What are externalities and why is Ronald Coase an important figure in economics?

Question

What will be an ideal response?

Answer 1

Externalities are unintended consequences of your actions on others. If you plant a garden, then your neighbor enjoys the benefits without compensating you for your unintended philanthropy. Similarly, your smoking may cause problems for others, but you get away with it because no one asks you for compensation. Positive and negative externalities distort the market system from functioning optimally from a societal point of view. Consider the case of a firm polluting the atmosphere. Without government intervention in the form of pollution taxes, "too much" will be produced. Similarly, consider the case of flu or vaccine shots. Again, without governmental subsidies, "too little" will be produced. In both cases, we see optimal allocation has failed to materialize. The standard response to externalities has been government intervention in the form of subsidies, taxes, fines, quotas, and limits. Coase was the first to point out that government action is not necessary to mitigate externalities. Rather, free markets have the capacity to produce efficient results as long as contracting costs between affected parties are kept to a minimum. The nonintuitive part of Coase's theorem is that efficient allocation is possible regardless of the initial assignment of property rights concerning the public good under question, so long as contracting costs are not imposing.