Externalities must be internalized through legal mechanisms from "summary" of Economic Analysis of Law by Richard A. Posner
Externalities are a common occurrence in economic transactions. When a person engages in an activity that affects others outside of the transaction, externalities are said to exist. These externalities can be positive or negative, depending on whether they benefit or harm third parties. The existence of externalities creates a problem because the parties involved in the transaction do not take into account the costs or benefits that accrue to others. To address this problem, externalities must be internalized through legal mechanisms. Internalizing externalities means that the parties involved in the transaction must bear the costs or receive the benefits of their actions on third parties. Legal mechanisms such as tort law, regulation, or market-based incentives can be used to internalize externalities. Tort law is one way in which externalities can be internalized. When a person's actions cause harm to others, tort law allows the injured party to sue for damages. By holding individuals accountable for the harm they cause, tort law internalizes the costs of externalities. Regulation is another way to internalize externalities. Government regulations can require individuals or businesses to take certain actions to mitigate the negative effects of their activities on third parties. For example, environmental regulations may require companies to reduce pollution or clean up contaminated sites. Market-based incentives, such as taxes or subsidies, can also be used to internalize externalities. By imposing a tax on activities that create negative externalities or providing subsidies for activities that create positive externalities, the costs and benefits of these externalities are shifted back onto the parties involved in the transaction. Internalizing externalities through legal mechanisms is essential for efficient economic outcomes. When parties are forced to consider the costs and benefits of their actions on third parties, they are more likely to make decisions that maximize social welfare. By internalizing externalities, legal mechanisms help to ensure that the costs and benefits of economic activities are properly allocated.
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