Private Solutions to Externalities

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?

According to the Coase theorem, even in the presence of externalities an economy can always reach an efficient solution as long as transaction costs—the costs to individuals of making a deal—are sufficiently low.

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.

When individuals take external costs or benefits into account, they internalize the externality.

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.

ECONOMICS in Action: How Much Does Your Electricity Really Cost?

How Much Does Your Electricity Really Cost?

In 2011, three leading economists, Nicholas Z. Muller, Robert Mendelsohn, and William Nordhaus, published a paper drawn from the results of an ambitious study that estimated the external cost of pollution generated by 10,000 pollution sources in the United States, broken down by industry. In it they model the costs to society of emissions of six major pollutants: sulfur dioxide, nitrogen oxides, volatile organic compounds, ammonia, fine particulate matter, and coarse particulate matter. The costs took a variety of forms, from harmful effects on health to reduced agricultural yields. In the case of the electricity-generating sector, the authors also included the cost to society from carbon dioxide emissions—one of many greenhouse gases, the pollution that causes climate change. For each industry a total external cost of pollution, or TEC, was calculated and then compared to the total value to society, or TVC, created by that industry.

What is the social cost of carbon?
Denis Pepin/Shutterstock

An industry with a TEC/TVC ratio greater than 1 indicates that the external cost of pollution exceeds the value created. In other words, a ratio greater than 1 means that a marginal reduction in both industry output and its ensuing pollution increases total social welfare. But as the authors of the study emphasize, this doesn’t mean that the industry should be shut down. Rather, it means that the current level of pollution emitted is too high. A contentious issue in any model of the external cost of greenhouse gases—commonly known as SCC, the social cost of carbon—is exactly what price to assign to it. That’s because the negative effects of climate change fall most heavily on future generations.

So how do you value today the cost imposed on those not yet born? A difficult question, for sure. Economists address this puzzle by using a range of estimates for SCC. For example, in November 2013, the Environmental Protection Agency, or EPA, the federal agency tasked with protecting the environment, published estimates ranging from $12 to $116 and settled on a cost of $37 per metric ton of carbon dioxide.

Using a relatively conservative estimate of $27 for SCC, Muller, Mendelsohn, and Nordhaus compare the TEC/TVC ratio and the TEC per kilowatt-hour produced for two types of electricity generation—coal-fired plants and natural gas-fired plants.

TEC/TVC

TEC/kilowatt-hour

Coal

2.83

$0.039

Natural gas

1.30

0.005

As you can see, both modes of electricity generation are under-regulated: with TEC/TVC ratios greater than 1, society would benefit from a reduction in their emissions. And although both emit greenhouse gases, the TEC per kilowatt-hour generated with natural gas is nearly one-eighth the cost of one generated with coal. That’s because natural gas burns cleaner than coal and produces less-toxic pollutants. With the average kilowatt-hour in the United States costing a little over $0.11 in 2013, a conservative estimate of the external cost of that kilowatt hour is one-third of the retail price when generated by coal, and one-twentieth when generated by natural gas.

In response to growing concerns about carbon emissions, in early 2014 the EPA issued rules that limited the amount of carbon emitted by newly constructed coal-fired and natural gas-fired plants. The rules are unlikely to hinder the construction of new natural gas-fired plants because the latest technology meets the standard. Under the new rules, however, new coal-fired plants cannot be built unless they use carbon-capture and storage technology, which captures 20% to 40% of their carbon emissions and stores them underground. While coal advocates argue that the new rules will effectively stop construction of new coal-fired plants, market forces have increasingly tilted toward natural gas over coal as the use of fracking has made the cost of natural gas plummet.

Quick Review

  • External costs and benefits are known as externalities. Pollution is an example of an external cost, or negative externality; in contrast, some activities can give rise to external benefits, or positive externalities.

  • There are costs as well as benefits to reducing pollution, so the optimal quantity of pollution isn’t zero. Instead, the socially optimal quantity of pollution is the quantity at which the marginal social cost of pollution is equal to the marginal social benefit of pollution.

  • Left to itself, a market economy will typically generate an inefficiently high level of pollution because polluters have no incentive to take into account the costs they impose on others.

  • According to the Coase theorem, the private sector can sometimes resolve externalities on its own: if transaction costs aren’t too high, individuals can reach a deal to internalize the externality. When transaction costs are too high, government intervention may be warranted.

16-1

  1. Question 16.1

    Wastewater runoff from large poultry farms adversely affects their neighbors. Explain the following:

    1. The nature of the external cost imposed

    2. The outcome in the absence of government intervention or a private deal

    3. The socially optimal outcome

  2. Question 16.2

    According to Yasmin, any student who borrows a book from the university library and fails to return it on time imposes a negative externality on other students. She claims that rather than charging a modest fine for late returns, the library should charge a huge fine so that borrowers will never return a book late. Is Yasmin’s economic reasoning correct?

Solutions appear at back of book.