Pricing externalities is not necessarily economically efficient

by Orborde 10d9th Nov 20191 min read9 comments

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[A]s long as externalities exist and are not internalized via Pigouvian taxes, the result is inefficient. The inefficiency is eliminated by charging the polluter an emission fee equal to the damage done by his pollution. In some real world cases it may be difficult to measure the amount of the damage, but, provided that that problem can be solved, using Pigouvian taxes to internalize externalities produces the efficient outcome.

That analysis was accepted by virtually the entire economics profession prior to Coase's work in the field. It is wrong—not in one way but in three. The existence of externalities does not necessarily lead to an inefficient result. Pigouvian taxes, even if they can be correctly calculated, do not in general lead to the efficient result. Third, and most important, the problem is not really externalities at all—it is transaction costs.