## Negative Externalities: Pollution

### Learning Objectives

• Explain and give examples of negative externalities, including pollution
• Show how differences between private costs and social costs cause market failure

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.

### Keystone XL

You might have heard about Keystone XL in the news. It is a pipeline system designed to bring oil from Canada to the refineries near the Gulf of Mexico, as well as to boost crude oil production in the United States. While a private company, TransCanada, will own the pipeline, U.S. government approval is required because of its size and location. The pipeline is being built in four phases, with the first two currently in operation, bringing oil from Alberta, Canada, east across Canada, south through the United States into Nebraska and Oklahoma, and northeast again to Illinois. The third and fourth phases of the project, known as Keystone XL, would create a pipeline southeast from Alberta straight to Nebraska, and then from Oklahoma to the Gulf of Mexico.

Sounds like a great idea, right? A pipeline that would move much needed crude oil to the Gulf refineries would increase oil production for manufacturing needs, reduce price pressure at the gas pump, and increase overall economic growth. Supporters argue that the pipeline is one of the safest pipelines built yet, and would reduce America’s dependence on politically vulnerable Middle Eastern oil imports.

Not so fast, say its critics. The Keystone XL would be constructed over an enormous aquifer (one of the largest in the world) in the Midwest, and through an environmentally fragile area in Nebraska, causing great concern among environmentalists about possible destruction to the natural surroundings. They argue that leaks could taint valuable water sources and construction of the pipeline could disrupt and even harm indigenous species. Environmentalist groups have fought government approval of the proposed construction of the pipeline, and as of press time the pipeline projects remain stalled.

Of course, environmental concerns matter when discussing issues related to economic growth. But how much should they factor in? In the case of the pipeline, how do we know how much damage it would cause when we do not know how to put a value on the environment? Would the benefits of the pipeline outweigh the opportunity cost? The issue of how to balance economic progress with unintended effects on our planet is the subject of this module.

## The 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.

 Table 1. Carbon Dioxide Emissions From Energy Consumption: (Million Metric Tons of Carbon Dioxide) Coal Petroleum Natural Gas Purchased Electric Power Total Energy Residential Sector CO2 Emissions[1] Residential Sector 2007 December 0.082 11.237 38.986 78.282 128.587 2017 December 0 7.368 45.286 60.115 112.77 Change -0.082 -3.869 6.3 -18.167 -15.817 Commercial Sector 2007 December 0.74 6.244 21.479 70.614 99.077 2017 December 0.169 6.543 26.818 53.671 87.201 Change -0.571 0.299 5.339 -16.943 -11.876 Industrial Sector 2007 December 14.764 34.442 38.373 55.823 143.805 2017 December 10.854 28.109 48.395 37.875 124.84 Change -3.91 -6.333 10.022 -17.948 -18.965 Transportation Sector 2007 December 0 163.66 3.66 0.442 167.762 2017 December 0 155.442 4.485 0.327 160.254 Change 0 -8.218 0.825 -0.115 -7.508 Power Sector 2007 December 173.557 3.557 27.056 0 205.161 2017 December 106.821 2.125 42.067 0 151.989 Change -66.736 -1.432 15.011 0 -53.172 BioMass Sector 2007 December 24.433 2017 December 29.584 Change 5.151 Change 2007-2017 -71.299 -19.553 37.497 -53.173 -102.187

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.

### Watch IT

Although this short clip was filmed over ten years ago, emissions remain a major problem and concern for China and the global economy.

## 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 (Sprivate) 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 Sprivate, 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 Ssocial. The new equilibrium will occur at E1.

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

Table 2. A Supply Shift Caused by Pollution Costs
Price Quantity Demanded Quantity Supplied before Considering Pollution Cost Quantity Supplied after Considering Pollution Cost
$600 50,000 40,000 30,000$650 45,000 45,000 35,000
$700 40,000 50,000 40,000$750 35,000 55,000 45,000
$800 30,000 60,000 50,000$850 25,000 65,000 55,000
$900 20,000 70,000 60,000 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 Ssocial. 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. ### IDENTIFYING THE EQUILIBRIUM PRICE AND QUANTITY Table 3 shows the supply and demand conditions for a firm that will play trumpets on the streets when requested. Output is measured as the number of songs played. Table 3. Supply and Demand Conditions for a Trumpet-Playing Firm Price Quantity Demanded Quantity Supplied without paying the costs of the externality Quantity Supplied after paying the costs of the externality$20 0 10 8
$18 1 9 7$15 2.5 7.5 5.5
$12 4 6 4$10 5 5 3
$5 7.5 2.5 0.5 Step 1. Determine the negative externality in this situation. To do this, you must think about the situation described and consider all parties that might be impacted. A negative externality might be the increase in noise pollution in the area where the firm is playing. Step 2. Identify the equilibrium price and quantity when only private costs are taken into account, and then when social costs are taken into account. Remember that equilibrium is where the quantity demanded is equal to the quantity supplied. Step 3. Look down the columns to where the quantity demanded (the second column) is equal to the “quantity supplied without paying the costs of the externality” (the third column). Then refer to the first column of that row to determine the equilibrium price. In this case, the equilibrium price and quantity when only private costs are taken into account would be at a price of$10 and a quantity of five.

Step 4. Identify the equilibrium price and quantity when the additional external costs are taken into account. Look down the columns of quantity demanded (the second column) and the “quantity supplied after paying the costs of the externality” (the fourth column) then refer to the first column of that row to determine the equilibrium price. In this case, the equilibrium will be at a price of \$12 and a quantity of four.

Step 5. Consider how taking the externality into account affects the equilibrium price and quantity. Do this by comparing the two equilibrium situations. If the firm is forced to pay its additional external costs, then production of trumpet songs becomes more costly, and the supply curve will shift up.

### Watch It

Watch this video to review what happens to the supply and demand graph when a negative externality (in this case, plastic bags) results in greater social costs.

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.

### Try It

These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of these questions”) to get a new set of questions. Practice until you feel comfortable doing the questions.

### Glossary

private costs:
production costs incurred by a company
social costs:
the costs of production plus the external costs that are passed on to society

1. Note that table totals may differ from the sum of the parts due to other (minor) categories.