Why does the government have to get involved when externalities exist?

No, the government does not have to get involved. Coase theorem proves that the problem can be settled through market mechanism and compensation. The only problem which the government has to get involved is that the cost of negotiation is higher than the benefit. This has been the basis for Canadian environmental model which get admired through out the world. But if the government has to get involved, theoretically, it must raise Pigouvian taxes or more regulations in the case of negative externalities, or subsidize the private sector in the case of positive externalities. But as we have experienced in many countries, the government intervention is not always successful, even the carbon taxes in Australia. The Climate changes are there still.

It should be noted that government should only intervene when there is a technological externality, especially when it is significant. Pecuniary externalities are the by product of a healthy competition, and should not be disrupted by government involvment.

Consider a McDonald’s operating in a rural area. It is the only fast food joint in the whole town, thus enjoying a certain amount of revenue. Let’s say a Burger King opened up next to it, we would expect the revenue of McDonald’s to drop, right ? Thus McDonald’s experience an externality due to the opening of Burger King, but it’s due to a free market competition (i.e. pecuniary externality), thus the government should not get involved.

Let us now consider the same rural area, which has a new fertilizer plant. The new plant produces fertilizer to exported, at the same time inflicting a certain amount of air pollution to the immediate vicinity. The locals suffers from the bad air quality (e.g. sickness etc.) The manufacturer did not account for this cost (the cost of pollution) in their manufacturing costs, thus the product (fertilizer) is produced below the actual cost (which tends to cause over-production). In cases such as this, the government has to step in (one way is to impose a Pigouvian Tax), to ensure the actual cost is borne by the producer, to ensure that the selling price reflects the cost to the environment.

p/s : The involvement here is explained from the aspect of microeconomics, as you requested. Although it should be noted that the scope of externality is more often discussed under macroeconomics. Hope this helps !

An externality is when the actions of one have an impact upon a third party. And it can be a positive or negative impact. In other words, the actions may help or they night hurt. Now if government decides to intervene, it is to encourage the behavior if it’s a good thing or to discourage the behavior in the case of a bad thing.

In other words, if the externality has a positive impact, the government will want to encourage that positive to continue happening. But if the externality is negative, the government will take action that will prevent this behavior from continuing and hurting even more.

Source(s): I have taught economics, both micro and macro for many years. And have a degree in it too.

When externalizes exist, there are spillover benefits and costs. The market doesn’t take into consideration all the costs and benefits when allocating resources.

This is a type of market failure. When the externality is large enough, the government steps in to correct it by making the market more efficient. (Note: the government does not need to remedy every small and insignificant externality, only the large ones).

For example, education is a positive externality. It provides addition benefits such as economic growth, people paying higher taxes since they earn more, decreases in property crime, and increase innovation. Therefore, the government solves this positive externality by increased demand via mandates and subsidies.

Pollution is a negative externality. When we pollute either through production or consumption, there are spillover costs. For example, say you live next door to a dirty polluting firm. Barring any legal action, the firm will spill costs onto you that they will not pay for.

You will have to clean your house, clothes, and care more. Your property value will do down. It might be smellier. You might have increased health problems.

Therefore, the government steps in and corrects this externality through environmental regulations and technological mandates, such as scrubbers on the smokestack.

As for the Coase Theorem, it is impractical in reality since it relies on zero transaction costs. Even Coase knew that his theorem was not a practical way to solve large externalities.