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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 smoke.

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 his errors?

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 abatement.

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.

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