EM SC 240N
Energy and Sustainability in Contemporary Culture

Externalities

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Learning Objectives Self-Check

Read through the following statements/questions. You should be able to answer all of these after reading through the content on this page. I suggest writing or typing out your answers, but if nothing else, say them out loud to yourself.

 What is an externality?
 Identify one positive and negative externality, and specifically describe why it would be considered an externality.
 If an external cost or benefit is integrated into the price of a good or service, is it an externality?
 Why are things with negative externalities usually overproduced and things with positive externalities usually underproduced?
 What does the term "social cost of carbon" refer to, and why is it used?
 Identify some uncertainties in deriving an accurate price for the social cost of carbon.

Economics 101

Think about the last time you spent money on something or considered spending money on something, even if it was something small and seemingly inconsequential. Then I want you to think about why you made the decision you did. Did you spend the money or not? What was your motivation? What factor(s) did you take into consideration? I’ll do the same.

As I write this, the last thing I thought about spending money on was a small table at a used furniture store (true story). I have been needing (okay, wanting) a small table for my front porch for a little while now. I thought this table looked nice and was kind of unique. I also liked that is was a used item, and the purchase supported a non-profit organization. I considered the fact that I was on my way somewhere else and had my dog in the car, and had to be able to fit the table in the car without crowding the dog too much or making it dangerous for him to be in the car. I also considered whether or not the rest of my family would like it, in particular, my wife. Of course, I also considered how much money it would cost ($10). After taking all of this into consideration, I purchased the table.

Not the most interesting story, I know. But this is a small illustration of the fundamental theory behind the system of economics that we’ve been using for the past 150+ years. Namely, that people make purchases based on weighing the personal costs and benefits given the information they have available to them. In a perfect world, consumers know everything about a product, the benefits they will receive from it, and how it compares to similar products. (This is generally not a reasonable set of assumptions, but that’s another story that we will address later in this course.) All of these combined add up to the private benefit - which economists call the private utility, or simply utility - of the good. They also consider the private cost, which includes at least the price, but could also include other factors such as inconvenience. This process would appear to most people to simply be common sense, and most likely this system of thought is what led you to buy or not buy whatever it is you were considering in the thought experiment above.

There is another side to this transaction. Whoever offered to sell you the good almost certainly decided on a price based at least on how they could maximize their profit (or at least make a profit). Again, this makes sense and is how most businesses run. There is a balancing act between what consumers want, what the "going price" is, how much it costs the business to procure and sell it, and so forth. Nothing wrong with being motivated at least in part by profit – if a business does not make money, they will not be in business for very long, after all! The merchant from whom I purchased the table was able to offer a very low price because the item was donated, the business was partially staffed by volunteers, it gets tax breaks from being a non-profit, and so forth.

You’re probably wondering if there is a point to all of this. Well, can you think of anything missing from this equation? Are there any costs or benefits missing from this decision-making process? Think about it, then hold that thought and watch the video below. You are required to watch the first 3:20 of the video (intro and negative externalities), as well as 5:06 - 6:22 (positive externalities). A summary of the key points can be found below. The rest of the video is optional.

Externalities
Click Here for Transcript of Externalities Videos

Externalities occur when costs or benefits accrue to a person, or persons, who are not involved in the decision-making process. Note that externalities can involve either third-party costs (this would be a negative externality) or third-party benefits (this would be a positive externality). Let's address each of these in turn.

Negative externalities occur when a decision or activity imposes costs on anyone not involved in making that decision. Think of it this way: every decision involves some cost to the decision-maker; that's the private cost of your choice. But sometimes the decision imposes costs on others as well, which would be the external cost. Social cost, then, is the total cost to all members of society, or the sum of the cost to the decision-maker (which is private cost), and to others (external cost). What this means is that if a decision imposes any kind of external cost, then the social cost will exceed the private cost.

Think about this: do you think that too many people use their cell phones while driving, or too few? Well, why do you think that is? The answer lies with this notion of externalities. Look at it this way: when you're deciding whether or not to get on your cell phone while you're driving, what are the private costs, i.e., the costs to you, the decision-maker? Perhaps the cost of buying a cell phone in the first place? Or maybe the minutes you'll be using, or the cost of sending a message? It might even occur to you that you're increasing the likelihood of you getting into an accident. Now, are there any costs to other people, people who have no control over your decision to use your phone while behind the wheel? What about the increased risks to them? Or even just the annoyance of you driving like an idiot because you're on the phone? These are the external costs or the costs you impose on others with your behavior.

In the end, this discrepancy between the cost to you and the cost to society (which is the sum of the private and the external cost) leads to overproduction, if you will, of people driving while on their cell phones. Why? Because we’re all rational decision-makers – using the cost to us and the benefits to us to make our decisions. Very rarely do you find someone who includes costs to others when weighing a private decision. Essentially, you make the decision to be on the phone while driving because you consider only part of the cost - the cost to you. With negative externalities, because the private decision is based on costs that are too low, from society’s standpoint, the behaviors, or products, are overproduced from society's view.

This market failure provides a role for the government to correct the market, i.e., bring the production back to the socially optimal level. In the case of cell phones, this is most often done by putting laws in place that ban such behavior while driving and have hefty fines attached if you're caught. This effectively raises the cost of engaging in such behavior, and thus decreases the amount of the behavior that occurs. The same idea would apply to, say, a steel factory. There's a certain private cost of producing steel (I’ll assume that on the benefit or demand-side, private and social are the same for now), but the production of steel also results in pollution, a cost to others in society. This means that the marginal social cost is greater than the marginal private cost. Left to its own devices, the steel market will be based on private costs and private benefits, yielding the price and quantity associated with equilibrium E1. What would society rather see? The socially optimal outcome would be based on social cost and social benefits, or equilibrium E2. Notice, this means society would like to see less production, meaning less pollution, and would be willing to pay a higher price to do so.

This is where the government comes in.

What is the government solution to a negative externality? Simple! Get the decision-maker to internalize the external effect. Since the problem arises from the decision-maker using costs that are too low, you need to somehow impose some additional cost, so the decision becomes based on level of social cost. This could be done by way of taxes, fines, regulation or cleanup fees. Or, in the case of pollution, there’s now a market for credits that allow you to pollute. If you're clean producer, you’ll have unused credits you can sell which is an incentive for cleaner production. If you create a lot of pollution, you’ll need to acquire extra credits to continue producing, which is also an incentive to cut back on pollution production.

What about positive externalities? Just as you can make choices that impose costs on others, you can also make choices that result in benefits to others. If this is the case, then social benefits equal the private benefits, or benefits to the decision-maker, plus external benefits, or benefits to others. In the case of a positive externality, social benefits exceed the private benefits. Take education, for example. YOU decided to continue your education; why is that? What are the benefits to you of making this decision? It might just be the love of learning, or because you know that education means a better, higher-paying job in the future. But what about society? Society as a whole benefits from having a better-educated populace; highly educated, highly-skilled workers tend to be innovators, which helps keep our economy moving forward. All of this is good except for the fact that, in a free market, education will be underproduced -- this is true of any positive externality.

Why? Because the private decision-maker doesn't see the full benefit of education that society sees, so not as much education is produced. For the consumer of education, there's a certain private benefit (I’ll assume private cost and social cost are going to be the same). Decision-making based solely on private costs and benefits results in equilibrium at E1. Society as a whole sees a greater benefit; if the equilibrium were based on social costs and social benefits, equilibrium would occur at E2. Society desires a greater level of education, and is willing to pay more to achieve it. From a social standpoint, in a free-market, education will be underproduced. What's the government solution to a positive externality? Well, get the decision-maker to internalize the external effect. Sounds familiar, doesn't it? Except that with the negative externality, we had to try to get the decision-maker to see higher costs; with a positive externality, the government needs to somehow make the decision more beneficial to the private decision-maker. In the case of education, the government may provide grant money, low-interest loans, or tax credits in order to provide added incentive to get more education.

Credit: mjmfoodie on Youtube

To Read Now

Please also read this very short reading from the Organisation for Economic Co-operation and Development (OECD). The OECD is an organization with representatives from 36 of the wealthier countries in the world, but also with some lower-income countries. You may see the term “OECD countries” in future courses and elsewhere, so this is useful to know. The OECD is also a good source of information and data.

Externalities

The OECD offers a reasonably good, concise definition of externalities:

Externalities refers to situations when the effect of production or consumption of goods and services imposes costs or benefits on others which are not reflected in the prices charged for the goods and services being provided

As noted in the video, there are usually external costs and/or external benefits to transactions. External costs and benefits are borne by people or other entities that had no input on the transaction and were not fully included in the price. A negative externality occurs when an external cost occurs, and a positive externality occurs when an external benefit occurs.

Pollution is a classic example of a negative externality, as noted in the reading (and later in the video). Most pollution - particularly air pollution - is emitted without the emitter paying for any negative consequences of the pollution. These costs could be in the form of respiratory problems caused by power plant particulates, loss of beautiful vistas because of smog from car exhaust, the climate change impact of carbon dioxide from a home furnace, or any number of problems. The reading from the OECD notes that roads may have positive externalities (making it easier to get to work or school, etc.), but keep in mind that they usually have some negative externalities as well, such as air pollution, noise pollution, possibly extra traffic, and more. The point is that many of these costs and benefits happen to actors that were not involved in the decision to emit the pollutants, but that they were not compensated for (or did not have to pay for them, in the case of benefits), and were not included in the price of the good (e.g., the cost to build the road), thus making them externalities.

Dr. Paul M. Johnson of Auburn University provides a little more specificity to this definition:

An externality is "a situation in which the private costs or benefits to the producers or purchasers of a good or service differs from the total social costs or benefits entailed in its production and consumption."

The narrator in the video also points this out when she says that a negative externality occurs when social cost exceeds private cost, and a positive externality occurs when the social benefit exceeds the private benefit. If an external cost is incurred by someone outside of the transaction, and that cost is fully integrated into the cost of the product, then by definition no positive or negative externality occurs. (Note that it is nearly, if not completely, impossible to fully integrate all costs and benefits into an action. But if they could be integrated, some economists still consider them externalities because they are "external" to the transaction. They would just be neither positive nor negative.)

Air pollution from a factory is considered an externality because certain costs to others that may be incurred - such as people getting sick from the pollution and missing work and paying for doctor's bills - are not paid by the factory. Even if the factory owner gets a small fine, if that fine is less than the external cost, then it is still an externality. It's difficult to imagine an external benefit to air pollution, but maybe there are people out there that enjoy asthma attacks and diminished lung capacity. (Who am I to judge?) If a state builds a road, neither all of the negative (e.g., noise and air pollution) nor the positive (e.g., decreased commute time, increased economic activity) are fully integrated into the cost of the road, and externalities abound.

Good to Know: Externalities without a Price

Economists tend to think of externalities in dollars and cents, even if an externality does not have a direct cost. For example, let's say I play in an outdoor basketball league. I love playing basketball, but don't get a direct monetary benefit from it. What if air pollution fouls the air and makes it impossible for me to play basketball? What is the externality in dollars and cents?

In order to figure this out, my "Willingness to Pay" (WTP) would have to be determined. If it were just my teammates and me, they would ask us something to the effect of: "How much would you be willing to pay to play basketball tonight?" Of course, if you scale this up and want to know how much 1,000 people or 10,000 people would be willing to pay, you would need to perform statistical analysis. You could do the same thing for many externalities, such as political freedom, beautiful views, safe neighborhoods, etc. At any rate, it is not necessary for our purposes to always think of externalities in financial terms, but it would be if we wanted to figure out the true cost of transactions. Here is one study that analyzes Willingness to Pay for environmental externalities in Spain. (Full disclosure: This is a random study that I found through a Google search. But it is a peer-reviewed study, so is legitimate research.)

Back to my table. Can you think of any externalities that may have resulted from it? It is probable that the steel, which is mostly iron, was mined somewhere. There may have been some chemical runoff from the mine that affected local people or wildlife. Manufacturing steel requires a lot of energy, usually from coal. This causes emissions, including carbon dioxide, that can affect local people and wildlife, and likely contributing to climate change. Even if there is a small effect on climate change, it is still an externality. Perhaps the coal mine acidified the local water supply, compromising the local fish supply. The table was probably shipped somewhere, which would have caused emissions. There are more, but you get the point. It is very important to remember that for purposes of this course, these costs are negative externalities if they are not fully integrated into the cost of making, and therefore buying the product. For example, if the company that mined the steel paid a fine equivalent to the damage from the pollution, then it was likely included in the cost. That is possible, though unlikely. If nothing else, the emissions that resulted from this whole process are almost certainly not integrated into the cost (more on this later), and so there are some externalities involved.

There are likely positive externalities as well. Perhaps the iron mining company brought jobs to the local economy, and the people earning wages spent the money on other businesses. These other businesses indirectly benefited from the mining of the iron. Perhaps the mining company built some local roads that facilitated business and allowed people to more easily visit family. Closer to home, my beautiful table is sitting on my front porch and makes my neighbors happy when they see it (I might have made that up), which is a positive externality. But if it makes them jealous, that is a negative externality (also not likely).

A picture of the course author's table
Figure 2.1: Who would have thought this table had so many economic and sustainability implications?
Photo credit: D. Kasper

One more thing: As mentioned in the video, goods/actions with negative externalities are usually overproduced. This means that more of it is produced/done than is socially optimal. In other words, if there were no externalities, every impact would be reflected in the price, and less of the good/action would happen because it would be more expensive than it would be otherwise. For example, if all of the negative impacts from pollution were added to the cost of generating the pollution, then it would be more expensive to pollute, and less of it would occur. Conversely, things with positive externalities tend to be underproduced. An example of each follows:

  • If the producer of the steel for the table was forced to pay the external costs associated with pollution, then the cost to manufacture them would go up and they would probably sell fewer tables. But, if they do not have to pay the external costs, they could produce and sell more, because they would be cheaper. Thus, the table is overproduced (more are made than is best for society) if external costs are not accounted for. In short, society is forced to endure these external costs because they are essentially free to the steel producer.
  • Education is the classic example of an underproduced good. There are many societal benefits to having an educated populace - lower crime rates, better economic competitiveness, more innovation, etc. (Here is one study that provides a description of these and more.) Often, these benefits are not fully included in the cost of education. (Though it probably seems like it when you get your Penn State tuition bill!) If all of these benefits were included in the cost, the cost of education would be lower than it is, and more people would pursue it. Thus, less education is provided than would be best for society.

Quantifying Externalities

Hopefully, this makes sense to this point. Most, if not all, economic transactions have externalities, which may be positive or negative. These externalities may have a direct economic cost/benefit associated with them (e.g., hospital bill from an asthma attack that occurred because of car exhaust fumes) or a non-economic cost/benefit (e.g., the sense of freedom I got while driving the car that contributed to the asthma attack). These are real impacts on real people that are not included in the cost of the transactions that led to the externalities. You could probably list a few more externalities from driving, but that's really the easy part. Think about this for a minute: How would you go about quantifying the externalities? More specifically from the example above, how would you quantify the external costs of one gallon of gasoline burned in a car engine? How about the total external cost of generating electricity with a coal-fired power plant? Think about all of the complex calculations you would need to perform, and also how many assumptions you would have to make. Fortunately, I will not ask you to do that, because this is actually a major avenue of research, and so numbers are available.

Suggested Reading

The reading below is a pretty well-balanced assessment of externalities from electricity generation. This reading is not required, but it will be very helpful to at least read the sections called "Indirect Subsidies" and "Conclusion."

There are a few important points to be gleaned from this article.

  • First, he notes a few peer-reviewed studies that have been done to calculate the external cost of coal-based electricity. The Epstein et al. study he mentions is cited frequently and calculates the external cost at 9.3¢ per kWh. This is near the average price per kWh in the U.S. He mentions another study that found a range between 10.3 €cent - 28.4 €cent (€cent refers to Euro-cents). These are "short-term local" externalities, meaning they are experienced directly from the emissions (e.g., sickness from pollution). Further, he notes that the latter study found that these costs can be significantly reduced by installing technologies to reduce pollution. These numbers are always controversial and require assumptions, but they are important to figure out if we are to know the true cost of energy.
  • Second, that these costs may not tell the whole story. He does not disagree that those costs are real, or even that the numbers are wrong. What he does point out is that the benefits may outweigh the costs, but it depends on where you are. In countries like China and India, the short-term economic benefits from increased access to electricity are likely significantly higher than the economic costs. If there are no other energy sources available, then this is probably a valid point. But it should be noted that there are a lot of opportunities for renewable energy in both of those countries and elsewhere.
  • However, all of the above does NOT account for the long-term global externalities, which mostly consists of the costs of climate change. For climate change, no legitimate study purports that the benefits outweigh the costs. We'll address this below.
  • One last thing that I'd like to point out is that he intimates that the benefits of coal-based electricity in the U.S. outweigh even the short-term costs, but this assumes that the alternative (e.g., wind) are not viable. This argument should be approached with caution, because there are strong indications that the U.S. could get all (or at least most) of its electricity from renewable sources in the relatively near future, at least in certain areas of the country. Many European countries are well on their way to a high percentage of renewables. This, too, should be taken with caution, because a lot has to change in the next 15-20 years for all of this to happen, but it is technologically feasible. Plus, natural gas is much less polluting than coal. All of this would negate the benefits of coal.

The Social Cost of Carbon

Without getting into the specifics about the probable causes of climate change (that will be covered in the next lesson), let's take a look at climate change as an externality. As you will see in the next lesson, if the climate continues to change, the impacts will be overwhelmingly negative. Quantifying these costs is an active area of research, but many countries - including the U.S. - have placed an "official" cost on the emission of carbon dioxide (this is used to calculate the cost of new legislation). Under the Obama administration, the U.S. federal government used a social cost of carbon (SCC) of $39 per ton of carbon dioxide. (Not surprisingly, the Trump administration has proposed to lower this significantly.) A 2015 study out of Stanford University found that the U.S. grossly underestimated the SCC and that it should be closer to 220 dollars/ton. In 2013, major corporations integrated the cost of carbon emissions into their projects (between 6 dollars and 60 dollars/tonne), though they use some different considerations than SCC, and by late 2016, hundreds of companies worldwide had integrated SCC internally.

Calculating the Social Cost of Carbon

Please note that you are not required to fully understand the calculation below, but you do need to understand the how assumptions regarding SCC could impact the cost of electricity in general, as well as the implications for using natural gas vs. coal to generate electricity. This technique could be applied to anything that causes carbon dioxide emissions.

Are you wondering how much CO2 is emitted by various energy sources, so you can calculate the SCC? For example, how much would each kilowatt hour of electricity cost if the cost to society (read: externalities) were included? If you have, you've come to the right place! The carbon dioxide emissions that result from electricity generation vary significantly by energy source, so we'll start there, then apply the assumptions for actual financial cost of carbon as outlined by the two sources referred to above. Note that the information in the table below takes into consideration the average efficiency of each type of power plant (the same power plant efficiencies from Lesson 1, by the way):

See link for tabular data.
Figure 2.2: Average carbon dioxide emissions per kWh generated by various fuel sources in the U.S. click for a text description
Average carbon dioxide emissions per kWh generated by various fuel sources in the U.S.
Fuel Pounds of CO2 per Million Btu Heat rate (Btu per kWh) Pounds of Co2 per kWh
Bituminous Coal 205.300 10,089 2.07
Sub-bituminous Coal 212.700 10,089 2.15
Lignite Coal 215.400 10,089 2.17
Natural Gas 117.080 10,354 1.21
Distillate Oil (No. 2) 161.386 10,334 1.67
Residual Oil (No. 6) 173.906 10,334 1.80
Credit: U.S. EIA (public domain)

What is the SCC of a kWh of bituminous coal vs. natural gas at different SCC rates (37 dollars/tonne vs. 220 dollars/tonne)? In other words, based on the number of pounds of CO2 are emitted when burning coal and natural gas, and assuming that the total cost to society of one tonne of CO2 is either $37 or $220, how much more would we pay per kWh if these external costs were integrated into the price of that kWh?

As you can see, there is a huge difference in the social cost of electricity, based on the social cost of carbon assumption used. And also note that less carbon-intensive fuel sources would cost less than higher-intensity sources. (This is the basis of a carbon tax, by the way!)

The point of all of this discussion of different social costs of carbon is not that one calculation is better than the other, but that climate change is increasingly being recognized as having a real cost, but much of that cost will be borne in the future and is thus an externality. Even current external costs are largely borne by people that did not make the decision to pollute. This all, of course, ignores the noneconomic costs of climate change, which could be substantial.

Suggested Reading

Here is a summary of the Stanford study referred to above. It is very short and describes some of the rationale and science behind Social Cost of Carbon calculations.

Summary

Almost everything that is bought and sold has externalities. Some are more impactful than others. Externalities – negative externalities in particular – are very important considerations in sustainability. By definition, they are not included in the cost of goods. The cost of goods drives our economy, and our economy is a (and many would argue the) dominant force in society. It’s easy to see that if the dominant force in society is not accounting for all costs to society, we might have some problems. Many of the issues discussed in this and the next lesson are the results of externalities - climate change included.

There is a lot of material on this page, so here is a summary of the key points:

  • An externality is a cost or benefit of the production or consumption of a good or service that is not included in the private cost/benefit of that good or service.
  • An external cost (e.g., damage from pollution) not included in the price is a negative externality. An external benefit (e.g., social benefits of education) that is not included in the price is a positive externality.
  • If all external costs and/or benefits are included in the price, then most economists believe that no externality has taken place. Everyone that is impacted is properly compensated. (This is very rare!)
  • Goods and services with negative externalities tend to be overproduced, meaning that more are produced than is socially optimal. This is because the private cost of the good/service is less than the total (social) cost, i.e., it is cheaper than it should be.
  • Goods/services with positive externalities tend to be underproduced because the total (social) benefit is higher than the private cost, i.e., it is more expensive than it should be.
  • The direct short-term external costs of energy generation can be significant, due to health problems and other issues. In other words, if external costs were included in the price of fossil fuels, they would be more expensive. However, in some emerging economies, these external costs may be overcome by the positive benefits of having more energy.
  • Climate change is considered a negative externality, because the impacts of emissions are felt by people that did not cause the emissions. Most of these costs are in the future.
  • The social cost of carbon (SCC) is an attempt to quantify the external cost of emitting CO2. This is very difficult to do, but has been quantified in terms of dollars per tonne of emissions. By using dollar per tonne, the cost of a kWh of electricity, gallon of gasoline, ccf of natural gas, etc. can be calculated.
  • The intent of using SCC is to integrate the external cost of carbon emissions into the price of things that cause these emissions. This would make them more expensive, but could more accurately reflect the true cost.

Check Your Understanding - SCC and Externalities

If the Social Cost of Carbon would be included in the cost of current carbon emissions, is human-induced climate change no longer a negative externality? Would it be an externality at all?

Optional (But Strongly Suggested)

Now that you have completed the content, I suggest going through the Learning Objectives Self-Check list at the top of the page.