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External Diseconomies and Property Rights: Part 2
Vinod Anand | 16 Feb 2012

In such cases, from a purely allocative point of view, the correct or optimal output is attained irrespective of which party compensates the other. The question of who ought to compensate has therefore to be settled on other grounds. This illustration may also seem to lend support to proposition (2), that such problems tend to be self-correcting, since it is clearly in the interests of the inhabitants themselves to agree voluntarily to offer him compensation so as to reduce smoke damage, whether the factory-owner chooses to do so by reducing his output or by installing anti-smoke devices.

THIS ILLUSTRATION may also seem to lend support to proposition (2), that such problems tend to be self-correcting, since it is clearly in the interests of the inhabitants themselves to agree voluntarily to offer him compensation so as to reduce smoke damage, whether the factory-owner chooses to do so by reducing his output or by installing anti-smoke devices.Before reviewing these arguments (I) and (2) critically, however, we must bear in mind the nature of the improvement involved in a movement to an optimal output.

In a partial economic setting, such as that exemplified by the factory whose smoky chimneys impose extra costs on the local inhabitants, we should be able to disregard as negligible all price movements in the economy save those under direct scrutiny. In such a setting, one in which all prices other than those of these vacuum cleaners remain unchanged, a movement towards the optimal output ? a contraction in the annual output of vacuum cleaners in this example can be identified as one in which everyone involved could be made better off.

Thus, beginning from the uncorrected volume of output, each additional reduction by a unit of output that brings us closer to the optimal output contributes some net social gain. This is because (1) the gain, equal to the reduction of social damages, estimated at £5 for each additional vacuum cleaner produced, exceeds (2) the loss of commercial profit per unit vacuum cleaner, which profit increases to £5 per vacuum cleaner only when output has been reduced by 40 per cent. These net social gains could then be distributed as to make all parties better off than they were in the uncorrected market situation.

All this is but an attempt at popular exposition of common doctrine, but in order to make intelligent use of this social marginal-cost rule as a means of reaching an optimal output we must recognize the influence of the existing institutional framework on the market solution, Indeed, any concern with (A) the distribution of wealth, (B) the incentive towards promoting improved allocation, and (C) equity or justice, must have regard to the key role played by institutional arrangements. (A) Under the heading of distribution, two kinds of situations must be distinguished.

These are briefly described below: (a) the first is that brought out in our smoky chimney example in which the optimal output is uniquely determined irrespective of whether the factory-owner is made to reduce his output by being legally compelled to compensate the inhabitants for the damage they suffer, or whether, instead, the inhabitants agree to compensate the factory-owner for each unit of output he forbears to produce. Whichever party compensates the other the movement to an optimal output is such as to enable everyone to be made better off there than he was in the uncorrected market situation. But even if the optimal output was reached while actually making everyone better off than he was in the uncorrected market situation -. Say, by having the inhabitants come together and bribe the factory-owner for each unit of output reduced, or to compensate him for the cost of installing smokeless chimneys ? we might well feel dissatisfied with the result.

After all, the factory-owner may be rich and the inhabitants poor. A more progressive distribution of income would result -. And, of course, the same optimal output reached ? if the factory- owner were, instead, compelled to pay the inhabitants full damages for each vacuum cleaner he produced (or else be compelled to install smokeless chimneys at his own expense). As it stands, however, the law may well favour the factory-owner who need take no account of the damages he inflicts on others in pursuit of profits and 'progress'. If so, be is then in a position to be made still better off if those who suffer damages at his hand have no recourse but to bribe him to restrain his activities: for the compensation offered him to reduce the initial units of output is likely to exceed the profit per unit be sacrifices.(b) The second kind of situation is that in which the optimal situation is not uniquely determined but itself depends upon the distribution of income as between the opposing parties.

Let us illustrate this possibility with an example of a person B having a legal right and wishing to build a house in a location that obscures the view of the surrounding countryside currently enjoyed by A. A, being richer than B, is willing to pay a maximum sum, say £2,000, rather than have a newcomer, B, build on the site in question, a sum which exceeds the minimum amount, say £500, that B agrees to accept in order to seek another Site. The existing Situation, with A?s view un-obscured by B?s house, is optimal according to the accepted definition. For it is not possible to adopt the alternative situation and make both A and B better off. (Indeed, if B initially decided to build there he could easily be bribed by A not to build there, so that both A and B would be better off in comparison with a new situation in which B just went ahead, built his house, and obscured A?s view.)

Another way in which income distribution influences optimal positions has been briefly described in the preceding chapter. There it was shown how a change in the distribution of incomes could lead of itself to a new optimal solution with a different set of relative prices in the economy as a whole.The phenomenon being discussed above is quite distinct, however. Here we focus on a small segment of the economy and disregard as negligible all price changes other than those operating within this segment. The issue now is the value to each of the contending parties of having its own way. And it will transpire that the richer is one party compared with the other, the more likely will the optimal solution coincides with his own interest.