Understanding Externalities: Pollution and Positive Impact
Externalities
An externality exists when the production or consumption of a good directly affects consumers or businesses not involved in the buying or selling of that good, and when those effects are not reflected in market prices.
When introducing the concept of externality, it’s useful to distinguish between social and private valuations. Social valuations include the social and private benefits or costs that the market has not taken into account due to the externality.
Negative Externalities: Pollution
Many negative externalities are caused by pollution. Cities contaminate rivers, lakes, and seas with spills, and cars, heating, and industries pollute the air. These externalities create inefficiencies.
Consider a factory that dumps waste into a river, polluting the water. Without any state intervention, the paper mill will only consider its private costs of producing paper and will not consider the costs imposed on others. Neither the company nor the market considers the harmful effects of water pollution on water users and society.
If there are polluting firms, they produce more than what society wants. Therefore, reducing production and consumption below the level of market equilibrium will increase market efficiency.
To address this problem, forcing producers to pay for the pollution they create, the state can set a pollution tax on each liter of wastewater discharged. The tax on pollution should equal the cost of the pollution.
Internalizing an externality means altering incentives so that people take into account the external effects of their actions. The state can internalize negative externalities by taxing goods that generate them.
Transferable Permits to Pollute
Another approach is using licenses or transferable permits to pollute. When using this method, a company agrees to pay to pollute a certain amount per unit of pollution. The authorities determine the maximum level of total pollution and the appropriate number of licenses. The price of these permits to pollute is set according to supply and demand.
Transferable permits to pollute can achieve the desired goals of reducing pollution at relatively lower costs than through direct controls.
Positive Externalities
A positive externality occurs when the activity of one entity benefits others, rather than harming them. Examples include the production of new technology and higher education.
A student, when attending university, takes into account their private costs and compares them with their assessment of private benefits. But the social value of education exceeds the private value.
Improving education also benefits other members of society; people tend to be more educated citizens who live together more harmoniously.
Positive externalities can cause markets to produce a significantly smaller quantity than is socially desirable. A market in which there is a positive externality associated with the production or consumption of a good will be inefficient. In a situation of market equilibrium, the benefit to all parties is greater than the cost to all parties.
A positive externality can be corrected by a subsidy equal to the difference between the social value and the private value, ensuring that the market is efficient.