Economic Externalties

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ECONOMIC EXTERNALTIES

An economic externality exists whenever the well-being of some individual is affected by the economic activities of others without particular attention to the welfare of that individual. For example, smog-related illnesses such as bronchitis and exacerbated cases of childhood asthma have been blamed, to some extent, on the emissions of nitrogen oxides from automobiles and large fossil-fuel-burning power plants. These illnesses have high treatment costs that are not incorporated in the related electricity-production and oil-consuming activities of the power plant and transportation industries, and must therefore be borne by the affected third parties. Air pollution sort is a classic example of an economic externality, and is called a negative externality because it has external costs.

Many environmental problems arise from externalities of energy exploration, production, refining, distribution, and consumption. This is especially so for fossil fuels. Air pollution, global warming and climate change, and acid rain are due mainly to emissions of carbon, sulfur, and nitrogen oxides associated with the burning of fossil fuels. Coastal and marine degradation, wildlife habitat destruction, and the availability and quality of fresh water can be blamed to some extent on oil spills, drilling for oil and gas, coal mining, and the underground storage of oil and gasoline. The nuclear power industry deals constantly with toxic-chemical and hazardous-waste issues. Some of these important environmental problems and others (e.g., deforestation and desertification) can also be attributed to the changing patterns of, and increases in, population, land use, transportation, and industry. Energy plays a significant role, and energy-environment externalities often have strong socioeconomic and environmental welfare effects.

Market forces determine much of energy production and use. Associated externalities are often beyond the capacity of the market to resolve. To understand how energy externalities impose costs on society, one must first understand how markets allocate resources (including energy) efficiently. Figure 1a shows a typical demand and supply diagram for a commodity (e.g., coal) or service. For many goods, the demand curve reflects marginal private benefit (MPB) and the supply curve reflects marginal private cost (MPC), since commodities usually are produced and consumed privately. The demand (or marginal benefit) curve is downward-sloping to reflect the fact that people will pay less for additional units of a good as they consume more of it. The demand curve also shows people's willingness to pay for a good, and so the downward slope means that as the price of the good decreases, people are willing to buy more of it. Thus the demand curve shows the amount of a good that is demanded at each price. Similarly, the supply (or marginal cost) curve shows the amount that is produced at each price. The upward slope of the supply curve reflects increasing costs of production, and also that producers are willing to supply more at higher prices.

The areas under the curves represent benefits from consuming, and costs of producing, the commodity. These benefits and costs increase as more of the good is consumed or produced. Benefits are higher than costs up to the point where MPB equals MPC, and thereafter costs are higher. Therefore net private benefits are maximized when MPB equals MPC, and Q units of the good are demanded and supplied at a price of P. The area enclosed by triangle ABC in Figure 1a represents maximum net private benefits. Social net benefits are maximized when MPB and MPC are identical to marginal social benefit (MSB) and marginal social cost (MSC), respectively. Markets efficiently allocate resources to achieve this outcome, and there is market failure whenever divergence exists between MPC and MSC, and/or between MPB and MSB. Market failure is caused by many factors, including:

externalities;
imperfect markets—when markets are not competitive;
incomplete markets—when property rights are not well defined to enable exchange;
public goods—goods that are indivisible and may be free to some consumers;
imperfect information—when costs and benefits are not fully known by all;
nonconvexities—when MSC is shaped so that it crosses MSB at several points.

Social net benefits must be used in considering how energy externalities impose costs on society. In Figure 1, private market forces promote production and consumption of Q units at a price of P, and social net benefits are maximized when MSB equals MSC with production of Q* units at a price of P*. In Figures 1b and 1c, triangles ABG and ABF represent maximum attainable social net benefits, respectively. Market production and consumption of Q units provide social net benefits equal to area ABG less area GCD in Figure 1b, and area ABF less area ECF in Figure 1c. Thus externalities impose costs on society by making it impossible to gain maximum social net benefits. In Figure 1b we can see that a negative externality such as energy-related pollution implies private market production of too much energy and pollution. Similarly, Figure 1c shows that a positive externality such as plant growth enhancement by carbon dioxide emissions from the burning of fossil fuels implies that too little energy and positive externalities are produced. In both cases, the market price for energy is too low. In reality, Figure 1b best represents the case of energy externalities, since the pollution effects outweigh the plant growth enhancement effects (i.e., the resultant external effect of energy production and use is negative).

The solution to the problems posed by energy externalities is to internalize the externality, so that the external costs and/or benefits are included in the transactions and other activities involved in the production and consumption of energy. For example, public policy that uses a tax to raise energy prices and/or restrict energy production to socially desirable levels would solve energy externality problems. Energy is an important factor of production, and any policy that affects energy price or quantity ultimately affects the entire economy.

The problems that energy externalities present are further complicated by the nature of energy pollution, other market failure issues, and inappropriate government intervention. Internalizing the externalities of air pollution and other emissions is sound in theory, but in practice, quantifying pollutants and their impacts and equitably dealing with the problem is very difficult. Energy pollutants are emitted from both stationary and mobile sources and may accumulate in the environment. Stationary sources (e.g., power plants) are generally large and few, are run by professional managers, and provide simple local pollution patterns. Mobile sources (e.g., cars) are abundant, are and run mainly by individuals, and complicate local pollution patterns. Pollutants that accumulate in the environment can affect future generations, and introduce intergenerational equity problems and issues. For example, carbon dioxide emissions in excess of the absorptive capacity of the environment can accumulate. This is because carbon dioxide is not a true pollutant because it is essential for plant life and is absorbed by plants and the oceans. Although carbon dioxide is the main greenhouse gas blamed for global warming, there is considerable scientific uncertainty regarding global warming and climate change, and there are critical measurement issues in determining both market and external costs and benefits.

The impact of energy pollutants on the environment can be local, regional, or global. As the zone of influence of pollutants extends beyond local boundaries, the political difficulties of adopting and implementing control measures are compounded. For example, sulfur oxides are regional pollutants, while excess carbon dioxide is a global pollutant. Carbon dioxide pollution policy thus requires international cooperation, but sulfur oxide policies may require only national policy. The United States has a program for trading sulfur emissions, and Japan taxes sulfur oxides, but there seems to be little progress with international attempts to control carbon dioxide. Developing nations fear that participating in carbon dioxide emission reduction programs will retard their economic development. This introduces international income distribution issues, but in many cases intranational income distribution issues also must be addressed. In short, the nature of energy pollutants, uncertainty and measurement issues, income distribution effects, intergenerational equity, economic development, and political difficulties make public policy regarding energy externalities very challenging.

Samuel N. Addy

See also: Air Pollution; Climatic Effects; Environmental Economics; Environmental Problems and Energy Use; Ethical and Moral Aspects of Energy Use; Government and the Energy Marketplace; Historical Perspectives and Social Consequences; Industry and Business, Energy as a Factor of Production in; Market Imperfections; Subsidies and Energy Costs; Supply and Demand and Energy Prices; True Energy Costs.