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.
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 [1], 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.
Please also read this very short reading from the Organization for Economic Co-operation and Development (OECD). The OECD [4]is an organization with representatives from 36 of the wealthier countries in the world [5], 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.
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 [7] 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.
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 [8] 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 [9], 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).
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:
The climate benefits of reducing fossil fuel combustion are essential sustainability considerations. However, there are many other negative externalities associated with fossil fuel use. There is increasing awareness of the negative health impacts of fossil fuel use, in particular due to PM 2.5 (particulate matter less than 2.5 microns in diameter) because they are small enough to get into lung sacs and even the bloodstream. The following are examples of recent research related to this. These are negative externalities because the costs are not included in the price of fossil fuels:
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 [13]) or a non-economic cost/benefit (e.g., the sense of freedom I got while driving the car [14] 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 it goes well beyond the scope of this course. Also, this is actually a major avenue of research, and so numbers are available.
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.
Without getting into the specifics about the 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 [18]of carbon dioxide. (Not surprisingly, the Trump administration has proposed to lower this significantly, and the Biden Administration is proposing to increase it to $51/ton.) A 2015 study out of Stanford University [19] 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 [20] (between 6 dollars and 60 dollars/ton), though they use some different considerations than SCC, and by early 2021, over 500 companies [21] worldwide had integrated SCC internally, with almost as many more planning on integrating one within the following two years.
Please note that you are not required to fully understand the calculation below, but you do need to understand 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):
What is the SCC of a kWh of bituminous coal vs. natural gas at different SCC rates (37 dollars/ton vs. 220 dollars/ton)? 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 ton 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.
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.
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:
If the Social Cost of Carbon were 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?
Now that you have completed the content, I suggest going through the Learning Objectives Self-Check list at the top of the page.
Links
[1] https://giphy.com/gifs/PIIMXAjqlO9zy
[2] https://www.youtube.com/user/mjmfoodie
[3] https://www.youtube.com/watch?v=yC5R9WPId0s
[4] http://www.oecd.org/
[5] http://www.oecd.org/about/membersandpartners/
[6] https://web.archive.org/web/20140802122709/http://stats.oecd.org/glossary/detail.asp?ID=3215
[7] http://www.auburn.edu/~johnspm/gloss/externality
[8] http://www.sciencedirect.com/science/article/pii/S2352146514001860
[9] http://www.britannica.com/technology/steel
[10] https://www.researchgate.net/publication/286620724_The_External_Benefits_of_Education
[11] https://www.hsph.harvard.edu/news/hsph-in-the-news/pollution-from-fossil-fuel-combustion-deadlier-than-previously-thought/
[12] https://www.cnbc.com/2022/06/14/air-pollution-takes-2-years-off-your-life-more-than-smoking-or-alcohol.html
[13] http://www.niehs.nih.gov/health/assets/docs_a_e/asthma_and_its_environmental_triggers_508.pdf
[14] https://www.youtube.com/watch?v=zNgcYGgtf8M
[15] http://www.theenergycollective.com/schalk-cloete/264701/energy-subsidies-and-externalities
[16] http://www.sciencedirect.com/science/article/pii/S0378775312014759
[17] https://www.eea.europa.eu/data-and-maps/indicators/renewable-gross-final-energy-consumption-4/assessment-2
[18] https://www.carbonbrief.org/qa-social-cost-carbon
[19] http://news.stanford.edu/news/2015/january/emissions-social-costs-011215.html
[20] http://www.economist.com/news/business/21591601-some-firms-are-preparing-carbon-price-would-make-big-difference-carbon-copy
[21] https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-state-of-internal-carbon-pricing
[22] http://www.eia.gov/tools/faqs/faq.cfm?id=74&t=11