Externalities, or external economies, are important subjects in economics, especially when negative externalities may adversely affect traditional Pareto-optimal outcomes. A system that protects private property rights is often the most efficient at correctly distributing costs and benefits as long as there is a visible economic impact from external economies. There are cases, however, where more complex arrangements might be necessary.

How Externalities Affect Property Rights

An externality occurs whenever an economic activity imposes a net cost or benefit on a third party. It is called a positive externality if the activity imposes a net benefit and a negative externality if it imposes a net cost.

For example, several positive externalities may arise if your neighbors decide to bike to work rather than take their car. In so doing, they create net benefits for you by reducing the amount of traffic you have to drive through. They also reduce the amount of car pollution in your immediate area; lower the demand, and therefore price, of gasoline; and slightly reduce your chance of being killed in an auto accident. Pollution is a classic negative externality. If you live next to a copper factory with a smokestack, you may experience net costs in the form of dirty property, lower property values, health complications or less sunshine.

Suppose your neighbors ride their bicycles through your front yard or the smokestack dirties your shirt. These are clear-cut cases when the externalities negatively affect your property rights. The ensuing economic problem is how to assign those costs to the producer of the external effect and away from you and your property.

Using Property Rights to Transfer Costs and Benefits

The classic and simplest solution to externalities is to either force the recipient of external benefits or the producer of external costs to pay 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. If they cannot agree, producers can withhold benefits or be forced to stop cost-imposing activities.

An excellent example of this is seen in the United Kingdom's wildlands and trout streams, which are almost entirely privately owned and operated. If an industrial polluter dirties the water or wildland, he is considered guilty of trespassing and creating property damage just as if he dumped trash onto your front lawn. The wildland or stream owner could sue the polluter and get an injunction to stop the practice. This transfers the costs back to the polluter and away from the third party.

Lack of Property Rights Cause Market Failures

Negative externalities may result from markets where property rights are not clearly defined or adequately protected. Traffic congestion is a clear example. Since no entrepreneur or business owns public roads, nobody can charge higher rates for using highly trafficked roads or offer discounts for traveling during nonpeak hours. This causes overuse of the roads during peak hours, leading to traffic congestion, accidents and other delays. The result is an inefficient allocation of highway travel.

Pareto Optimality and Externalities in the Real World

If you have taken any 200-level or higher economics courses, you have likely heard plenty about Pareto efficiency or the Pareto optimal solution. These theoretical situations arise if no extra economic exchanges can take place that make someone better off without also making someone else worse off. Many externality discussions are rooted in terms of Pareto optimality.

The problem with Pareto optimality is it is impossible to discover and possibly inapplicable to the real world entirely. All economic value is subjective and, by its nature, impossible to compare interpersonally. Even if it were possible, it is unlikely that anyone could possess the adequate knowledge of timing and circumstance to know how each individual values any given transaction. In practical terms, this means it is not possible to move markets towards a Pareto Optimal solution through a top-down approach.