PrintExternalities is one of the more nuanced concepts from EM SC 240N, so I am giving it its own page. This is mostly a summary of EM SC 240N's version.
At this point, I'm sure you are all familiar enough with basic economics to know these three fundamental principles:
- All else being equal (this is known in economics as ceteris paribus), as the demand for something in a market economy increases, the price increases, and when the demand decreases the price decreases.
- All else being equal, as the price of a good increases, the demand decreases, and if the price goes down, demand increases.
- Economic actors buy and sell things based on a cost-benefit analysis. They consider the private utility (the benefit to them) and the private cost (the cost to them) and engage in the transaction if they deem the cost-benefit balance to be in their favor.
The first two are not very controversial - if very few people want something (it has low demand) then it makes sense that companies would need to drop the price to sell it, and if something is in high demand, a company can charge more. Also, as the price of something rises, it makes sense that fewer people would want (or be able to) buy it, and vice versa. (It should be noted that some goods can be "inelastic" to a certain degree, which means that a price increase does not reduce demand by much and/or a price drop does not increase demand by much. Oil can be inelastic under certain conditions, for example.)
The third point makes a lot of sense, too. If I go to buy apples and I go to the grocery store and see two different brands of the same apples (probably Honeycrisp, since my kids are obsessed with them) side-by-side, but one is cheaper than the other, I'll probably buy the cheaper one. The same type of decision-making process goes into most economic decisions that you make, whether it involves clothes, cars, where to go out to eat, which detergent to buy, which cell phone to purchase, and so on. You ask yourself: "Is it worth it to buy this product or that one?" and this is based on the price combined with the perceived value of the good. This lies at the heart of modern economic models.
Thus, the price of something is an essential consideration in how much of it is used, and thereby produced. But how is the price determined? In simplified terms, all of the costs that go into getting the product to the end user should be reflected in the price. For my Honeycrisp apple, the costs of at least the following should be included: the farm (paying for seeds, workers, growing equipment, etc.), the company that shipped the apple to the store (paying for workers, fuel to drive the trucks, people to arrange logistics, etc.), and of course the grocery store (paying workers, electricity bills, paying investors, insurance, etc.). These and any other costs associated with getting the apple to you should be covered. Otherwise, the businesses lose money and won't be able to stay in business much longer. In sum, all of the costs to get the good to you should be included in the price. Seems pretty straightforward, right?
As you may remember, it is not always this simple. All of the apple-related costs included in the price that was noted above are internalized, that is, they are reflected in the price. But can you think of any externalized costs, that is, costs that are not reflected in the price? Examples may include:
- If the apple is not organic, the workers may get sick from the chemicals, which costs them medical bills and lost work.
- If the farm sprays a lot of pesticides, this could harm local bee populations, which in turn reduces other crops that rely on bees to pollinate.
- The fuel used to ship the apples emits CO2, which contributes to climate change, and other pollutants such as particulates, which cause health problems and associated costs.
- The electricity used to power the grocery store may have been generated by burning coal, which has similar impacts to the gas or diesel noted above.
There may also be some external benefits involved with the process of getting the apple to you. Possible examples include:
- The tree absorbed CO2 and some pollutants from the air, reducing the damages noted above. (It should be noted that this would likely be lower than the amount emitted by the truck and the power plant noted above.)
- The trucking job provided enough income for the worker to go to school and eventually get a higher-paying job with better benefits.
- The money paid to the grocery store helped it stay in business, which contributed to the viability of the community around it.
There are many more possible impacts that are not included in the price of the apple. All of these would be considered externalities, as long as they were not included in the cost. 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
(Please note that some economists consider anything that happens to someone that was not directly involved in a transaction an externality whether or not that "anything" is included in the price. In this course, we will only consider it if it is not included in the price.) Before moving on, feel free to watch the video below. The most relevant parts are the first 3:20 of the video and 5:06 - 6:22.
OPTIONAL video
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 a 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.
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.
Sustainability Implication
There are a few important sustainability implications of externalities:
- Negative externalities are very common, and often impact sustainability. Pollution is a prime example of this. It is rare that all of the costs of pollution are included in the price of something, whether it is mercury, sulfur dioxide, or particulates emitted from a power plant, CO2 emitted from a car's tailpipe or fertilizers that run off of farms and cause dead zones. These can all have major negative sustainability impacts.
- Negative externalities are overproduced because they make the price lower than it should be. If the negative impacts of climate change were included in the cost of coal-fired electricity, for example, the cost of coal-based electricity would be higher and the demand for it would diminish.
- Positive externalities are underproduced because they make the cost lower than it should be. If all of the benefits of say, education were included in its price, the price would be lower and thus in higher demand.
- In a broader context, economics plays such an important role in modern society that externalities have become a major problem.
In sum, externalities are by definition not included in the cost of goods. Positive externalities, which are usually good for sustainability, do not occur as often as they should because the benefit is not included in the price. Negative externalities (which are more common, by the way) happen more often than they should because their cost is not included in the price.
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 tonne 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/tonne. In 2013, major corporations integrate 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.
Summary
There is a lot of material to these points and it is very important, 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. pollution) not included in the price is a negative externality. An external benefit (e.g. 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.
- Goods and services with negative externalities tend to be overproduced, meaning that more is 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, a 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.