Carbon: The Ultimate Externality

The House of Representatives just passed (barely!) the climate change bill, although analysts say that it will face a tough road in the Senate. This is the bill that includes a cap and trade system for carbon, or “cap and tax,” as the Republicans call it. Certainly the Republicans, and all the conservative bloggers, have attacked the bill, saying that it will increase the cost of energy and of many manufactured goods, and those increased costs will be passed on to consumers. And I agree; costs will go up, which is exactly the point. The cost of things that create carbon should go up. To explain this, I thought it might make sense to take a step back and discuss externalities.

In economics, “an externality…of an economic transaction is an impact on a party that is not directly involved in the transaction.” There can be positive and negative externalities, but the classic example is a negative one: pollution. If a plant manufacturing widgets spews its waste chemicals into a river, poisoning that river for 15 miles downstream, that is an externality. People downstream – fishermen, swimmers, kayak tour guides – suffer an impact from the widget manufacturing, but they have no economic say in that impact.

You might just say “whatevs,” as many have said over the years about pollution, but even the most ardent free market fan should recognize that externalities warp the market. As the supply-demand graph (a diagram dear to the heart of any good capitalist, and to me, since I was an econ major) below shows, an externality causes the market to produce too much of a good, at too low of a price, relative to the optimal solution if the externality is taken into account. This is not efficient, and economists hate inefficiency.

Of course, as regular readers of Thoughtbasket know, I am not an ardent free market fan, so I would layer in an ethical cost as well. Why should the owners of the widget plan make money at the cost of the health of people living downriver? Who gives them the right to take the public good – the river – and ruin it?

Fortunately, both the economic and the ethical problem can be solved by actually monetizing the externality and including it in the business calculation. Polluting a common good should not be free. Assign an actual cost to polluting, and charge the factory owner that cost, and you will quickly see the plant move to producing the preferred social equilibrium quantity. Of course it is tremendously difficult to come up with the appropriate cost, but it’s difficult to go to the moon too, and we still managed that (unless you are a conspiracy theorist). Just because something is hard doesn’t mean we shouldn’t do it.

Unfortunately for factories, as science discovers more pollutants that are bad for us, there are more and more externalities that they have to take into account. Carbon and global warming are a perfect example. Carbon emissions didn’t reach the externality level – unlike, say, dioxin spewing into a lake – until science discovered that global warming was going to kill us all.

Hence, cap and trade legislation. Which is, in many ways, as the Republicans have pointed out, like a carbon tax. Either way, the point is to take what was a social cost – the spewing of carbon – and then monetize it and apply it to producers. What will happen as the costs of carbon go up? We will use less of it. Factories will figure out how to make their widgets using less carbon. People will turn their air conditioners down. Whatevs. Make carbon expensive and people will use less of it, moving production down to the appropriate social equilibrium. That’s what the economists would want, and it’s certainly what our grandkids will want.


5 responses to “Carbon: The Ultimate Externality

  1. Great stuff.

    One of the most common conversations I get into with conservatives is how government intervention that targets sustainability “undercuts” the free market system of democratic capitalism that we enjoy in our country. In point of fact, as you point out, our capitalistic system is flawed in how it attributes value (or not) to all aspects of a supply chain.

    The only reason that we think things cost less is because we are ignoring the immaterial costs of a balanced, clean system. People have to become more aware that their actions bear greater costs and if that has to happen by them actually shelling out some cash, bring it on.

  2. An Imperfect Servant

    While I agree that our continued over production of carbon into the atmosphere must be lessened, I don’t believe that a “Carbon Tax” is the most positive way to do such a thing. This is Negative Reinforcement, and in my experience, that only encourages people to find loop holes and ways around it. If you positively reinforce lowering the Carbon consuption of the country, say by emmision insentives, a tax break in other areas in addition to a carbon tax for excessive use, you will achieve better results. Who doesn’t want to pay the government less. If you reward people and companies for doing what you want, you are more likely to get full and total cooperation.

  3. I agree with both of you. Linking personal actions and their impacts is important, and a financial linkage would be the easiest way to do it. And although economists would say that a carbon credit system is effectively the same as a carbon tax, psychology and words do matter.

  4. I think the idea of rewarding positive performance is nice, but I don’t know if it actually produces results and certainly not at the speed in which we need. To me it is like deposits for bottles. If you recycle your bottles and cans you get money back, but how many people just throw them out anyway? But moreover, why is it even a choice anyway? People should have to recycle everything that they can because recycling requires no extra effort and just makes communal, long-term sense (even if everyone doesn’t take the time to realize that.)

    It’s not like people of the country are “doing the best that they can” and it’s just not cutting it. Our situation derives from a misguided stigma of entitlement and apathy. I don’t know why we have to be paying people to be more conscious citizens.

  5. zeusiswatching

    I’d like to see your model work. The cheating and workarounds (loopholes) that lobbying will certainly work to create, worry me greatly. I have developed a deep distrust of both industry and regulators since this wondrous “meltdown”.

    Let’s see how this works on the negative side. If we see results, we can revisit the positive side of the scale and encourage tax breaks too.

    As for retail prices going up? That seems likely to happen anyway. As for unemployment going up because of this legislation? I don’t understand that argument. I see plenty of joblessness now and we don’t have this legislation. These issues could be linked, but they could be linked in a way that could make for a more stable economy in the long run.

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