Since the extent and way how private markets can respond to externalities depends from the reason, type and method for internalizing of a particular externality, it is appropriate to identify these concepts.

Externalities are internalized when the marginal value of the externality is priced, that is, when the private marginal costs of carrying out the activity are equal to the social costs resulting from the activity. The lack of property rights or difficulty in enforcing them constitutes a cause of externalities. Property rights consist of the right to use a resource or asset, to convert the asset or resource into an alternative use, or to sell the resource. In the case of common property resources, it is difficult to prevent other persons from using the resource. In the case of pollution for example, individuals cannot enforce rights to the use of the atmosphere.

There are three major types of externalities: producer-producer externalities, producer-consumer externalities and consumer-consumer externalities. Producer-producer externalities occur when the output or inputs used by one firm affect those employed by another one, and the effect is un-priced. For example, the output of an upstream firm may pollute the water downstream, thereby destroying fishing resources and affecting the fishing industry. In the case of producer-consumer externalities, the utility function of the consumer is dependent on the output of the producer. This type of externality occurs in the case of noise pollution by aircrafts and the effects of emissions from factories. Consumer-consumer externalities occur when the activities of one consumer affect the utility of another consumer without being priced.

We can also distinguish between pecuniary and technological externalities. Technological externalities refer to the effects where the production function or utility function is affected. A pecuniary externality, on the other hand, refers to output or utility effects on a third party due to changes in demand. These effects are reflected in changes in prices and profits of the producer, but do not alter technological possibilities of production. A negative pecuniary externality can become a result when an increase in production of one industry causes an increase in the price of inputs used by other industries.

Economic theory is based on the premise that one wishes to modify the behavior of an economic unit, one must modify the incentives facing that unit so that the preferred behavior becomes more appealing to it (i.e., more pleasant, more profitable or both). That is why in order to deal with and respond to the above-mentioned types of externalities, private markets and separated individuals develop private solutions to these problems. According to Coase, in order for these solutions to be realized, three basic conditions should be met, “First, clearly specified property rights must be assigned to either the benefiting party or the harmed party (property rights are laws that describe what people can do with their property). Second, the involved parties must have an equal amount of bargaining power. Third, the transaction costs of negotiation, or bargaining costs, must be low to ensure that the bargaining actually takes place.”

Self-interest of the Relevant Parties

According to Gregory Mankiw (2008), “the private market can often solve the problem of externalities by relying on the self-interest of the relevant parties”. In different situations the solution takes the form of integrating different types of businesses, entering into a contract of different business entities, verbal agreement between business owners and a number of others.

The suggestion that private markets may achieve solutions to externality problems is described through a Pareto-relevant externality, which is characterized by the existence of potential gains from trade between the acting and affected parties. Surely, then, self-interest can be relied upon to ensure the realization of these potential gains through exchange between the involved parties. As always, efficient exchange requires precisely defined and rigidly enforced property rights. In the case of external diseconomies, these property rights include some specification of the laws of liability for damages associated with the diseconomy. If liability rules are specified in a particular manner – allowing a specified amount of externality to be created with impunity and that amount to be exceeded only if the affected party is willing to agree – they serve as the starting point for negotiations to realize the potential gains from trade.

The two extreme examples of such liability rules are the zero liability rule and the full liability rule. Aside from these, an infinite number of intermediate rules could be conceived. The zero liability rule specifies that external diseconomies in any amount may be created with impunity; under such a rule, the affected party would have an incentive to offer a bribe to induce the acting party to reduce their output of external diseconomy. Full liability specifies that absolutely no externality may be created without the consent of the affected party; under such a rule, the acting party would have an incentive to offer compensation to induce the affected party to accept a positive amount of externality.