Negative Externalities

A negative externality is a spillover of an economic transaction that negatively impacts a party that is not directly involved in the transaction. The first party bears no costs for their impact on society while the second party receives no benefits from being impacted. This occurs when marginal social cost is greater than marginal private cost (MSC > MPC).

There are two types of negative externalities:

1) Negative Production Externality - when a firm's production reduces the well-being of others who are not compensated by the firm.

  • The production of smoke from factories may create clean-up costs to reduce air pollution by nearby residents.
  • The building of a dam that prevents the fish from swimming upstream, thus destroying the fishing industry in towns upstream. Note that if the fishermen are compensated by the dam builders for the full value of their loss, then no negative externality exists. This and other examples can be found in the article "Environmental Economics: Pollution"


2) Negative consumption externality - when an individual's consumption reduces the well-being of others who are not compensated by the individual.

  • The consumption of cigarettes in a restaurant that allows smoking decreases the enjoyment of a non-smoker who is consuming his/her meal at the same restaurant. (Public Finance and Public Policy, Second Edition. Jonathan Gruber. Chapter 5. Pages 123-125.)


Ways to Correct Negative Externalities

1) Taxing

The government can use the pigouvian tax to reduce consumption of a specific good or service. Consider the example of cigarettes; a pigouvian tax would be implemented by the government in order to discourage consumers from purchasing more of this good. Although this tax acts as an additional cost of consuming cigarettes, certain individuals still choose to consume this good because they may simply adjust their spending or may have a higher amount of income reserved for discretionary spending. In this situation, the tax acts more like a source of government revenue rather than a solution to the negative consumption externality. The pigouvian tax is discussed in more detail below.

2) Environmental Protection Agency Regulations

A tax causes companies at fault to pay; however, if the tax is cheaper than an alternative method of production, the pollution problem will not be solved. Then, the government can issue emissions permits that limit the amount of pollution a firm can legally emit.

3) Tort System (Tort Law)

Involves government that defines Tort law and your rights (i.e. you have the right to own a company without someone pouring toxic waste over the premises), as well as looking at case law (looking at cases in the past and it's outcome).

In the battle between business and environmental interest it is easy to side with the defenseless entity. This idea fuels the argument that much of legislation passed to crusade against negative externalities, often is exaggerated to play on the emotions of the audience seeing images of pollution in the media. Environmental issues have become popular and state level data implies that congressional voting on such issues relies heavily on whether or not there was a catalytic environmental event. Many times people assume that large corporations are tied to pollution (oil spills, dumping, and smog) because of incidences due to gross negligence and incompetence, but fail to consider simple human error. Consider the infamous Exxon Valdez oil spill in which it took almost twenty years to settle on reparations and clean up. If Exxon had any idea of the bad press they'd receive, they may have previously taken measures to avoid such an accident.

4) Internalizing Costs

Internalizing the external costs of a good is an attractive way to respond to the issue of externalities. By internalizing the costs, the actual and higher social cost and price is attained, and in doing so leads to an efficient method of allocating resources. The basic assumption here is that internalizing costs can quantify external costs.

Dealing With Pollution

First, there must be a distinction between different pollutants. The two major types of pollutants are stock pollutants and fund pollutants.

1) Stock pollutants - pollutants the environment has little or no capabilities of absorbing.

Examples of these include non biodegradable bottles and heavy metals. Since these pollutants do not biodegrade or become absorbed, they simply accumulate over time. As the accumulation of stock pollution increases with the continual release of the pollutant, so does the damage from this pollution. The damage from this pollution often can cause health related problems and environmental problems like that of acid rain.

To find the efficient allocation of stock pollutants take for instance the production of commodity X. The production of commodity X generates a proportional amount of stock pollutant (whatever that may be). The pollutant can be reduced however its at a cost equal to that of reducing an equal amount of production of commodity X. The damage from the stock pollutant is equal to the amount of accumulated stock over time. Therefore as long as the stock of pollutants exists the damage persists.

Another way of looking at it is with the dynamic efficient allocation. This is when the present value of the net benefits is maximized which where the benefit at any point in time is equal to the benefit received from the consumption of commodity X minus the cost of the damage caused by the stock pollutant. The cost of damage must be dealt with by society making it a social cost. Costs continue to rise as the accumulation of the stock pollutant is allowed to persist. Because of accumulation of stock pollutants being proportional to the production of commodity X, the more pollution we incur with the damage continuing to accumulate over time. As production continues, the price will start to reflect this cost and the commodity will eventually phase out of production.

To summarize, the efficient quantity of commodity X would decline over time due to the the marginal cost of damage rising. The price of commodity X would rise as well indicating the rising social cost of production. To deal with the increasing marginal damage, more resources will be allocated to help control the pollution until a steady state is reached where additions to the amount of pollution will stop and the stock will stabilize. This is the equilibrium point in which further emissions of the pollutant will be controlled.

2) Fund pollutants - pollutants the environment has some capabilities to absorb.

One example of a fund pollutant is carbon dioxide. These can build up over time and act as stock pollutants; however, as long as the emission of carbon dioxide is less than the absorptive capability of the environment the pollutant is under control. Fund pollutants are better understood if we differentiate between costs. There are two costs: damage costs and control costs. The analysis can be visualized in the graph below.


In the above graph, Marginal Damage Cost is read left to right, while Marginal Control Cost is read from right to left. Both curves are upward sloping because when one increases, the cost increases. To find the most efficient allocation of costs, the equilibrium is found where Marginal Control Cost equals Marginal Damage Cost.

Source - (Tietenberg, Tom, and Lewis Lynne. Environmental and Natural Resource Economics, 8th edition. New York. Pearson Education, Inc, 2009.pg358-362.)

How Fossil Fuel Effects Us and Our Environment

We live and work in a world driven by a fossil fueled economy. Our cars and other dominant forms of transportation run primarily on gasoline derived from oil. We heat and cool our homes and work places from electric utilities heavily dependent on natural gas, coal and oil. Many air pollution issues such as climate change, acid rain, and smog are directly related to our energy choices.

With respect to the environment, fossil fuel production creates a host of negative externalities. For example, fossil fuel energy production is the primary contributor of the greenhouse gasses (GHG) associated with climate change. All of the costs of the potential problems associated with climate change, loss of coastal land, dramatic weather changes causing floods or drought etc. are not costs that are or will be borne by the energy producers. They will be borne by those directly affected in the U.S. and around the world. One need go no further than the Adirondacks of New York to discover that the costs of the cleanup from acid rain and the losses from fish kills and dead rivers and lakes are costs related to the coal burning power plants in the Mid-west.

Health issues also add uncalculated costs to fossil fuel energy production. During the past decade thousands of research projects documenting the ill effects produced by the fossil fuel energy production process have been published. For example, the National Resource Defense Council (NRDC) recently released a report called Danger in the Air stating that "Every year, some 64,000 people may die prematurely from cardiopulmonary causes linked to particulate air pollution".


The Coase Theorem

Two Conditions:

1) Property rights well defined.
2) Low transaction costs.

The Coase Theorem suggests a very particular and limited role for the government in dealing with externalities: establishing property rights. In Coase's view, the fundamental limitation to implementing private-sector solutions to externalities is poorly established property rights. If the government can establish and enforce property rights, then the private market will do the rest. The Coase Theorem has an important second part: the efficient solutions to an externality do not depend on which party initially is assigned the property rights, as long as someone is assigned those rights. Here is an example illustrating the Coase Theorem.

Ronald Coase - Simplified

We shouldn't think that party A is harming party B, but more along the lines of how can party A be restrained. Essentially, if the conflict between party A and party B is about property rights, should party A have the property rights, or should party B.

Critiques of Coase Theorem

There have been criticisms of the idea of "low transaction cost" and whether or not they actually exist in the real world. Also the difficulty in finding an efficient compromise between both parties induces the need of government intervention.

The Pigouvian Tax

Marginal Social Cost (MSC): The private marginal cost to producers plus any costs associated with the production of the good that are imposed on others.

Marginal Private Cost (MPC): The direct cost to producers of producing an additional unit of a good.

Marginal Private Benefit (MPB): The direct benefit to consumers of consuming an additional unit of a good by the consumer.

Marginal Social Benefit (MSB): The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others.

The Pigouvian tax (marginal damage at the socially efficient level of production, or MD at Q*) is a per-unit tax that causes firms to reduce output. Marginal damage is the difference between the Marginal Social Cost (MSC) and the Marginal Private Cost (MPC) at Q*. Q* is the socially efficient level of output, which corresponds to the intersection of the MSC and MPB (marginal private benefit) curves.

To calculate the Pigouvian tax:

If you are supplied the MPB, MPC and MSC equations,
1) Find the free market equilibrium by setting the MPB = to the MPC. Solve for Quantity. (Q1)
2) Find the equilibrium price by plugging the quantity found in step one into either the MPC or MPB formulas. (P1)
3) Find the socially efficient level of output by repeating step 1 and 2 using the MPB and MSC formulas. (Q2 & P2)
4) Plug in P2 into the MPC formula; this is the price the sellers get to keep after the tax (P3)
5) The difference between P2 and P3 is the amount of the tax. This amount is equal to the marginal damage. The Tax revenue is this amount multiplied by Q2.

Below is a graphical representation.


Special Note: The government does not rely on taxation to correct negative externalities usually they rely on regulation.

Critiques of Pigouvian Taxing

Efficiency and enforcement problems

When it comes down to reducing negative externalities through taxation, Pigouvian taxing is not always efficient. In pursing maximization and avoidance of tax, firms have the option to either pay the tax or spend to abate pollution. Firms will choose to continue causing the externality if the cost is below the price of abatement. Firms will also proceed to layoffs to make up for the cost of the tax. Cost of monitoring firms to make sure they are not polluting in the middle of the night or causing externalities that do not result from market transaction would be too extravagant to be an efficient method.

On the other hand, an externality can have such a drastic affect on individuals that the government must regulate production parameters strictly. In that case, even a slight overproduction of a good could have a very negative affect. For example, radioactive waste is strictly regulated since even a small disposal problem, which might result from the implemention of a more lax tax-based system, would create serious health issues; for background, see Mangement of nuclear waste.

Equity problems

Pigouvian taxing is generally administered as a flat sales tax and not as a progressive tax, meaning that these measures usually do not take into account the consumers' or producers' ability to pay. Thus, a Pigouvian tax could potentially be applied in a way in which the poorest or least well off individuals in the market pay most or all of the cost. For example, carbon taxes designed to raise the price of gasoline and other fuels have been deeply controversial. Opponents argue that poor individuals may not have a choice in their consumption habits- they simply have to buy gas to commute to work, school, and so on- whereas wealthier people can cut back more easily. The Canadian provience of British Columbia has enacted a tax that includes money rebates for low-income people; for more information on the debate, see: Is BC’s Carbon Tax Fair? and To be fair, BC's carbon tax needs work.

Articles and Outside Information

Excerpt from "The Problem of Social Cost" by R. Coase.
This article is an attack on A.C. Pigou.

The Coase Theorem Rules at NYU Law.
Freakonomics author Steven Levitt discuses the recent changes to the registration process at New York University and explains the influences of Ronald Coase's Theorem.

Strange bedfellows: Activists and companies can move from confrontation to co-operation (May 22, 2008).
This article, from The Economist, takes a look at how companies are working with, rather than against, environmental advocacy groups in order to begin to gain some control over externalities.

Illustration by Satoshi Kambayashi

Cap and Trade 101
This is an article discussing Cap and Trade systems for CO2 emissions. Cap and Trade systems are how many countries already deal with the differences between social costs and private costs for polluting industries such as electricity generation.

Raise The Gas Tax
Harvard Economics professor Greg Mankiw advocates the increase of the gasoline tax contrary to public opinion demanding otherwise. He briefly discusses how a $1 per gallon increase spread over the next decade would solve many growing problems.