Externalities in Business Organization Essay Sample

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Externality is a situation that occurs when the benefits or private costs entitled to the producers and consumers of a product are different from the total costs or benefits that were used in producing or consuming the product. These situations occur when the outcomes of an individuals actions affects another individuals well being. The affected person according to the existing property rights in the society is not entitled to any payment.

A negative externality occurs when a firm bears a part of the production cost of a good or service instead of the purchaser or the producer. Negative externality can also be referred to as an external diseconomy or an external cost. An example of a negative externality is, in a neighborhood a neighbor who keeps his house in a bad condition reduces the attractiveness of the neighborhood and lowers its market value (Eskeland & Jimenez 1992).

Externalities whether negative or positive makes an organization incapable of functioning effectively in the market therefore incapable of maximizing its total utility in the community. The external portions of the production cost are not factors to the functions of supply and demand because buyers and sellers are only focused on making profits and therefore do not take into the account these costs because they do not have to bear them (Vogel 1992).

Therefore these cost portions will not factor in the determination of equilibrium market prices. The prices of these goods or services therefore will tend to equalize the marginal personal costs of the producer with the marginal personal utility of the purchaser rather than equalizing the marginal social production cost with the marginal social utility of consumption.

In negative externalization therefore the society expects the normal market incentives to the buyer and seller to lead to overproduction of the product and not optimal level of production.

Like in the example given above therefore the homeowners will to an extend keep their homes spruced up only if their neighbors will pay something for all of them to share the benefits created by sprucing up the house. An example of a negative utility is pollution caused by a company for example air or water pollution produced during the course of production that causes harm to the society.

Environment is defined to include water, air, land and the relationship between these entities with humans and other living things and property by the 1986 Act on environmental protection. As a result of rapid industrialization and population increases the vital environmental resources such as water and land are becoming scarce.

 Most industries have caused major environmental deterioration by directing their wastes in the air and water. Negative externalities results when exhaustible resources are depleted and also when renewable resources get depleted at a rate higher than the one regenerating them.

 Environmental externalities are the economic concepts of the environmental effects of production and consumption that have not been compensated and affect the utility of the consumer and the cost of enterprises outside the mechanisms of a market. Negative externalities make the costs of private production to be low than its social costs

Ethics in environmental Externality

Utilitarianism bases its idea on the fact that the moral worth of ones action is determined by ones contribution to the well being of all people meaning that the morality of ones action is determined by the outcome of that action. If the outcome is beneficial then the action is considered moral and if it is not beneficial then it is considered immoral. It can be described as the stand one takes with the ultimate aim of being happy.

Many environmental conservation institutions and philosophers view utilitarianism as a means of consumption rather than a concept of preservation (IUCN, UNEP, and WWF 1991).

 In other words these philosophers accuse utilitarianism of preferring to destroy the environment without restoring or conserving it. They argue that utilitarianism does not value biodiversity, ecosystem or take into account the value of endangered species.

According to these environmental critics, businesses and organizations using this concept are bringing the environment to the edge of destruction and therefore they need to form other environmental ethics to protect the environment. These critics however fail to see some important strength brought about by utilitarianism, which is the requirement by this ethic to do what is best for everyone.

Having good theoretical answers to practical questions does not necessarily mean that one knows what is right all the time. Therefore embracing the utilitarianism theory could be the first step an organization may need to take in doing what is right. But utilitarianism is definitely not the last step in bringing out the best outcomes.

Another theory that can be applied in the environmental externality is the golden rule. This theory is based on the idea that one should treat the others as they would expect to be treated. To apply it a business would have to put it self in the same position as the society which is the receiving end of their environmental externalities (Sorsa 1992).

 It requires the firm to consider how it would like to be treated and if it does not treat the society in the same way therefore it violates the rule. This theory is seen as a consistent principle that does not replace regular morals. It only prescribes a consistency that a company’s action should be in harmony with how it desires to be treated.

Relativism is another ethical theory that can be applied in externality.  Relativism proposes that different people and societies have their own definitions of what is wrong and what is right.

It is a theory that remains to be widely criticized in that critics argue that what is moral or ethical is common to all humanity and that while there are some believes that are common to certain communities, morality should be uniform in all communities. Therefore businesses and organizations should apply to the common ethics and morals known to all.

Impacts of Externalities

The global problems related to environmental externalities in business can be categorized into three types; biodiversity, pollution and trade related externalities. The most obvious negative impacts and the most loathed by the society caused by industry production include the emission of greenhouse gases by most good producing companies, the depletion of resources.

            It is usually very difficult to quantify the values of externalities because most of the time they represent the ethical views of the whole society and also their preferences. In cases like these one is never sure whose preference or view is more important than the other therefore interests may conflict in determining the value of the externalities with each party trying to influence the policy responses towards their benefits and interests.

            Collective agreement between the community and the society are needed to control the occurrence of these kinds of problems. On industrialization and environment different types of consensus are needed to control and regulate the industries on dealing and moving of hazardous chemicals, trading in endangered species and exporting goods and in the process negatively affecting the countries of origin (Chakravarty 1991).

Some implicated impacts of environmental externalities include environmental problems such as pollution, depletion and degradation of the naturally occurring resources. Mostly these outcomes are as a result of failures in the government and industries.

Failures in the market are as a result of inexistence of markets for environmental goods and services. If these markets occur though the social scarcity, values of these goods are underestimated by the market prices. Markets can only exist and function effectively with well defined property rights on goods and services offered and if the costs of transaction are small.

The property rights on the environmental resources are not well defined. These environmental resources include air, springs, rivers, oceans and atmosphere. In most countries these resources are viewed as being under the control of the public. Users of these resources especially industries view these resources as free cost production goods.

These industries therefore spend next to nothing by using these resources therefore they continue to use them even in scarcity. Existence of markets is determined by two important factors; definitions of distributions and property rights enforcements and the costs incurred in creating and operating the markets.

There are some property regimes in existence that control the access to forests and fisheries. Without these regimes overuse of these resources could result because there are no binding agreements that would bind the users to share the resulting costs and benefits. In such a situation different users do not care about the effects of their actions on others.

Forests are important sources of both the widely marketed materials like wood and the non-marketed materials like carbon sink. When a business or an individual owns a forest they only consider their production benefits and revenues and not the benefits to the whole community. For example many companies do not care about conservation of biodiversity and other ecosystem benefits.

Therefore community ownership of resources poses serious problems to the environment because everyone only focuses on their benefits and reaping the maximum benefits from an environmental resource.

Another impact caused by some companies in the industry market is cause of health problems in both human and animals through pollution. Although in some countries the government tries to regulate pollution by making the culprits to internalize these externality costs there are still some major polluter companies in existence.

 There have also been impacts on the environment and society caused by some companies drilling for oil and natural gas. Many critics have argued that if these companies took into account the costs of these externalities they would not make as much profit as they do.

Externalities also have impacts on the economy just as well as the environment. Environmentalists have argued that these economic impacts should be added to the costs of energy and the compensation premiums. They argue that if this condition was imposed on all forms energy and its processing costs then the green houses would be more viable economically (Williamson & Winter 1991).

The environment has been bearing the expenses of externalities for some time now and it is possible for a farmer in one side of the world to be affected by the climate change caused by industrialization in the other side of the world. For the successful existence of business and society together with the environment the importance of externalities have to be considered even though they are difficult to measure and use practice  in day to day life. 

Types of Environmental Externalities

Environmental externality types are categorized according to their effects on people and regions. An environmental externality can occur locally as in pollution of a local river or local air pollution. The public views an externality as a public bad when it is non-exclusive and non- rival. Pollution of large rivers can affect extensive regions and also greenhouse gas emission affects the global community (Pelt 1993).

The different types of externalities are used in determining the appropriate approaches for regulating and controlling the type of governance to be used in conserving the environment. The subsidiarity principle comes into play in making this decision. The principle argues that environmental decisions and regulations be given to the lowest rank of government that is capable of handling the enforcements without causing any residual externalities.

For the impacts affecting a local region the appropriate reinforcement involves the local figures of power like the municipalities. However pollutions and other ecosystem degradations involving larger regions the government or the state should be the appropriate enforcement body.

Internalization of Externalities

The looming global warming due to climate change is a sign enough by it self that the industrious companies are causing devastating affects on the environment. A lot of dialogue has been going on calling out for the industrious countries to take part in correcting this phenomenon. Many researchers believe that by the businesses doing so it would be considered as an environmental etiquette (Leduc 2007).

 The World Council of Churches for example released a letter that stated that every one in the community is equal before God who created the environment, a creation that every one in the community wants to remain healthy and thriving for the future generations.

This without doubt is a good enough reason for any business polluting the ‘creation’ to clean it up for the sake of the future generations. Failing to clean it would not be ethical since it is considered to be etiquette to clean up a mess one has created and not expecting anyone else to do it for you.

According to the WCC, responding to the climate change, which we can say has been accelerated greatly by these companies, is supposed to be a primary issue of the justice system which should require the overdeveloped countries to be more responsible for the deleterious impacts they are causing the environment.

It is therefore ethical for consumption oriented countries like these to be accountable for the promises they have given to promote justice in responding to climate change rather than increasing economic efficiency for the rich and ‘sustaining’ development for the poor.

The Earth Charter (2005) defines a common cross cultural ethical responsibility on how to interact with other human beings and with the environment. These businesses therefore can not correlate properly without being responsible for the environment and they can only do that by cleaning the environment or causing lesser harm to it.

This document was written in an attempt to find fundamental principles that could be useful in creating comprehensive approaches to sustain development and at the same time protect the environment. By looking at these expectations of the society as a whole for the government and business to look out for the environment it would be unethical for them not to internalize some of these harmful effects to the environment.

Environmental regulations and laws have been put in place to make firms and organizations to take responsibilities of their actions by internalizing their externalities through considerations of external production costs. Therefore a firm is made to meet all the taxes imposed on them for pollution as per unit of output. This has resulted to a product market that is well regulated with higher prices and minimum quantity.

There are various environmental policies that were specified by the United Nations conference on environment in 1992 that aids in guiding firms and companies on how to internalize internalities. These policies include: a firm should incorporate its environmental costs in decision making, an approach that reverses the conception that the environmental resources are free entities (Ouchi 1980).

Another policy aims at integrating the environmental and social costs into economic activities. This policy when properly implemented reflects the relative scarcity and the total value of resources through the prices. This usually contributes significantly to the prevention and control of degradation of the environment. The policies also require a firm to include market principles in framing and planning of economic instruments whenever appropriate and also integrate polices for pursuing sustainable development into their plans.

Currently there are a number of policies available for companies in industries to use in internalizing environmental externalities. They regulate pollution from a stationary point source, pollution from non stationary point source and natural resources. Pollution from a stationary point involves a regulatory mechanism that is based on given and generally accepted standards and regulations (George1953).

The standard charges against pollution are based on the amount of effluent or emission a business is producing. The charges are also determined by the concentration of the emission and effluent a company is discharging, if they exceed the outlined limits then the charges get higher. The policies also impose taxes according to the output or input units of pollution (Foy & Daly 1989).

 A company involved in industrialization requires liability insurance, guarantees from the bank and environmental bonds before it can be issued with a license permitting the production of particular goods. It also requires to be assigned with trading permits of pollution and it is also a requirement that they create markets that determine their pricing.

The policy guidelines also require that the companies provide fiscal incentives to abate pollution and it is also required of the companies to introduce clean technologies that emit the minimum pollution materials. Companies causing pollution are supposed to use market signals that indicate that they have complied with the environment conservation requirements. These signals may include eco-labeling, public disclosures and green ratings among others.

Pollution from non stationary sources involves a deposit refund system in which the company is required to pay some amount of money to cover the pollution. The policy requires that a firm upgrade and keep their technology standards high. For example the company’s vehicles should be in good conditions, and also the products by a company should be of high quality and standards for example there should be no traces of pesticides in foodstuff or any other contaminants (Baumol & Oates 1988).

 The policy also entitles the reinforcement teams to impose taxes on observable and measurable items that can act as contributors of pollution. The amount of the taxes is based on the weight of a car for example and the kind of fuel the car consumes.

The government and other bodies that impose control on pollution have a variety of approaches to use to control pollution they can choose from. The choice depends on different factors like intensity of information, feasibility in terms of the political environment, the capacity of an institution, effectiveness of cost and also the effectiveness on the environment.

Development and industrialization depends heavily on the natural and environmental resources for sustenance. These resources act as inputs into production of goods and in this way they are seen as private goods. Problems however may arise incase of over dependence a situation that leads to depletion and degradation.

Companies dealing in waste disposal services follow given policies that guide them in preventing environmental pollution. These policies require that the waste a company disposes not be more than the capacity the environment can assimilate. Without this kind of regulations companies may perceive the environment as a common property and misuse it by using it as a natural sink or a free resource that they can use as they wish. Therefore this gives enough reasons for the government to intervene and control these market failures (Jodha 1992).

The government has put measures that govern the use of private goods like coal and petroleum and other resources that are exhaustible in that the prices of their products reflect the marginal social costs including costs of depletion.  For the renewable natural resources the government has put control measures in that the prices of the products or the user charges are fixed such that the rates associated with harvesting do not exceed the rates of regeneration.  The government has also phased out the subsidies that encourage utilization of resources that can not sustain themselves.

For the companies that use resources with use value and also non use value the government requires that incentive packaging be used that involves basing prices on the ultimate marginal costs for products with use value and subsidies for products with non use value to yield the ecosystem benefits. The government can implement internalization in companies by designating an area under irreversible threat or danger of degradation, a protected area whereby the habitat becomes unavailable to the public use.

There are four main steps that many companies involved in industrial internalization follow; the recognition of externalities, identifying the perpetrator, evaluating the costs and the benefits involved in internalizing and assigning the costs and benefits of the exercise of internalizing.

There are several groups in the community that influence the exercise of internalization. These groups include the citizen groups, the environment groups and the consumer groups. These groups have influence decisions a company makes involving these four stages (Panayotou 1991).

Most of the time the victims of externalities are poor and illiterate and do not know their rights and therefore do not recognize that they have a right to compensation when hurt by these externalities. Therefore a third party usually the government has to be involved to make the perpetrators of the externalities face their responsibility of meeting the costs of internalization.

To explain these four stages a model of perpetrators and their victims will have to be used. Suppose a company discharges effluents into a river that is used by many other people. The effluents however they do not exceed the maximum threshold assigned by the regulatory policies. In this case there is no harm done to the residents and in so speaking there is no externality recognized in such a case.

However if more companies notice that the area is beneficial in terms of profits and decide to move their business in to the area the amounts of effluents discharged may increase and surpass the maximum thresholds recommended. As a result residents are affected and in this case an externality is recognized as the utility functions of the residents also have been affected.

Identification includes categorizing the involved parties either as perpetrators or the victims. In the case seen above the first company initially did not cause any harm to the residents until the arrival of the other companies and then it was also included in the list of perpetrators. There different thoughts on if the first company should meet the same costs as the other companies.

The evaluation stage involves the assignment of costs and damages the externalities have caused usually by a third party which is usually the government. The third party usually uses the initial assigned property rights, transaction costs and utility or production functions of a company to decide on compensation and whom to assign the compensation (Eggertsson 1990).

In case the government names all the companies perpetrators of the externality and asked to compensate the victims, these companies may decide to self govern or regulate their actions in trying to eliminate the appearance of the externality (Gould 1985).

They could do so by; setting maximum aggregate limits of the effluents so that nature can be able to absorb and neutralize some of these effluents and therefore reducing the harm to the other residents. The companies can agree on distribution of the discharge quotas, penalties of violation, monitoring and conflict of mechanisms of resolution.

Another way in which the companies can reduce externalities through self governance is by installing and operating a common treatment facility for the effluents either by themselves or by hiring a contractor. In internalizing, the policy maker who usually is the government state has to decide on the routes to use to achieve internalization and the criteria to use in deciding the routes.

For success in internalization one has to understand that the concept of externalization originated from neo classical economies whose main concern is the allocation efficiency. These economies have also been used in tackling issues related to growth and equity.

For the sustenance of the environment therefore changes in the structural and marginal functions of the economy are needed. For example if an environmental degradation occurs at a global scale as a result of over consumption, relying on the marginal routes for adjustments may not be the right idea because the degradation is a structural function and therefore it needs a structural route to solve (Demsetz 1964).

Usually markets never indicate any environmental stress that may be present in time mainly because markets for such environmental products do not exist actively and by the time the markets signal a problem it could be so late to reverse the problem. Therefore the society needs to set limits on the scale of exploitation which helps in choosing the appropriate routes for internalization (Dragun 1983).

A company aims at minimizing the total costs of internalization by choosing a criterion that leads to an appropriate route of an economical internalization. The total cost function is categorized into three different groups the total cost of technology, the costs of transactions and the total management costs.

Internalization of externalities calls for modification of the production process design, distribution and the waste disposal processes. It entails the renewal or the modification of the existing technology to a more suitable one. The cost also is divided into two categories the cost of buying technology and the cost of using technology. A number of technologies are available to help in internalization for example the coal washeries and the electro static precipitators that are used in the internalization of soot emissions.

            The cost of using technology is the efficiency brought about by the technology in terms of in put and out put ratio and determining what technology is economically feasible for each different level of externalities. Transaction costs are the costs associated with the capture, transfer and protection of the property rights. They are costs that that arise before a technology can be contracted for, they can also be referred to as the costs incurred during the organization of resources across companies (Dietz & Straaten 1991).


            Generally externalities are internalized through mechanisms in the market, regulation by the government, self regulation programs or a combination of all or some of these approaches. The institutional route is usually recommended because it minimizes the total cost of technology used, transaction and management.

            These costs are however also influenced by the externality attributes like occurrence, polluter, technology and time. Therefore different routes of internalization are appropriate for different levels and stages of externalities.

            In internalization the government intervention is not always required because the traditional ways of life have evolved that can deal with the costs and benefits that can result. However some communities that are ran democratically may reason to agree on an amicable way to deal with these extra costs and benefits.

                        So externalities can also be resolved by the parties involved agreeing on some form of settlement however most of the time the resolutions that such parties come to are usually as a result of threat of action by the government. Some examples of agreements that are common include the tacit agreement which is usually through a political agreement or process. This is because governments are elected for the sole purpose of serving the people and therefore may decide to strike political compromises between two disagreeing parties.

Most of the time however the government establishes laws and regulations that address pollution and other externalities that are harmful to the environment (Dasgupta & Maler 1991). These regulations might therefore be helpful in making sure that the companies meet their responsibility by keeping the environment clean.


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