Question: What is an external cost? Give some examples. Assess different strategies to internalize an external cost.
An external cost is an uncompensated cost imposed on third parties not directly involved in a market transaction. A negative externality occurs when MSC > MPC as there is an external cost imposed on third parties.
At market equilibrium, agents act in their own self-interest and set MPB = MPC at P* and Q*. The socially optimum equilibrium is MSB = MSC at P’ and Q’. A negative externality occurs because MSC > MPC. External costs are imposed on third parties. The sum of these external costs is the welfare loss to society. A market does not exist for external costs, so the goods’ market price is too low and output is too high compared to the socially optimum level. Market failure occurs because the good is under-priced and over-consumed.
Some examples of external costs include:
- Air pollution from smoking or burning fossil fuels. This damages the climate, crops and people’s health.
- Water pollution by an upstream factory that discharges toxic waste into a river that travels downstream. Water, plants, sea life, animals and humans downstream are harmed.
- Alcohol and drugs intoxicate people and may cause them to injure or kill others.
- Noise pollution from a neighbour playing loud music at night when others are sleeping.
- Litter and destruction of buildings and the environment are bad to look at.
The government must intervene to correct market failure. A mechanism must be used to internalize the externality, that is, to make agents take into account the external costs of their actions. Many different mechanisms could be used including taxation, regulation, property rights and marketable permits.
A Pigouvian tax (t) is an indirect tax levied on an agent’s consumption/production. The tax is equal to the marginal external cost at the socially optimum level. Taxes increase private costs so MPC shifts left. Market price rises from P* to P’ and output falls from Q* to Q’. At MPB = MPC + t, the market is now at the socially optimum level.
However, the government may not be able to estimate external costs accurately yet alone place a monetary value on them. The tax may be too high or too low, so the socially optimum level will not be reached. The government may only be able to move the market towards a more socially optimum level.
The government could also set regulations and laws directly set the amount produced/consumed in a market to the socially optimum level. A quota system could be set up by the government so that each firm/consumer is only allowed to produce/buy up to a fixed amount.
But, the government must monitor each firm/consumer to enforce regulation. Maybe firms can hide their pollution levels, making it even more difficult for the government to monitor pollution. Maybe pollution monitoring equipment is too costly to install.
Another option for the government to consider is property rights. Maybe externalities arise because of undefined property rights. A property right defines who owns a resource and what they can do with it. A chemical factory may discharge toxic waste into a river because nobody owns the river so nobody has the right to stop them. The government could allocate property rights so that agents who are harmed by externalities are given the property rights over the resources being damaged. Agents can then legally stop or charge a price to others who damage their resources. Agents must negotiate how much of the negative externality there will be and what compensation will be paid to the property right owners. The externality is then internalized into the price mechanism and the socially optimum level is reached.
On the other hand, resource owners may not be able to identify who is polluting or how much damage each polluter is causing. Air pollution could be caused unequally by any number of pollutants. Resource owners then cannot charge polluters.
Alternatively, the government could use marketable (trade-able) permits. A pollution level is set at the socially optimum level and divided over a number of permits. Permits are allocated to polluters to let them pollute a certain amount (which sums to the socially optimum level). Polluters can buy or sell permits amongst themselves if they want to pollute more or less.
Although, it may be too difficult to allocate permits fairly. How should permits be allocated? An auction? Equal amounts? Maybe grandfathering (allocating permits in proportion to past pollution)? Any option will cause some firms to argue that the decision is unfair.