The tinny sounds of Greensleeves comes floating through your window. Your parents place a couple of pound coins in your palm before you run out. A brief conversation with the ice cream man concluded, your hands lose the pound coins only to gain a couple of 99s a few minutes later. The ice cream man’s happy; the money being enough to compensate him for his ice cream and the time spent driving in his van past your house. You’re happy, there’s few better things to spend your money on a hot summer’s day. Your neighbours aren’t happy though – their getting a bit fed up with the tinny sounds of Greensleeves.*

This isn’t pointless nostalgia. I’m describing a negative externality**. In the above market transaction, the buyer and seller are happy (they wouldn’t have made the trade else). The seller’s costs are met, the buyer gets the benefits they paid for. But people outside (external to) the transaction aren’t happy – the neighbours get the costs of hearing the noise without being paid for it.

Dealing with these externalities is a legitimate cause of government intervention in the market. They may deal with such negative externalities by regulating it, such as the rules on ice cream vans playing music. Or it may be possible to make people pay for the external costs (an ice cream van tune tax anyone?)

But maybe the way to deal with these market failures is… more markets.

Let’s take the ultimate negative externality – pollution leading to global warming. The argument is we all pay for our lovely factory-made consumer goods and drive our cars; while, in order to do so, burning fossil fuels, pumping greenhouse gases into the atmosphere, heating the globe, melting the ice caps, causing the sea level to rise and ensuring many of us will be sharing our homes with the fishes in a few centuries’ time.

One option is to regulate greenhouse gas emissions, like CO2, just as we regulate ice cream vans. Ban dirty factories and cars. Set limits on how much we pollute. All very well, we do need limits. But its a bit of a blunt instrument. Some industries, like producing steel, are inherently polluting. If we regulate it too much, it will just up shop and move to where environmental standards are laxer. Meanwhile, it doesn’t provide much incentive for those who aren’t near the polluting limit or who could easily cut their emissions.

Instead, the government could decide on how much CO2 emissions it will allow, and then give everyone a right to emit so much each – a pollution permit, if you will. Not only that, but it could allow people to buy and sell the permits. We would have a market in pollution. This is emissions trading or cap-and-trade, as the government first caps how much emissions it will allow.

The big, dirty factory won’t have enough permits at the start to do its work. However, there will be many other companies who will never hope to emit as much CO2 as they are allowed. They’ll have permits left over which they can sell. The big, dirty factory can buy the left-over permits these non-polluters don’t need from them, and use it themselves.

Obviously, the factory now is having to pay to buy these extra permits, and so will stretch every sinew to pay as little as possible – that is, will try its darnedest to reduce its emissions. Meanwhile, those who are selling their unused permits will realise that they can get richer the less CO2 they emit, as they’ll have more left-over permits to sell.

Everyone now has the incentive to reduce their emissions – an incentive they can count in pounds and pence every day. But people can do so now with much more flexibility and discretion. Under simple regulation, those who found it hardest to adapt were forced to do so first, and probably went out of business as a result. Meanwhile those who could adapt most easily had no reason to do so. Under emissions trading, those who can reduce their emissions most cheaply and easily will. Society can meet the inevitable costs of avoiding climate change at the least cost to itself.

This isn’t an academic theory, such markets in CO2 emissions exist now. The first and largest is the European Union Emission Trading Scheme, which has had some teething problems***, but could end up showing the way. There are similar schemes in Switzerland, Australia, New Zealand and South Korea. There are also subnational schemes in parts of the US, Canada, and Japan. There was a very successful SO2 cap-and-trade scheme in the US, which helped prevent the Acid Rain problem.

So, sometimes little bits of economic theory might show the way to dealing with our most pressing problems.

P.S. There can also be positive externalities.  If you plant an apple tree in your front garden, your neighbour may get the benefit of its shade and its cast-off apples without having paid anything.

These positive externalities are like the public goods I discussed in my other post, The Logic of Collective Action. Benefits are bestowed that people need not have paid for, and so may not get paid for in effective amounts. The market on its own would produce too little of these benefits.


*See how I tied this in with my last post? See what I did? See what I did?

**I discussed negative externalities, using traffic congestion as an example, in my post The UnWisdom of Crowded Roads. A cost is imposed on those outside the transaction without compensation. A market on its own would produce too much of this cost.

***There are a lot of details I’ve left out in this broad-brush explanation, which mean such emission trading schemes won’t necessarily work as smoothly as I’ve suggested. But these problems are surmountable. The bigger problems are political. People will object to paying for something that was previously free, even though they are just piling up the costs for future generations. Also, we all share one atmosphere, so there is not much benefit unless the whole world gets involved in reducing emissions. And we are not yet very good at sorting things out at a world level.



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3 responses to “Externalities

  1. Pingback: Scarcity | Steven Clarke's Blog

  2. Pingback: Community Land Auctions | Steven Clarke's Blog

  3. Pingback: People Respond To Incentives | Steven Clarke's Blog

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