Externalities and Environmental Impact Analysis

Externality

A form of market failure; costs or benefits from the production process that are not reflected in the market price and are usually borne by a third party not involved in the transaction.

Negative Externality

Costs associated with a transaction that negatively impact third parties.

Marginal Private Cost (MPC)

Private costs of production such as wages, costs of materials, rent, insurance, taxes, etc.

Marginal External Cost (MEC) or Marginal Damage (MD)

Valuation of marginal harm caused by negative externality; here it is the distance between A & B.

Marginal Social Cost

MSC = MPC + MEC; represents the total cost to society.

Social Optimum (Q*)

The quantity of output that is considered socially efficient.

Positive Externality

Benefits associated with a transaction that positively impact third parties.

Marginal Private Benefit (MPB)

Private benefits of production or consumption.

Marginal External Benefit (MEB)

Valuation of marginal benefit created by positive externality.

Marginal Social Benefit (MSB)

MSB = MPB + MEB; represents the total benefit to society.

Coase Theorem

Assuming bargaining costs are low and that resource owners can identify the source of pollution and legally prevent damages, an efficient allocation can be reached independently of who is assigned the property rights; no government intervention is necessary.

Mergers

If the polluter and the pollutee can merge into one firm, then the externality is said to be internalized.

Tax the polluter

Levy a tax on each level of output in an amount equal to the MD inflicted at the socially efficient level of production (Q*).

Subsidize the polluter

Provide financial support to the polluter not to pollute.

Cap and Trade

Pollution rights or marketable permits; the government sells producers permits to pollute.

Regulation

Government tells the polluter to abate or face sanctions.

Clean Air Act of 1963

An example of regulation where the government mandates pollution control.

Scientific Consensus

Ninety-seven percent of climate scientists agree that climate-warming trends over the past century are very likely due to human activities.

Sulfur-Dioxide Market

A market for pollution rights related to sulfur-dioxide emissions.

Public Responses to Externalities

Actions taken by the government to address externalities, including taxes, subsidies, pollution rights, and regulations.

Private Responses to Externalities

Actions taken by individuals or firms to address externalities without government intervention.