Externalities

"When individuals use property, they may cause externalities, namely, harm or benefit to others. As a general matter, it is socially desirable for individuals to do more than is in their self-interest to reduce detrimental externalities and to act so as to increase beneficial externalities. The socially optimal resolution of harmful externalities often involves the behavior of victims as well as that of injurers. If victims can do things to reduce the amount of harm more cheaply than injurers (say install air filters to avoid pollution), it is optimal for victims to do so. Moreover, victims can sometimes alter their locations to reduce their exposure to harm. Legal intervention can ameliorate problems of externalities. A major form of intervention that has been studied is direct regulation, under which the state restricts permissible behavior, such as requiring factories to use smoke arrestors. Closely related is the injunction, whereby a potential victim can enlist the power of the state to force a potential injurer to take steps to prevent harm or to cease his activity. Society can also make use of financial incentives to induce injurers to reduce harmful externalities. Under the corrective tax, a party pays the state an amount equal to the expected harm he causes, for example, the expected harm due to a discharge of a pollutant into a lake. There is also liability, a privately-initiated means of providing financial incentives, under which injurers pay for harm done if sued by victims. These methods differ in the information that the state needs to apply them, in whether they require or harness information that victims have about harm, and in other respects, such that each may be superior to the other in different circumstances (Shavell, 1993). Parties affected by externalities will sometimes have the opportunity to make mutually beneficial agreements with those who generate the externalities, as Coase (1960) stressed. But bargaining may not occur for many reasons: cost; collective action problems (such as when many victims each face small harms); and lack of knowledge of harm (such as from an invisible carcinogen). If bargaining does occur, it may not be successful, owing to asymmetric information. These difficulties often make bargaining a problematic solution to externality problems and imply that liability rules are needed, as discussed by Calabresi and Melamed (1972)."