depletable externality because one person's enjoying  it does not reduce  the fragrance  for others.

The classic  examples  of externalities  suggest as  if  they are  a  trivial concept without any grave consequences. Externalities,  however, have serious consequences  in the context of environment. Contaminated  drinking water, smog  in cities, deforestation, threat  to coastal areas, depletion of ozone  layer, acid rain, global warming,  etc. are  important examples of externality that pose a  threat  to sustainability of mankind.  There  is an urgency to  tackle  them.