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Externalities and Public Goods

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Each day, thousands of spectacular explosions occur in a process called calving, when ice breaks off from mountains of glaciers and falls into the ocean as icebergs, eventually melting away. The withering ice shelves and frozen tundra that constitute the vast wilderness of the arctic (and the Antarctic) have affected the landscape that hundreds of wildlife species, including the polar bear, call home.

According to a recent NASA study, the volume and area of the Arctic ice caps fluctuate from year to year based on atmospheric cycles, but the overall trend has been declining as average surface temperatures rise. Estimates show that the overall area covered by the thickest ice, known as multiyear ice, has been shrinking between 12% and 17% per decade over the last 30 years. Other ice caps and glaciers around the world are also melting, and the consequences extend beyond the wildlife affected. Human lives also are affected as ocean levels rise. Despite widely varying estimates that ocean levels will rise between 7 inches and 63 inches by the end of the century, these statistics highlight the important idea that actions taken today, both positive and negative, will affect future generations.

The impact of human actions that contribute to global climate change is one that economic policy tries to address, although not without significant challenges and obstacles. An important issue is that the Earth’s climate is shared. One country’s efforts are not enough, while achieving consensus on environmental policy is difficult, if not impossible.

How environmental policies are set depends largely on the priorities placed by individual countries. For example, during much of the 20th century, the United States was a highly industrialized country; standards of living increased dramatically, but at the cost of greater pollution. However, many Americans now place a higher priority on maintaining a cleaner environment for future generations. This transformation from a polluting industrial society to a cleaner, energy-efficient society can be seen in many developed nations, such as the United States, the countries of the European Union, Japan, and Australia.

In contrast, much of the world remains very poor. In these developing countries, efforts to improve basic living conditions often take precedence over environmental concerns. In countries that have grown significantly in recent years, such as China and India, polluting factories are churning out goods as fast as they can, and consumers are buying more cars and air travel. China is now the largest market in the world for new cars. The ability of previously impoverished nations to experience economic prosperity often comes at the expense of the environment.

Because of differing environmental priorities among nations, it is difficult to achieve a consensus. In addition, any one country’s efforts to improve the environment benefit the entire world, yet that country bears the full costs of these efforts. Meanwhile, other countries may exploit the environment for their economic gain, offsetting the environmental efforts made by others.

At a microeconomic level, individuals and firms make decisions that affect the environment, such as the type of cars we buy and the production methods companies use. Each of these decisions affects not only the individual or company, but also others who share the environment that is being affected.

On a brighter note, economic growth has led to increasing efficiencies in resource use. The growing popularity of hybrid and plug-in electric cars has improved fuel efficiency. Even new technologies in cow feed (such as the infusion of garlic) have reduced the level of harmful methane gases emitted by cows. Yet, clearly we still have many environmental problems that must be addressed, including global climate change, species extinction, overharvesting of fisheries, and overcrowding of highways and parks.

Still, global climate change seems to be an almost intractable problem. Beyond the obvious scientific issues of how to reduce our environmental footprints stands market failure. Market failure describes how markets fail in specific ways to provide the socially optimal amount of goods and services. In the particular case of global climate change, what makes it so hard to deal with is that several specific market failures come together to make a solution tough to reach.

This chapter starts by examining market failures caused when actions taken by consumers or producers have effects on third parties (externalities), when certain types of goods called public goods provide little or no incentives to market participants, and when specific resources are shared. After analyzing these market failures, the chapter then looks at the ways policy tries to mitigate them in the context of environmental issues. Finally, after you get your hands around market failures and various policies to resolve them, the chapter takes what you have learned and applies it to global climate change and sustainable development.