Key Takeaways
- Property rights can help resolve externalities by enabling negotiation of costs and benefits.
- Market failures occur when property rights are not clearly defined or protected.
- Externalities are side effects of economic activities that impact third parties.
- Property rights provide the legal ground for seeking redress from negative externalities.
- Efficient distribution of costs and benefits relies on well-defined property rights.
In economics, an externality is a side effect of a business deal that affects a third party outside of the deal. The externality may have a positive or a negative effect on that party. Property rights are often at the heart of externalities.
A legal system that protects private property rights is often the most efficient at correctly distributing costs and benefits to all parties, as long as there is a measurable economic impact to each of them.
Market failure can occur if those rights are not clear. In this case, market failure means that a transaction can have consequences to third parties that are not captured in the values of the transaction. There is no path to a solution that leads to an efficient use of the resources in the absence of private property rights.
Property Rights Are a Bargaining Chip
An externality can occur whenever an economic activity, or planned activity, imposes a cost or benefit on another party. It is called a positive externality if the activity imposes a net benefit and a negative externality if it imposes a net cost.
In many cases, the outside party’s power to seek redress for a negative externality lies in their property rights.
Positive and Negative Effects
For example, say many of your neighbors decide to bike to work rather than drive.
Those bike-riding commuters create a net benefit by reducing the amount of traffic you have to deal with. They also reduce the air pollution in your immediate area and lower the demand, and therefore the price, of gasoline. You may even experience a reduced chance of being injured in an auto accident.
But suppose your neighbors ride their bicycles through your front yard and damage your landscaping. This is a clear-cut case of externalities negatively affecting your property rights.
The issue to be negotiated is the reassignment of those costs to the producer of the external effect—the bicycling commuters—rather than to you.
On a more serious scale, pollution is a classic negative externality. If you live next to a factory with a smokestack, you may experience net costs in the form of health complications, lower property value, and a dirty house. Your rights as a property owner allow you to seek a resolution to the issue.
Negotiating Costs and Benefits with Property Rights
The simplest solution to externalities is to convince the recipient of external benefits or the producer of external costs to pay fairly for them.
Just as in a buyer-seller dynamic, the two parties can negotiate the market value of the external impact and come to an agreement. When they cannot agree, the producers of the problem may be forced to stop their cost-imposing activities until they come to terms.
Important
In the absence of private property rights, there is no path to a solution that satisfies all parties.
Resolving Externalities Through Property Rights
The wildlands and trout streams of the United Kingdom are almost entirely privately owned. An industrial polluter who dirties the water or wildland is considered guilty of trespassing and creating property damage.
The wildland or stream owner can sue the polluter and get an injunction to stop the practice. This effectively transfers the costs back to the polluter and away from the external party.
Market Failure and the Role of Property Rights
When property rights are not clearly defined or adequately protected, market failure can occur. That is, no solution that meets the needs of all parties involved can be achieved.
Traffic congestion can be an example of an externality without a solution. Since no business owns the roads, there is no incentive to charge higher rates during peak times or discounts during nonpeak hours. The individual drivers on the roads have no distinct property rights. The result is an inefficient allocation of highway travel.
Understanding Pareto Optimality in Externalities
Among economists, discussions about externality often focus on the concept of the Pareto optimal solution, or Pareto efficiency. This theory states that it is sometimes impossible to arrive at a resolution that makes someone better off without also making someone else worse off.
Pareto optimality represents an ideal that is probably impossible—that an exchange of goods or services could occur in which every single person who is directly or indirectly affected by it is perfectly satisfied.
How Do Property Rights Affect the Economy?
Property rights are key to a functioning economy. They determine how a resource is to be used, they can serve as collateral, and they provide the security and confidence for investment and improvement.
How Do Externalities Affect Market Failure?
Externalities can lead to market failure because the true cost or benefit is not factored into the product or service’s price equilibrium. They can cause inefficiencies; these may be overcome through strongly defined property rights and bargaining to properly allot costs and benefits.
What Happens to a Market in the Absence of Property Rights?
Property rights create a set of controls on net positive or negative externalities, because they provide incentive to impose costs or realize benefits. Without property rights, or when property rights are unclear, there is no way to efficiently solve the problems posed by externalities.
The Bottom Line
Property rights are the foundation for the efficient distribution of measurable costs and benefits to all parties involved. Without them, there is no incentive for altering a deal to account for externalities that affect third parties. Market failure can occur. A transaction can have consequences to third parties that aren’t captured in the values.