Pollution as an Externality

Externalities are common in almost every area of economic activity. An externality is a cost or a benefit imposed upon a third party by the production or consumption of a good. In other words, externalities exist when the activities of one or more agents affect the welfare of other agents and the welfare of other agents was not considered in decisions determining the level of activity.

We know that there are two types of externality. They are Positive and Negative externalities.

Positive externality arises when an action by an individual or a group confers benefits to others. Let us take an example. Let us assume that Ms Lucy is a person who loves gardening and maintains a beautiful garden. Her action generates a positive externality and it occurs since her action not only benefit herself i.e., it not only gave her satisfaction because of the beauty of the garden but it also gives satisfaction to her neighbour who has a chance of enjoying the beauty of her garden without any contribution. Hence her action benefits her neighbour and society as a whole.

Negative externalities arise when an action by an individual or group produces harmful effects on others. Pollution is a negative externality. 

Let us concentrate our discussion on the topic of pollution as an externality. Let us assume a car manufacturing firm located near a residential plot and a river. Prior to the setting up of the plant in the area, people were enjoying good health and the surrounding environment was clean.

With the setting up of the car manufacturing plant, when the firm discharges its untreated toxic smoke into the atmosphere and waste effluents in the river, the air and river are polluted affecting the health and welfare of the people residing near the plant. People no longer enjoy the fresh air and the river has become contaminated because of the waste effluents release into it. People living nearby are now having a variety of health issues and have to bear a cost in the form of medical expenses/ health costs or other expenses such as air and water purification costs. These costs are called external costs. The private cost is the cost of producing the car by the firm. 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.

Let us assume that the car manufacturing firm sells the car to Mr John.He purchases the car at a price that is equal to the cost of producing the car or the private cost. The car manufacturing firm does not take into account the external cost borne by the people. If the firm takes into consideration the cost borne by the people then it would increase the price of the car and give a portion of it to the people staying near the plant as compensation. Compensation may be in the form of monetary compensation to each person or construction of a community hospital providing health services free of cost or at a cheaper rate or any other form of compensation. Since the firm does not take into account the sufferings of the people and cost associated with it and Mr John purchases the car at a comparatively cheaper rate, the social cost borne by the people is not taken into account. The transaction between the firm and Mr. John leads to an externality. The external cost borne by the people residing near the plant who are not involved in the transaction between the firm and Mr. John is called an externality.

Hence pollution is a negative externality. In an activity generating negative externality, the social cost is higher than the private cost. Externalities create a divergence between the private and social costs of production.

Let us try to understand the concept of pollution as an externality with the help of a diagram

The demand curve, DD, shows the quantity demanded at each price. The supply curve,  S shows the quantity of cars 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 supply is also denoted by MPC and the demand is also denoted by MSB

Marginal private cost (MPC) is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service.

Marginal social benefit (MSB) is the marginal benefit enjoyed by society—by the consumers of a good or service and by everyone else who benefits from it.

The market equilibrium, E₀, where quantity supplied and quantity demanded are equal, is at a price of $P₁ and a quantity of Q₁ units.  

In this case the car manufacturing firm is not taking into consideration the external cost borne by the people.  The car manufacturing plant pollutes the environment. Pollution is created as a byproduct of the metals, plastics, chemicals, and energy that are used in producing cars. Let us say that, if these pollutants were emitted into the air and water, they would create costs of $150 ( 11000 INR) per car produced. These costs might occur because of injuries to human health and include costs such as medical expenses/ health costs or other expenses such as air and water purification costs.  

In a market with no anti-pollution restrictions, firms can dispose of certain wastes at no cost. Now imagine that firms that produce cars must factor in these external costs of pollution, that is, the firms have to consider not only the costs of labour and materials needed to make a car but also the broader costs to society from pollution. If the firm is required to pay $150 ( 11000 INR) for the additional external costs of pollution each time it produces a car, production becomes more costly and the entire supply curve shifts up by $150.

By taking external costs of pollution into account, the firm will need to receive a price of P₂ per car and produce a quantity of Q₂. It can be seen that there is a shift on the graph by looking at the supply curve, S’. The supply curve is also denoted by MSC.

Marginal social cost (MSC) is the total cost to society of producing an additional unit of a good or service. MSC is equal to the sum of the marginal costs of producing the product and the correctly measured damage costs involved in the process of production. Marginal social cost (MSC) is the sum of marginal private cost (MPC) and marginal external cost (M E C).

Marginal private cost (MPC) is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service.

Marginal external cost (M E C) is the cost of producing an additional unit of a good or service that falls on people other than the producer.

MSC = MPC + MEC

The new equilibrium will occur at E₁; by 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 supply curves are based on choices about the 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 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 firm 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. 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.