The Problem of Externalities

Happy New Year! Or Happy Financial New Year at the very least.

It’s been a month since I’ve last written a blog, and while I’d like to say that I’ve been fighting Samoan pirates on the high seas, or staging a daring coup d’état that now sees me placed as the new King of Sweden, the fact of the matter is that I’ve been busy with final assignments and exams. That and I haven’t had a clue of what to write about.

I’ve been on holiday for the last week now, and my stubble has gone beyond the level of ‘acceptably shaggy’ and is well on the way to ‘unemployably scrubby’. I’m letting it go if only to see what grows, like an experimental Petri dish more likely to result in anthrax than penicillin.

As many of you should know, today also marks the introduction of the Gillard government’s new Carbon Tax, which is set to put a price on carbon emissions and give Tony Abbott supporters plenty of chances to wave their fingers and say: “See! See! She lied!” as if it were the first time they had ever watched a political campaign. It also marks the start of a set of offsetting reforms, which include the tax-free bracket increasing from $6,000 to $18,200. I’m a strong supporter of the Carbon Tax, so while I’m as unqualified as an elk to even discuss it, and at the risk of bush-lawyering, I thought I’d write a few words on the basic theory that underpins these kinds of actions.

Left entirely to its own devices the private sector is remarkably efficient in the allocation of resources. Inefficient practices have the effect of increasing a firm’s overall production costs. Over time, this provides an incentive to move to more efficient production methods, increasing overall profit.

 Similarly a free and competitive market provides an efficient allocation of resources as firms bid up the price of goods depending on their individual assessment of their value (two people value a piece of cake, they will continue to bid up the price until it’s just higher than what the other would otherwise be willing to pay). Where individuals can trade according to their individual preferences, the market will theoretically result in an efficient allocation.

The issue comes in when we’re dealing with a common resource (air quality, the environment, fishing stocks, etc). In this situation, individuals are not able to trade according to their own individual costs and benefits, and the resulting market allocation may not be socially efficient.

For example: a washing company may be remarkably effective in washing old socks and underwear in a nearby river, but has the unfortunate effect of poisoning it for everyone down-stream. This is known as an externality – a cost not included in the normal price allocation of supply and demand.

Externalities can be either positive or negative. A beekeeper provides a positive externality in the pollination of local fruits and flowers (and a negative in the increase of beestings). Positive externalities are benefits that can’t be captured by the profit system, and so too little will be produced. Negative externalities are costs that aren’t incurred by the producing firm and so too much will. In either case a market failure occurs, and there is potential scope for the government to intervene. Carbon emissions are a classic example of a negative externality.

The Carbon Tax introduces a base cost to the production of carbon. While the extent that this cost is passed onto consumers largely depends on the degree of market control a firm is able to exert, the effect is an overall reduction in carbon pollution. Over time it provides an economic incentive to innovate and switch to less carbon intensive forms of production.

It must be noted that the current fixed price is only a temporary measure. Eventually an Emissions Trading Scheme is to be implemented, where a number of free credits for the production of carbon are allocated, and the free market determines the price of these credits in the free market. This is generally seen as a more economically efficient model for reducing carbon emissions.

The potential effectiveness of the tax is a divisive issue. The effects of carbon emissions are distributed globally, as opposed to locally or nationally such as in acid rain (a similar example of a national ETS implemented in America) or chemical pollutants, and has led some commentators to declare it a Tragedy of the Commons rather than a matter of externalities.  However I remain personally optimistic in the overall effectiveness of the scheme, and that it will coincide with similar measures being enacted internationally.