A negative externality exists when the cost to society of a economic agent’s action is greater than the cost to the agent. In other words, there are external costs. Failure to consider those external costs results in a market failure. In this section we examine some examples.

Externalities and Pollution

In 1969, the Cuyahoga River in Ohio was so polluted that it spontaneously burst into flame. Air pollution was so bad at that time that Chattanooga, Tennessee was a city where, as an article from Sports Illustrated put it: “the death rate from tuberculosis was double that of the rest of Tennessee and triple that of the rest of the United States, a city in which the filth in the air was so bad it melted nylon stockings off women’s legs, in which executives kept supplies of clean white shirts in their offices so they could change when a shirt became too gray to be presentable, in which headlights were turned on at high noon because the sun was eclipsed by the gunk in the sky.”

Figure 1. Environmental Debate. Across the country, countless people have protested, even risking arrest, against the Keystone XL Pipeline. (Credit: modification of image by “NoKXL”/Flickr Creative Commons)

The problem of pollution arises for every economy in the world, whether high-income or low-income, and whether market-oriented or command-oriented. Every country needs to strike some balance between production and environmental quality. This module begins by discussing how firms may fail to take certain social costs, like pollution, into their planning if they do not need to pay these costs. Traditionally, policies for environmental protection have focused on governmental limits on how much of each pollutant could be emitted. While this approach has had some success, economists have suggested a range of more flexible, market-oriented policies that reduce pollution at a lower cost. We will consider both approaches, but first let’s see how economists frame and analyze these issues.

Economics of Pollution

From 1970 to 2012, the U.S. population increased by one-third and the size of the U.S. economy more than doubled. Since the first Earth Day in April 1970, the United States, using a variety of anti-pollution policies, has made genuine progress against a number of pollutants. Table 1 lists users of energy—from residential to industrial—the types of fuels each used, and the emissions from each, according to the U.S. Energy Information Administration (EIA). The table shows that emissions of certain key air pollutants declined substantially from 2007 to 2012; they dropped 730 million metric tons (MMT) a year—a 12% reduction. This seems to indicate that progress has been made in the United States in reducing overall carbon dioxide emissions, which cause greenhouse gases.

Despite the gradual reduction in emissions from fossil fuels, many important environmental issues remain. Along with the still high levels of air and water pollution, other issues include hazardous waste disposal, destruction of wetlands and other wildlife habitats, and the impact on human health from pollution.

Pollution as a Negative Externality

Pollution is a negative externality. Economists illustrate the social costs of production with a demand and supply diagram. The social costs include the private costs of production incurred by the company and the external costs of pollution that are passed on to society. Figure 2 shows the demand and supply for manufacturing refrigerators. The demand curve (D) shows the quantity demanded at each price. The supply curve (S_private) shows the quantity of refrigerators supplied by all the firms at each price if they are taking only their private costs into account and they are allowed to emit pollution at zero cost. The market equilibrium (E₀), where quantity supplied and quantity demanded are equal, is at a price of $650 and a quantity of 45,000.

Figure 2. Taking Social Costs into Account: A Supply Shift. If the firm takes only its own costs of production into account, then its supply curve will be S_private, and the market equilibrium will occur at E₀. Accounting for additional external costs of $100 for every unit produced, the firm’s supply curve will be S_social. The new equilibrium will occur at E₁.

This information is also reflected in the first three columns of Table 2.

However, as a by-product of the metals, plastics, chemicals and energy that are used in manufacturing refrigerators, some pollution is created. Let’s say that, if these pollutants were emitted into the air and water, they would create costs of $100 per refrigerator produced. These costs might occur because of injuries to human health, property values, wildlife habitat, reduction of recreation possibilities, or because of other negative impacts. In a market with no anti-pollution restrictions, firms can dispose of certain wastes absolutely free. Now imagine that firms which produce refrigerators must factor in these external costs of pollution—that is, the firms have to consider not only the costs of labor and materials needed to make a refrigerator, but also the broader costs to society of injuries to health and other values caused by pollution. If the firm is required to pay $100 for the additional external costs of pollution each time it produces a refrigerator, production becomes more costly and the entire supply curve shifts up by $100.

As illustrated in the fourth column of Table 2 and in Figure 2, the firm will need to receive a price of $700 per refrigerator and produce a quantity of 40,000—and the firm’s new supply curve will be S_social. The new equilibrium will occur at E₁, taking the additional external costs of pollution into account results in a higher price, a lower quantity of production, and a lower quantity of pollution. The following feature will walk you through an example, this time with musical accompaniment.

Remember that the supply curve is based on choices about production that firms make while looking at their marginal costs, while the demand curve is based on the benefits that individuals perceive while maximizing utility. If no externalities existed, private costs would be the same as the costs to society as a whole, and private benefits would be the same as the benefits to society as a whole. Thus, if no externalities existed, the interaction of demand and supply will equate marginal social costs and benefits, and thus produce the allocatively efficient outcome.

However, when the externality of pollution exists, the supply curve no longer represents all social costs. Because negative externalities represent a case where markets no longer consider all social costs, but only some of them, economists commonly refer to externalities as an example of market failure, as we learned about earlier. When there is market failure, the private market fails to achieve the efficient output, because either firms do not account for all costs incurred in the production of output and/or consumers do not account for all benefits obtained (a positive externality). In the case of pollution, at the market output, social costs of production exceed social benefits to consumers, and the market produces too much of the product.

We can see a general lesson here. If firms were required to pay the social costs of pollution, they would create less pollution but produce less of the product and charge a higher price.