How to Deal with Externalities
Or Getting Your Smoke Out of My Face
An externality, in economic terms, is a cost or benefit from
an economic transaction that parties "external" to
a transaction receive. For example, when you pay for the mariachi
singers to come to your table and sing, you get the pleasure
of the songs and they get the ten dollar tip you give them. I,
on the other hand, although external to the transaction, still
enjoy the benefit of the music merely because I am sitting at
a nearby table. This is a positive externality.
Positive externalities, as you can imagine, aren't much of
a political problem. It is the negative externalities that become
problems. You buy a cigarette for the pleasure, for example,
and the company sells it to you for the profit, but I pay a cost
when I have to breath your smoke and I may even pay for more
medical care after years of breathing many people's second-hand
On a larger scale is the classic externality of environmental
pollution. We may argue about the value of the "environment"
for its own sake. Perhaps it is none of our business if a man
destroys some beautiful land he owns or poisons the plants there.
But it certainly isn't fair for a person or company to make me
or you breath dangerous levels of pollutants, drink dangerous
water or otherwise pay a cost for their activities.
Of course, some pollution is inevitable if we are to live
on earth, but there is a reasonable amount beyond which you are
violating my right to clean air (a reasonable subsidiary of my
right to life and liberty). We can argue about what level of
pollution of various sorts should be permissible, but once we
agree on that, what do we do about it?
The blunt and clumsy approach is to try to regulate pollution
directly, by making rules about who can pollute and how much.
This causes all sorts of problems in an economy. A government
might force on businesses regulations that cost ten times as
much as the solutions the businesses themselves would have found,
for example. Imagine if a government bureaucrat decided what
foods you should buy to save money, and made it mandatory. Doesn't
it seem likely that you would spend even more money correcting
In fact, we all have more information about ourselves and
our businesses than any outside expert could possibly have, and
we are the ones that can best see immediately what works and
what doesn't, and so quickly adjust course. This is why bureaucratic
regulation is often so inefficient (it isn't that bureaucrats
are stupid). In fact, the inefficiency of this approach costs
so much that one could argue it reduces the prosperity necessary
to truly have a cleaner environment. You may have noticed that
rich countries do have the luxury of worrying about the environment
more than poor countries, after all.
Is there a better approach? Yes. It is to charge for externalities
directly, and let people and companies figure out how to deal
with the cost. A good example is the emissions of sulfur dioxide
that are a part of certain industries. For years companies claimed
that the cost of reducing this pollution was too much, and that
they would be crippled by any measures that effectively reduced
emissions. But in the 1990s the EPA (Environmental Protection
Agency) in the United States found out this just wasn't true.
It may have been truly too expensive if the EPA had simply
demanded that the polluting companies install certain emission-control
devices, such as sulfur scrubbers. The congress and the EPA were
certainly likely to be lobbied by those who sold such devices,
and almost certainly would have prescribed inefficient and expensive
solutions. Instead, they held an auction for the right to pollute.
Actually, they first set reduced quotas for emissions for
polluters. Then the companies could either reduce their emissions
to meet their quota, or they could buy more permits (allowing
them to emit more sulfur dioxide) at auction. They would effectively
buy the right to pollute, with the general idea being that the
resulting pollution rights sold off would allow only for a safe
level of pollutants to be released (contrary to what many believe,
there is certainly a safe level - and a dangerous level - for
everything from peanut butter to cyanide).
Prior to the auction, the EPA estimated the cost of reducing
sulfur dioxide emissions would be somewhere between $250 and
$1,500 per ton. Various companies, trying to avoid regulation,
had probably put out much higher estimates to show that the new
rules would be too costly. What did the auction itself show?
When the initial auction was conducted in 1993, not many high
bids came in. It soon was clear that the companies had overestimated
the costs. In fact, by 1996, companies could buy permits as cheap
as $70 per ton, but many chose other measures rather than buy
the right to pollute more. This means of course, that they found
ways to reduce emissions at less than $70 per ton - otherwise
they just would have bought the permits.
Naturally, there had been some exaggerating of costs by companies
that were afraid of the changes. But that doesn't fully explain
why the true costs of reducing emissions were now down to almost
25% of the governments lowest estimates (or less than 5% of their
highest estimates). The other part of the equation is that the
by wise policy the government created a market for pollution
How does this work? Well, at the point where permits cost
$100 a ton, for example, any company that could design a new
sulfur scrubber that reduced emissions for less than that could
expect companies to line up to buy it. The process stimulated
creativity and innovation. To this day, if a new invention makes
it cheaper than the current permit costs, there is a profit to
be made in reducing sulfur emissions.
Now imagine if the government had simply demanded that a certain
technology be used to reduce sulfur emissions. The cost at that
time might have been $200 or even $2,000 per ton of sulfur dioxide
emissions reduction. That's bad enough, but if certain technologies
were required, it would have meant a stifling of creativity and
innovation. All the better methods of reducing pollution would
have been left uninvented.
By the way, there is another benefit to charging for externalities
in this way. The permits allow for a total amount of sulfur dioxide
emissions which is (hopefully) a safe level. But what if the
permits are not all used? Then there would be even less pollution,
right? But why would they not be used?
This is where speculators enter the picture. As industries
expand, it is reasonable to assume that permits could become
more expensive. A speculator might buy a million dollars worth
of permits at $70 per ton, and sit on them for a year or two.
When the price goes up to $140 per ton, he would make a nice
profit. There really was some speculation in the permit markets,
and there would likely be more if these kind of systems were
more widespread. The result is that the net pollution possible
is reduced by the amount of permits that are floating around
in the speculative markets at any given time.