Externalities

December 15, 2007

[this is Microeconomics 101. If you were an economics major, you definitely don’t need to read this]

In most economic transactions, all of the costs and benefits are assumed to accrue to the individuals directly involved in the transaction. Wikipedia uses a lemonade stand as an example. The person who makes and sells the lemonade has borne all the costs of making the lemonade, setting up the stand, etc. I, the lemonade buyer, am getting all the benefits of drinking the lemonade. Nothing fancy there.

Supply and Demand

The optimal amount of lemonade sold is the quantity where cost equals benefits (indicated by the point where the supply and demand curves meet). If there were more lemonade than that optimal quantity, there would be people who had to sell lemonade at a loss (they would be better off doing something else). Less than that optimal quantity, and the price will be too high for many people who could have engaged in beneficial transactions (though some will still occur).

Economists have adapted the model to deal with situations where not all of the costs and benefits accrue to the producer and consumer via externalities. If second-hand smoke, for example, harms or annoys the people around me as a smoker, then the cost of that harm to other people is an externality. As such, it hadn’t been accounted for when I bought the pack of cigarettes.  There is a difference between the private cost and the social cost of cigarette smoking.

When the social cost is higher (or lower) than the private cost, the best solution is not to stop smoking entirely. The optimal amount of cigarettes can still be found by adding the externality to the private cost via a tax, thus bringing the total social cost in line with private cost.

That’s the sketch of the argument that can be applied to carbon taxation. I will leave a more detailled explanation to Wikipedia.

Externalities, Pigovian Taxes, and Social Cost.

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