Mark Kehoe
Senior Freshman

This essay is divided into three parts. The first part deals with how externalities arise and how they theoretically affect resource allocation. The second deals with the importance of externalities in actual resource allocation and the third deals briefly with ways of correcting for externalities and for better resource allocation.

Externalities and Resource Allocation

Externalities arise when the consumption and/or the production of one or more individuals unintentionally alters the utility and/or the production functions of one or more individuals without those persons being compensated or forced to compensate others for that economic activity (Arrow, 1971). Externalities can either be positive or negative.

Externalities affect resource allocation because the market fails to fully price the external effects generated by some economic activities. This is because market prices tend to reflect the cost sellers charge buyers of a commodity, a price based on the personal utility derived, while ignoring the costs/benefits imposed on third parties. Thus the pricing mechanism fails to reflect the true or social costs of economic activity so private costs may diverge from social costs. Resources will be allocated on the basis of private consumption and/or production decisions and not on social welfare maximising ones and for this reason resources will be allocated inefficiently.

The failure of all relevant effects to make their impact on the pricing system will result in a sub-Pareto optimum allocation of resources as the social marginal cost (MSC) of an activity will not equal its marginal private cost (MPC) which equals its price, The real price of the commodity does not fully determine its allocation so the function of the market to efficiently allocate resources based on their true prices breaks down resulting in a misallocation. The existence of externalities will thus lead to a sub-optimal allocation as either too many resources are used in processes conferring uncompensated social costs or too few are used in processes conferring uncompensated social benefits as the profit maximising output is less than the socially optimal output. This misallocation of resources is best seen by an example.

Let a firm be in perfect competition with a given market price, p, and a profit maximising output of xl and a marginal cost curve as in figure 1. Suppose now that the production of x creates air pollution which imposes a cost on local residents of [[sterling]]1 per unit of x produced. To obtain the MSC of x [[sterling]]1 must be added to the MPC of x. As a consequence of the negative externality the profit maximising output xl, exceeds the socially optimal level x* where the MSC=MPC=P.

If the firm is permitted to pollute, the firm produces too much of x, the reason being that part of the real cost of production, [[sterling]]1 per unit, is not recognised as a cost by the firm (Johansson, 1991). Therefore the existence of uncorrected externalities implies that resource allocation is inefficient as a Pareto improvement is possible. Thus externalities, which tend to be mostly negative, result in an inefficient resource allocation as commodities are not allocated on the basis of their true economic price.

Externalities and Cost Benefit Analysis

The importance of externalities in actual resource allocation is best seen by studying cost- benefit analyses. Such a cost-benefit analysis is Barretts and Mooneys (1982) cost benefit study of the Naas Motorway Bypass. This study showed how the construction of the bypass resulted in significant positive externalities and a few negative ones.

There were three main positive externalities. The first was a time savings of 10.28 minutes from reduced traffic congestion in Naas centre at peak hours accounting for 90.5 per cent of the total benefits from the bypass, making the social feasibility of the project was very dependent on this positive externality. The second was a reduction in road accidents in Naas centre due to the transfer of traffic to the safer motor way, while the third was a fuel saving accounting for 2.6 per cent of the benefits.

There were other positive externalities such as reduced lead and smoke pollution in Naas centre and especially reduced noise pollution which constituted a serious negative externality. There were also negative externalities on the environment associated with the construction of the motorway. The Letich committee (1977) detailed some of these costs on non-road users such as the demolition of property, visual intrusion and the impact of farm severance. There exist substantial problems in pricing these externalities and for this reason they were excluded from the study as no accurate price could be put on them. This pricing problem will have affected exceeded the negative ones so yielding a net positive externality suggesting that the real cost of the project was lower than its private cost. This would imply that similar projects should be undertaken for congested towns on the national primary routes (Barrett, 1984), thus leading to a more optimal resource allocation.

Resource allocation will not be optimal unless all costs and benefits associated with the project are calculated. This is the major difficulty with cost-benefit analysis as we do not know how to accurately measure externalities. Some economists such as Roth have suggested that it is impossible to price them, so much so that he ignores them in his road pricing study. This is also echoed in the Smeed Report (1964).

By ignoring to price externalities resource allocation will suffer as projects which would be socially profitable when including all externalities may not be so if only private costs are calculated. This point is addressed by Mishans horse and rabbit stew analogy (1990). He says that economists can easily ignore externalities as they are quantitatively difficult to measure, but doing so could result in a sub optimal resource allocation as such analysis would favour mostly commercially viable projects. There is another school of thought which says that social expenditure cannot be justified largely on the grounds of correcting for externalities. Lees makes the point that only 5 per cent of health expenditure can be justified in terms of correcting for externalities as most medical expenditure centres on non-contagious diseases where the benefits are quite private. Peacock and Wiseman make a similar point saying that the positive externalities of education of the individual may be exaggerated. They suspect that the recipient may appropriate most of the benefits in the form of higher wages and salaries (Allan, 1971).

Therefore externalities, although important in causing resource allocation to be sub-optimal, have varying effects. One thing that is sure, however, is that they must be included in cost-benefit analysis even if they are estimated very roughly.

The existence of externalities implies that unless special arrangements are made resource allocation may not be Pareto optimal. One way to Pareto optimality is by modifying the pricing system to reflect the true price of the resource. Through this process of internalisation/shadow pricing resources are allocated on the basis of their true prices. It may not be possible to internalise all externalities (Mishan, 1990) so government intervention in the market may be needed.

An area where externalities may be tolerated even though they affect resource allocation is where the correction of them may have regressive social welfare distribution effects and clash with other government objectives (OHagan, 1991). This arises because the Pareto criterion takes no account of welfare distribution. The other case is where the benefit of internalisation exceeds its cost. But society is always worse off with existence of externalities even when they are corrected than without them. By internalising them we are doing no more that making the best of a bad job. We are certainly not as well off as we should be if they had not appeared on the economic scene.(Mishan, 1990). Thus we are forced to the theory of the second-best.

Externalities effect resource allocation by distorting the pricing mechanism, resulting in an allocation of resources that is not optimal. Therefore the importance of externalities in resource allocation is crucial if it is to be optimal and it is observation that gives cost- benefit analysis some of its justification as it is necessary to measure those created by activities and to intervene to correct them.


Allan, C (1971) The Theory of Taxation

Arrow, K (1971) Public Expenditure and Policy Analysis

Barrett, S (1982) Transport Policy in Ireland

Barrett, S & Mooney, D (1984) The Naas Motorway Bypass - A Cost Benefit Analysis in Quarterly Economic Commentary 1/1984

Johansson, P (1991) An Introduction To Modern Welfare Economics

OHagan, J (ed. 1991) The Economy of Ireland

Mishan, E (1990) Cost Benefit Analysis

Mishan, E (1988) Elements of Cost Benefit Analysis. Road Pricing: the Technical and Economic Possibilities [ The Smeed Report], (1964).