0.20 Economic forces

External costs

Economic activity generally affects the environment, usually negatively. Natural resources are used, and large amounts of waste are produced. These side effects can be seen as ways in which the actions of a producer impact the well being of a bystander. The market fails to allocate adequate resources to address such external costs because it is only concerned with buyers and sellers, not with the well being of the environment. Only direct (or internal) costs are considered relevant. External costs are harmful social or environmental effects caused by the production or consumption of economic goods. Governments may take action to help alleviate the effects of economic activity.

When external costs occur, a company’s private production cost and the social cost of production are at odds. The firm does not consider the cost of pollution cleanup to be relevant, while society does. The social costs of production include the negative effects of pollution and the cost of treatment. As a result, the social costs end up exceeding the private production costs. When external pollution and treatment costs are included in the production cost of the product, the supply curve intersects the demand curve at a higher price point. As a result of the higher price there will be less demand for the product and less pollution produced.

For example, exhaust pollutants from automobiles adversely affect the health and welfare of the human population. However, oil companies consider their cost of producing gasoline to include only their exploration and production costs. Therefore, any measures to reduce exhaust pollutants represent an external cost. The government tries to help reduce the problem of exhaust pollutants by setting emissions and fuel-efficiency standards for automobiles. It also collects a gasoline tax that increases the final price of gasoline, which may encourage people to drive less.

Sometimes, pollution results from the production process because no property rights are involved. For example, if a paper manufacturer dumps waste in a privately owned pond, the landowner generally takes legal action against the paper firm, claiming compensation for a specific loss in property value caused by the industrial pollution. In contrast, the air and most waterways are not owned by individuals or businesses, but instead are considered to be public goods. Because no property rights are involved the generation of pollution does not affect supply and demand.

Firms have an incentive to use public goods in the production process because doing so does not cost anything. If the paper manufacturer can minimize production costs by dumping wastes for free into the local river then it will do so. The consequences of this pollution include adverse impacts on the fish and animal populations that depend on the water, degradation of the surrounding environment, decrease in the quality of water used in recreation and business, human health problems and the need for extensive treatment of drinking water by downstream communities. An important role of the government is to protect public goods, especially those with multiple uses, from pollution by companies seeking to minimize company costs and to maximize profits. People desire clean water for recreation and drinking, and the government must act to protect the broad interests of society from the narrow profit-driven focus of companies.