The environmental costs of pollution are the best known and most important example of an external cost—an uncompensated cost that an individual or firm imposes on others. In a modern economy there are many examples of an external cost that an individual or firm imposes on others. A very familiar one is the external cost of traffic congestion: an individual who chooses to drive during rush hour increases congestion and has no incentive to take into account the inconvenience inflicted on other drivers. Another familiar example is the cost created by people who text while driving, increasing the risk of accidents that will harm others as well as themselves (see the upcoming For Inquiring Minds).

Pollution leads to an external cost because in the absence of government intervention those who decide how much pollution to create have no incentive to take into account the costs of pollution that they impose on others. In the case of air pollution from a coal-fired power plant, the power company has no incentive to take into account the health costs imposed upon people who breathe dirty air. Instead, the company’s incentives are determined by the private monetary costs and benefits of generating power, such as the price of coal, the price earned for a kilowatt of energy, and so on.

We’ll see later in this chapter that there are also important examples of external benefits, benefits that individuals or firms confer on others without receiving compensation. For example, when you get a flu shot, you are less likely to pass on the flu virus to your roommates. Yet you alone incur the monetary cost of the vaccination and the painful jab. Businesses that develop new technologies also generate external benefits, because their ideas often contribute to innovation by other firms.

External costs and benefits are jointly known as externalities, with external costs called negative externalities and external benefits called positive externalities. Externalities can lead to private decisions—that is, decisions by individuals or firms—that are not optimal for society as a whole. Let’s take a closer look at why.

Pollution is a bad thing. Yet most pollution is a side effect of activities that provide us with good things: our air is polluted by power plants generating the electricity that lights our cities, and our rivers are damaged by fertilizer runoff from farms that grow our food. And groundwater contamination may occur from fracking, which also produces cleaner-burning fuel. Why shouldn’t we accept a certain amount of pollution as the cost of a good life?

Actually, we do. Even highly committed environmentalists don’t think that we can or should completely eliminate pollution—even an environmentally conscious society would accept some pollution as the cost of producing useful goods and services. What environmentalists argue is that unless there is a strong and effective environmental policy, our society will generate too much pollution—too much of a bad thing. And the great majority of economists agree.

To see why, we need a framework that lets us think about how much pollution a society should have. We’ll then be able to see why a market economy, left to itself, will produce more pollution than it should. We’ll start by adopting the simplest framework to study the problem—assuming that the amount of pollution emitted by a polluter is directly observable and controllable.

How much pollution should society allow? We learned in Chapter 9 that “how much” decisions always involve comparing the marginal benefit from an additional unit of something with the marginal cost of that additional unit. The same is true of pollution.

The marginal social cost of pollution is the additional cost imposed on society as a whole by an additional unit of pollution.

For example, sulfur dioxide from coal-fired power plants mixes with rainwater to form acid rain, which damages fisheries, crops, and forests, while groundwater contamination, which may be a side effect of fracking, damages health. Typically, the marginal social cost of pollution is increasing—each additional unit of pollution emitted causes a greater level of damage than the unit before. That’s because nature can often safely handle low levels of pollution but is increasingly harmed as pollution reaches higher levels.

The marginal social benefit of pollution is the benefit to society from an additional unit of pollution. This may seem like a confusing concept—how can there be any benefit to society from pollution? The answer lies in the understanding that pollution can be reduced—but at a cost. For example, air pollution from coal-fired power plants can be reduced by using more-expensive coal and expensive scrubbing technology; contamination of drinking water due to fracking can be limited with more-expensive drilling techniques; wastewater contamination of rivers and oceans can be reduced by building water treatment facilities.

All these methods of reducing pollution have an opportunity cost. That is, avoiding pollution requires using scarce resources that could have been employed to produce other goods and services. So the marginal social benefit of pollution is the goods and services that could be had by society if it tolerated another unit of pollution.

Comparisons between the pollution levels tolerated in rich and poor countries illustrate the importance of the level of the marginal social benefit of pollution in deciding how much pollution a society wishes to tolerate. Because poor countries have a higher opportunity cost of resources spent on reducing pollution than richer countries, they tolerate higher levels of pollution. For example, the World Health Organization has estimated that 3.5 million people in poor countries die prematurely from breathing polluted indoor air caused by burning dirty fuels like wood, dung, and coal to heat and cook—a situation that residents of rich countries can afford to avoid.

Using hypothetical numbers, Figure 16-1 shows how we can determine the socially optimal quantity of pollution—the quantity of pollution society would choose if all the social costs and benefits were fully accounted for. The upward-sloping marginal social cost curve, MSC, shows how the marginal cost to society of an additional unit of pollution varies with the quantity of pollution. As we mentioned, marginal social cost of pollution is typically increasing, as another unit of pollution causes more harm than prior units. The marginal social benefit curve, MSB, is downward sloping. At high levels of pollution, the cost of achieving a reduction in pollution is fairly small. However, as pollution levels drop, it becomes progressively more costly to engineer a further fall in pollution as more expensive techniques must be used, so the MSB is higher at lower levels of pollution..

The socially optimal quantity of pollution in this example isn’t zero. It’s Q_OPT, the quantity corresponding to point O, where MSB crosses MSC. At Q_OPT, the marginal social benefit from an additional unit of pollution and its marginal social cost are equalized at $200.

But will a market economy, left to itself, arrive at the socially optimal quantity of pollution? No, it won’t.

While pollution yields both benefits and costs to society, in a market economy without government intervention too much pollution will be produced. In that case it is polluters alone—owners of power plants or gas-drilling companies, for example—who decide how much pollution is created. And they have no incentive to take into account the cost that pollution inflicts on others.

Figure 16-2 shows the result of this asymmetry between who reaps the benefits and who pays the costs. In a market economy without government intervention, since polluters are the only ones making the decisions, only the benefits of pollution are taken into account when choosing how much pollution to produce. So instead of producing the socially optimal quantity, Q_OPT, the market economy will generate the amount Q_MKT. At Q_MKT, the marginal social benefit of an additional unit of pollution is zero, while the marginal social cost of an additional unit is much higher—$400.

Why? Well, take a moment to consider what the polluter would do if he found himself emitting Q_OPT of pollution. Remember that the MSB curve represents the resources made available by tolerating one more unit of pollution. The polluter would notice that if he increases his emission of pollution by moving down the MSB curve from Q_OPT to Q_H, he would gain $200 − $100 = $100. That gain of $100 comes from using less-expensive but higher-emission production techniques. Remember, he suffers none of the costs of doing this—only others do. However, it won’t stop there. At Q_H, he notices that if he increases his emissions from Q_H to Q_MKT, he would gain another $100 as he moves down the MSB curve yet again. This would be achieved by using even cheaper and higher-emission production techniques. He will stop at Q_MKT because at this emission level the marginal social benefit of a unit of pollution is zero. That is, at Q_MKT he gains nothing by using yet cheaper and dirtier production techniques and emitting more pollution.

The market outcome, Q_MKT, is inefficient. Recall that an outcome is inefficient if someone could be made better off without someone else being made worse off. At an inefficient outcome, a mutually beneficial trade is being missed. At Q_MKT, the benefit accruing to the polluter of the last unit of pollution is very low—virtually zero. But the cost imposed on society of that last unit of pollution is quite high—$400. So by reducing the quantity of pollution at Q_MKT by one unit, the total social cost of pollution falls by $400 but the total social benefit falls by virtually zero.

So total surplus rises by approximately $400 if the quantity of pollution at Q_MKT is reduced by one unit. At Q_MKT, society would be willing to pay the polluter up to $400 not to emit the last unit of pollution, and the polluter would be willing to accept their offer since that last unit gains him virtually nothing. But because there is no means in this market economy for this transaction to take place, an inefficient outcome occurs.

As we’ve just seen, externalities in a market economy cause inefficiency: there is a mutually beneficial trade that is being missed. So can the private sector solve the problem of externalities without government intervention? Will individuals be able to make that deal on their own?

In an influential 1960 article, the economist and Nobel laureate Ronald Coase pointed out that in an ideal world the private sector could indeed solve the problem of inefficiency caused by externalities. According to the Coase theorem, even in the presence of externalities an economy can always reach an efficient solution provided that the costs of making a deal are sufficiently low. The costs of making a deal are known as transaction costs.

For an illustration of how the Coase theorem might work, consider the case of groundwater contamination caused by drilling. There are two ways a private transaction can address this problem. First, landowners whose groundwater is at risk of contamination can pay drillers to use more-expensive, less-polluting technology. Second, the drilling companies can pay landowners the value of damage to their groundwater sources—say, by buying their properties outright so that the landowners move. If drillers legally have the right to pollute, then the first outcome is more likely. If drillers don’t legally have the right to pollute, then the second is more likely.

What Coase argued is that, either way, if transaction costs are sufficiently low, then drillers and landowners can make a mutually beneficial deal. Regardless of how the transaction is structured, the social cost of the pollution is taken into account in decision making. When individuals take externalities into account when making decisions, economists say that they internalize the externality. In that case the outcome is efficient without government intervention.

So why don’t private parties always internalize externalities? The problem is transaction costs in one form or another that prevent an efficient outcome. Here is a sample:

To be sure, there are examples in the real world in which private parties internalize the externalities. Take the case of private communities that set rules for appearances—no cars on blocks in the driveway!—and behavior—no loud parties at midnight! These rules internalize the externality that one homeowner’s lack of upkeep or rowdy behavior has on the market value of a neighbor’s house. But for major externalities like widespread pollution, it is necessary to look for government solutions because transaction costs are just too high to achieve an efficient private outcome.

In some cases, people do find ways to reduce transaction costs, allowing them to internalize externalities. For example, a house with a junk-filled yard and peeling paint imposes a negative externality on the neighboring houses, diminishing their value in the eyes of potential home buyers. So, many people live in private communities that set rules for home maintenance and behavior, making bargaining between neighbors unnecessary. But in many other cases, transaction costs are too high to make it possible to deal with externalities through private action. For example, tens of millions of people are adversely affected by acid rain. It would be prohibitively expensive to try to make a deal among all those people and all those power companies.

When transaction costs prevent the private sector from dealing with externalities, it is time to look for government solutions. We turn to public policy in the next section.