Key Points

  • Economic production can cause environmental damage. This tradeoff arises for all countries, whether high-income or low-income, and whether their economies are market-oriented or command-oriented.
  • An externality, sometimes called a spillover, occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. Externalities can be positive or negative.
  • Market failure is when the market does not allocate resources on its own efficiently in a way that balances social costs and benefits; externalities are one example of a market failure.
  • Social costs are costs that include both the private costs incurred by firms and also additional external costs incurred by third parties outside the production process.

Pollution

From 1970 to 2012, the population of the United States increased by one-third and the size of the US economy more than doubled. Despite this growth, the United States, using a variety of anti-pollution policies, has made genuine progress against a number of pollutants.
According to the US Energy Information Administration, the emissions of certain key air pollutants declined substantially from 2007 to 2012; in fact, they dropped 730 million metric tons 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 of pollution on human health.

Externalities

Private markets offer an efficient way to put buyers and sellers together and determine what goods are produced, how they are produced, and who gets them. The principle that voluntary exchange benefits both buyers and sellers is a fundamental building block of the economic way of thinking. But what happens when a voluntary exchange affects a third party who is neither the buyer nor the seller?
Consider, for example, a concert producer who wants to build an outdoor arena that will host country music concerts a half-mile from your neighborhood. You will be able to hear these outdoor concerts while sitting on your back porch—or perhaps even in your dining room. In this case, the sellers and buyers of concert tickets may both be quite satisfied with their voluntary exchange, but you have no voice in their market transaction.
The effect of a market exchange on a third party who is outside, or external, to the exchange is called an externality. Because externalities that occur in market transactions affect other parties beyond those involved, they are sometimes called spillovers.
Externalities can be negative or positive. If you hate country music, then having it waft into your house every night would be a negative externality. If you love country music, then what amounts to a series of free concerts would be a positive externality.

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.
The diagram below shows the demand and supply for manufacturing refrigerators. The demand curve, start text, D, end text, shows the quantity demanded at each price. The supply curve, start text, S, p, r, i, v, a, t, e, end text, 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, start text, E, 0, end text, where quantity supplied and quantity demanded are equal, is at a price of $650 and a quantity of 45,000. You can find this same information in the first three columns of the table below as well.
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
The situation is not actually that simple, however. Pollution is created as a byproduct of the metals, plastics, chemicals, and energy that are used in manufacturing refrigerators. 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, impact on property values, destruction of 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 at no cost. Now imagine that firms that 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 from 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.
Notice the fourth column of the table above. Taking external costs of pollution into account, the firm will need to receive a price of $700 per refrigerator and produce a quantity of 40,000. You can also see this shift on the graph by looking at supply curve start text, S, s, o, c, i, a, l, end text. The new equilibrium will occur at start text, E, 1, end text; 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.
Remember that supply curves are based on choices about production that firms make while looking at their marginal costs; demand curves are 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 would coordinate social costs and benefits.
But the reality is that externalities do exist. Because of this, a supply curve showing private costs doesn't actually represent all social costs.
Because 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. When there is market failure, the private market fails to achieve 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, in the case of 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.
There's a general concept here. If firms are required to pay the social costs of pollution, they create less pollution but produce less of the product and charge a higher price.

Summary

  • Economic production can cause environmental damage. This tradeoff arises for all countries, whether high-income or low-income, and whether their economies are market-oriented or command-oriented.
  • An externality, sometimes called a spillover, occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. Externalities can be positive or negative.
  • Market failure is when the market does not allocate resources on its own efficiently in a way that balances social costs and benefits; externalities are one example of a market failure.
  • Social costs are costs that include both the private costs incurred by firms and also additional external costs incurred by third parties outside the production process.