Compensation for externalities

Updated: Aug 20, 2021

The payment of compensation by those causing adverse externalities to the victims of the externality. There are two different points involved here. The economic benefit of ‘making the polluter pay’ is that it creates an incentive to avoid creating a pollution externality, unless avoiding it is too expensive to be worthwhile. This internalizes the externality concerned, and makes for economic efficiency, whether or not the charge the polluter pays goes to the victims of pollution. Where these are widely diffused it may be impossible or too expensive to identify and compensate them. Compensating the victims may be appealing on grounds of equity, but is irrelevant to efficiency. It may indeed create inefficiency: if the victims could have avoided being damaged at low cost by changing their own conduct, getting compensation for actual damage may lead to too little preventive action being taken. On efficiency grounds, if the victims of externalities are compensated at should only be for unavoidable damage. See also polluter pays principle.

Reference: Oxford Press Dictonary of Economics, 5th edt.

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James Knight
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James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.