IN JUNE 2013, RESEARCHERS AT Duke University published a paper with an unassuming title, “Increased stray gas abundance in a subset of drinking water wells near Marcellus shale gas extraction.” Yet the effects of that publication were anything but restrained. While its results are not definitive, the paper presented evidence that fracking—the extraction of natural gas by fracturing underground shale deposits with chemical-laden pressurized jets of water—at the Marcellus gas field in Pennsylvania contaminated underground drinking water supplies with ethane and propane. The paper provided support to some critics of fracking who claim that it poses an intolerable pollution threat to drinking water supplies. The Duke paper has helped fuel an increasingly polarized debate over the costs and benefits of fracking.
You may recall our discussion of fracking in Section 3, where we learned that fracking has dramatically reduced the cost of energy in the United States, leading to lower heating bills for homeowners and lower production costs for suppliers. And fracking has the potential to significantly reduce air pollution as consumers and industries move from dirtier-burning gasoline and coal to cleaner-burning natural gas. However, as we anticipated in Section 3, the environmental benefits of cleaner air from cheaper natural gas have been challenged by the specter of polluted drinking water from fracking. A key question in assessing the trade-off is the role of government: should regulators do more to protect groundwater supplies? Would more regulatory oversight of how fracking wells are drilled reduce groundwater contamination? What amount of contamination would regulators find acceptable? And how would they enforce it?
The dilemma posed by fracking is just one example of the dilemmas that are caused by externalities. An externality occurs when individuals impose costs or deliver benefits to others, but don’t have an economic incentive to take those costs or benefits into account when making decisions. We briefly noted the concept of externalities in Sections 1 and 4. There we stated that one of the principal sources of market failure is actions that create side effects that are not properly taken into account—that is, actions that create externalities. In this section economics of externalities, seeing how they can get in the way of market efficiency and lead to market failure, why they provide a reason for government intervention in markets, and how economic analysis can be used to guide government policy.
Externalities arise from the side effects of actions. First, we’ll study the case of pollution, which generates a negative externality—a side effect that imposes costs on others. Whenever a side effect can be directly observed and quantified, it can be regulated: by imposing direct controls on it, taxing it, or subsidizing it. As we will see, government intervention in this case should be aimed directly at moving the market to the right quantity of the side effect.