<p>Pareto efficiency and inefficiency, as Michael Greinecker comments, are properties of allocations of resources.  An allocation is efficient if there is no alternative allocation which makes someone better off without making someone else worse off.  It is inefficient if there is an alternative which makes someone better off and no one worse off.  The question ‘Are all externalities inefficient’ must be understood therefore as shorthand for something like the following: Are market outcomes always inefficient when externalities are present?  The answer, as I shall show below, is that this is not <em>necessarily</em> the case.</p>
<p>For the avoidance of doubt, and to avoid over-complexity, I will focus on the case of negative production externalities, and assume a context in which the government enforces property rights and contracts, but takes no specific measures such as regulation or taxes to mitigate externalities.  In particular, I assume that those who suffer harm or loss of utility as a result of externalities are not protected by specific property rights (such as right to a quiet environment where the issue is a noise externality).  As a consequence, producers who are the source of externalities are not constrained by any such specific property rights on the part of others, so will mitigate their externalities only if they have a financial incentive to do so.  In the absence of any such incentives, the market outcome will therefore be that the externality is unmitigated.</p>
<p>Here are some circumstances in which the market outcome would <em>not</em> be inefficient:</p>
<p><strong>1.    Where there is a continuum of options to mitigate the externality to different degrees and Coasian bargaining can reach agreement on an optimal level of mitigation</strong></p>
<p>Coasian bargaining normally requires that there be just two or at most a very small number of parties involved, otherwise inter-party negotiation is likely to become too complicated and costly.  What your question overlooks is that, often, negotiation need not be restricted to a choice between extremes (noise or no noise, payment or no payment) but can focus on trying to agree levels or degrees of mitigation (level of noise, level of payment).  In the case of noise, for example, the factory owner may have options of fitting equipment that will reduce the level of noise but not eliminate it altogether.  Such options will have costs, but probably less than that of stopping the noise altogether.  Often (though not always) the marginal abatement cost, the cost of reducing the level of the externality by one unit at the margin, is an increasing function of the amount of reduction.  Similarly, the marginal benefit to the neighbour of a reduction in noise may be greatest for the first unit of reduction and then gradually decline, the final reduction from barely audible to nil yielding very little extra benefit.  Where this is the case, there may exist an optimal or efficient level of abatement where marginal abatement cost equals marginal benefit, as in the diagram below.  Coasian bargaining among a small number of rational utility-maximising parties can (at least sometimes) result in a market outcome at that efficient level.  Notice in particular that an optimum exists despite the fact that (as in your changed example) the cost of reducing the noise to zero, represented by the total area under the marginal abatement cost curve, greatly exceeds the total benefit from reducing the noise to zero, represented by the total area under the marginal benefit curve.</p>
<p><a href="https://i.sstatic.net/1To5wi3L.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/1To5wi3L.png" alt="enter image description here" /></a></p>
<p><strong>2.    Where no available option to mitigate the externality represents a Pareto improvement on zero mitigation</strong></p>
<p>Even if there are a continuum of mitigation options as above, it could be that marginal abatement cost exceeds marginal benefit at every mitigation level, as shown below.</p>
<p><a href="https://i.sstatic.net/pBV2kN6f.png" rel="nofollow noreferrer"><img src="https://i.sstatic.net/pBV2kN6f.png" alt="enter image description here" /></a></p>
<p>If so, no level of mitigation represents a Pareto improvement on zero mitigation, which is therefore both the market outcome and the efficient outcome.  Notice that in this situation there is no need for Coasian bargaining to reach the efficient outcome, so it does not matter whether the number of parties affected by the externality is small or large.  This seems quite a plausible scenario: an example might be the construction of a small business premises marginally impairing the views of neighbours.</p>
<p><strong>3.    Where another form of market failure is present as well as the externality, and their respective effects exactly offset each other</strong></p>
<p>Suppose for example that a good subject to a negative externality in production is produced and sold by a monopolist.  Suppose further that there is no way of mitigating the externality while maintaining output, so that the only way of mitigating it is to reduce output.  Because of the externality, marginal social cost will exceed marginal private cost to the producer.  However, well-known theory shows that a profit-maximising monopolist  will charge a price exceeding marginal private cost and restrict output.  Whilst unlikely, it could in principle happen that these effects exactly offset each other so that the price charged equals the marginal social cost at the resulting output level, which will be an efficient outcome (in the absence of other complications such as consumption externalities).</p>

CC BY-SA 4.0
2024-04-25T18:20:12.490Z
2024-04-25T18:20:12.490Z
Adam Bailey
<p>There might be a bit of a misunderstanding. It is not the existence of the externality as such that is Pareto inefficient, but rather the level of the externality which is usual Pareto inefficient.</p>
<p>Usually it is not Pareto efficient to entirely eliminate the level of the externalities (i.e. put the amount equal to zero). As such, there still will be some amount of externality left at the optimal Pareto efficient level.</p>
<p>In your example the level of the externality is binary: either there is noice or there is no noise. In your first case, the Pareto optimal level of the externality was zero. For your second case, the Pareto optimal level was different from zero.</p>

CC BY-SA 4.0
2024-04-24T08:41:58.150Z
"*Usually it is not Pareto efficient to entirely eliminate the level of the externalities (i.e. put the amount equal to zero).*" In what population is this "usually" true? In textbook externality exercises definitely, but those suffer from survivorship bias. I'd wager you are allowed to fire 0 fireworks next to your neighbors house on most nights, can run around naked in the street for 0 seconds, etc. There are many externality levels that are so thoroughly set to 0 we simply do not think about them.
Giskard
CC BY-SA 4.0
2024-04-24T12:25:33.910Z
@Giskard I agree that there are indeed many externality levels set to 0 in reality, but that does not mean that 0 is the efficient level though. If my neighbour likes to shoot fireworks and pays me enough, I'm probably willing to let him shoot some fireworks.
tdm
CC BY-SA 4.0
2024-04-24T13:33:11.373Z
Not many covert millionaires living in the densely populated areas these days. But hey, maybe I am wrong; what is the source/reasoning behind your claim "*Usually it is not Pareto efficient to entirely eliminate the level of the externalities (i.e. put the amount equal to zero).*", and how exactly are we supposed to understand "usually"?
Giskard
CC BY-SA 4.0
2024-04-24T14:41:49.390Z
Thank you for these comments. I thought I was taught (in my Econ class 25 years ago!) that all externalities are necessarily Pareto-inefficient. That seems to be a faulty memory. Maybe I was taught that externalities = market failures. But if not owing to inefficiency, why do externalities = market failures? Is the idea that (typically?) in the case of an externality the marginal social costs outweigh the marginal social benefits? Or some other reason? (Side note: in my 2nd example in the OP, the marginal SB > marginal SC, right? If so, then this externality is not a market failure, right?)
Craig Duncan
CC BY-SA 4.0
2024-04-24T05:11:01.730Z
2024-04-24T05:11:01.730Z
tdm
<p>Suppose Frank owns a factory which creates noise that disturbs nearby homeowner Hank. This noise pollution is an externality. Is it also <strong>necessarily</strong> Pareto inefficient? If I recall my college economics correctly, ALL externalities are market failures and hence are inefficient. So the answer to this question is YES. But is that really so?</p>
<p>Sure, we could argue as follows. Suppose eliminating the noise is a benefit that homeowner Hank values at 500 dollars annually. Suppose further that noise eliminating technology costs factory-owner Frank 400 dollars annually. Then via Coase-style negotiations Hank and Frank can strike a deal whereby they agree on a price between 400 and 500 which Hank pays to Frank to install the technology. E.g. if Hank pays 450 to Frank, then Hank gets a 500 dollar benefit (no noise) for 450 and thus comes out ahead. And Frank gets paid 450 to install 400  dollar technology and thus also comes out ahead. That's a Pareto improvement, showing that the previous situation was Pareto inefficient. (Of course, it may be <strong>unfair</strong> that Hank has to pay Frank, but we are talking about efficiency, not fairness, so let's set the fairness question aside.)</p>
<p>Let's change the example's details, however. Now suppose the noise elimination technology costs Frank 1000 dollars annually. There is now no win-win Coase-style deal possible, given the 500 dollar value that Hank sets on quietness. Eliminating the noise pollution will entail a loss for either Frank or Hank. So, since there are no possible Pareto-improvements, how is this particular externality a case of Pareto-inefficiency?</p>
<p>(Yes, government could tax Frank $1100 if he noise-pollutes, say. That will give Frank incentive to install the noise elimination technology. I'm in favor of such a tax! But it doesn't seem to me to be a Pareto-improvement, since Frank is made worse-off relative to the no-tax baseline. In other words, I get how internalizing the externality via a pollution tax does some good, but I don't understand how to view this good as the good of &quot;removing inefficiency.&quot;)</p>
<p>What am I overlooking?</p>

CC BY-SA 4.0
2024-04-24T06:24:42.147Z
Efficiency is a property of allocations and externalities are not allocations.
Michael Greinecker
<pareto-efficiency><externalities><coasian-bargaining>
Are ALL externalities inefficient?
Craig Duncan
# Are ALL externalities inefficient?

(Asked by: username_0 on 2024-04-22)

Suppose Frank owns a factory which creates noise that disturbs nearby homeowner Hank. This noise pollution is an externality. Is it also **necessarily** Pareto inefficient? If I recall my college economics correctly, ALL externalities are market failures and hence are inefficient. So the answer to this question is YES. But is that really so?

Sure, we could argue as follows. Suppose eliminating the noise is a benefit that homeowner Hank values at 500 dollars annually. Suppose further that noise eliminating technology costs factory-owner Frank 400 dollars annually. Then via Coase-style negotiations Hank and Frank can strike a deal whereby they agree on a price between 400 and 500 which Hank pays to Frank to install the technology. E.g. if Hank pays 450 to Frank, then Hank gets a 500 dollar benefit (no noise) for 450 and thus comes out ahead. And Frank gets paid 450 to install 400 dollar technology and thus also comes out ahead. That's a Pareto improvement, showing that the previous situation was Pareto inefficient. (Of course, it may be **unfair** that Hank has to pay Frank, but we are talking about efficiency, not fairness, so let's set the fairness question aside.)

Let's change the example's details, however. Now suppose the noise elimination technology costs Frank 1000 dollars annually. There is now no win-win Coase-style deal possible, given the 500 dollar value that Hank sets on quietness. Eliminating the noise pollution will entail a loss for either Frank or Hank. So, since there are no possible Pareto-improvements, how is this particular externality a case of Pareto-inefficiency?

(Yes, government could tax Frank $1100 if he noise-pollutes, say. That will give Frank incentive to install the noise elimination technology. I'm in favor of such a tax! But it doesn't seem to me to be a Pareto-improvement, since Frank is made worse-off relative to the no-tax baseline. In other words, I get how internalizing the externality via a pollution tax does some good, but I don't understand how to view this good as the good of "removing inefficiency.")

What am I overlooking?

**Tags:** pareto-efficiency, externalities, coasian-bargaining
> **Comments:**
> **username_1**: Efficiency is a property of allocations and externalities are not allocations.  

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## 2 answers

### Answer by username_2 on 2024-04-25. Score: 2

Pareto efficiency and inefficiency, as Michael Greinecker comments, are properties of allocations of resources. An allocation is efficient if there is no alternative allocation which makes someone better off without making someone else worse off. It is inefficient if there is an alternative which makes someone better off and no one worse off. The question ‘Are all externalities inefficient’ must be understood therefore as shorthand for something like the following: Are market outcomes always inefficient when externalities are present? The answer, as I shall show below, is that this is not *necessarily* the case.

For the avoidance of doubt, and to avoid over-complexity, I will focus on the case of negative production externalities, and assume a context in which the government enforces property rights and contracts, but takes no specific measures such as regulation or taxes to mitigate externalities. In particular, I assume that those who suffer harm or loss of utility as a result of externalities are not protected by specific property rights (such as right to a quiet environment where the issue is a noise externality). As a consequence, producers who are the source of externalities are not constrained by any such specific property rights on the part of others, so will mitigate their externalities only if they have a financial incentive to do so. In the absence of any such incentives, the market outcome will therefore be that the externality is unmitigated.

Here are some circumstances in which the market outcome would *not* be inefficient:

**1. Where there is a continuum of options to mitigate the externality to different degrees and Coasian bargaining can reach agreement on an optimal level of mitigation**

Coasian bargaining normally requires that there be just two or at most a very small number of parties involved, otherwise inter-party negotiation is likely to become too complicated and costly. What your question overlooks is that, often, negotiation need not be restricted to a choice between extremes (noise or no noise, payment or no payment) but can focus on trying to agree levels or degrees of mitigation (level of noise, level of payment). In the case of noise, for example, the factory owner may have options of fitting equipment that will reduce the level of noise but not eliminate it altogether. Such options will have costs, but probably less than that of stopping the noise altogether. Often (though not always) the marginal abatement cost, the cost of reducing the level of the externality by one unit at the margin, is an increasing function of the amount of reduction. Similarly, the marginal benefit to the neighbour of a reduction in noise may be greatest for the first unit of reduction and then gradually decline, the final reduction from barely audible to nil yielding very little extra benefit. Where this is the case, there may exist an optimal or efficient level of abatement where marginal abatement cost equals marginal benefit, as in the diagram below. Coasian bargaining among a small number of rational utility-maximising parties can (at least sometimes) result in a market outcome at that efficient level. Notice in particular that an optimum exists despite the fact that (as in your changed example) the cost of reducing the noise to zero, represented by the total area under the marginal abatement cost curve, greatly exceeds the total benefit from reducing the noise to zero, represented by the total area under the marginal benefit curve.

[![enter image description here](https://i.sstatic.net/1To5wi3L.png)](https://i.sstatic.net/1To5wi3L.png)

**2. Where no available option to mitigate the externality represents a Pareto improvement on zero mitigation**

Even if there are a continuum of mitigation options as above, it could be that marginal abatement cost exceeds marginal benefit at every mitigation level, as shown below.

[![enter image description here](https://i.sstatic.net/pBV2kN6f.png)](https://i.sstatic.net/pBV2kN6f.png)

If so, no level of mitigation represents a Pareto improvement on zero mitigation, which is therefore both the market outcome and the efficient outcome. Notice that in this situation there is no need for Coasian bargaining to reach the efficient outcome, so it does not matter whether the number of parties affected by the externality is small or large. This seems quite a plausible scenario: an example might be the construction of a small business premises marginally impairing the views of neighbours.

**3. Where another form of market failure is present as well as the externality, and their respective effects exactly offset each other**

Suppose for example that a good subject to a negative externality in production is produced and sold by a monopolist. Suppose further that there is no way of mitigating the externality while maintaining output, so that the only way of mitigating it is to reduce output. Because of the externality, marginal social cost will exceed marginal private cost to the producer. However, well-known theory shows that a profit-maximising monopolist will charge a price exceeding marginal private cost and restrict output. Whilst unlikely, it could in principle happen that these effects exactly offset each other so that the price charged equals the marginal social cost at the resulting output level, which will be an efficient outcome (in the absence of other complications such as consumption externalities).


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### Answer by username_3 on 2024-04-24. Score: 1

There might be a bit of a misunderstanding. It is not the existence of the externality as such that is Pareto inefficient, but rather the level of the externality which is usual Pareto inefficient.

Usually it is not Pareto efficient to entirely eliminate the level of the externalities (i.e. put the amount equal to zero). As such, there still will be some amount of externality left at the optimal Pareto efficient level.

In your example the level of the externality is binary: either there is noice or there is no noise. In your first case, the Pareto optimal level of the externality was zero. For your second case, the Pareto optimal level was different from zero.

> **Comments:**
> **username_4**: "*Usually it is not Pareto efficient to entirely eliminate the level of the externalities (i.e. put the amount equal to zero).*" In what population is this "usually" true? In textbook externality exercises definitely, but those suffer from survivorship bias. I'd wager you are allowed to fire 0 fireworks next to your neighbors house on most nights, can run around naked in the street for 0 seconds, etc. There are many externality levels that are so thoroughly set to 0 we simply do not think about them.  
> **username_3**: @Giskard I agree that there are indeed many externality levels set to 0 in reality, but that does not mean that 0 is the efficient level though. If my neighbour likes to shoot fireworks and pays me enough, I'm probably willing to let him shoot some fireworks.  
> **username_4**: Not many covert millionaires living in the densely populated areas these days. But hey, maybe I am wrong; what is the source/reasoning behind your claim "*Usually it is not Pareto efficient to entirely eliminate the level of the externalities (i.e. put the amount equal to zero).*", and how exactly are we supposed to understand "usually"?  
> **username_0**: Thank you for these comments. I thought I was taught (in my Econ class 25 years ago!) that all externalities are necessarily Pareto-inefficient. That seems to be a faulty memory. Maybe I was taught that externalities = market failures. But if not owing to inefficiency, why do externalities = market failures? Is the idea that (typically?) in the case of an externality the marginal social costs outweigh the marginal social benefits? Or some other reason? (Side note: in my 2nd example in the OP, the marginal SB > marginal SC, right? If so, then this externality is not a market failure, right?)  

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