Internalizing Costs

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Internalizing costs

Private market activities create so-called externalities. An example of a negative externality is air pollution . It occurs when a producer does not bear all the costs of an activity in which he or she engages. Since external costs do not enter into the calculations producers make, they will make few attempts to limit or eliminate pollution and other forms of environmental degradation .

Negative externalities are a type of market defect all economists believe is appropriate to try to correct. Milton Friedman refers to such externalities as "neighborhood effects," (although it must be kept in mind that some forms of pollution have an all but local effect). The classic neighborhood effect is pollution. The premise of a free market is that when two people voluntarily make a deal, they both benefit. If society gives everyone the right to make deals, society as a whole will benefit. It becomes richer from the aggregation of the many mutually beneficial deals that are made. However, what happens if in making mutually beneficial deals there is a waste product that the parties release into the environment and that society must either suffer from or clean up? The two parties to the deal are better off, but society as a whole has to pay the costs. Friedman points out that individual members of a society cannot appropriately charge the responsible parties for external costs or find other means of redress.

Friedman's answer to this dilemma is simple: society, through government, must charge the responsible parties the costs of the clean-up. Whatever damage they generate must be internalized in the price of the transaction. Polluters can be forced to internalize environmental costs through pollution taxes and discharge fees, a method generally favored by economists. When such taxes are imposed, the market defect (the price of pollution which is not counted in the transaction) is corrected. The market price then reflects the true social costs of the deal, and the parties have to adjust accordingly. They will have an incentive to decrease harmful activities and develop less environmentally damaging technology. The drawback of such a system is that society will not have direct control over pollution levels, although it will receive monetary compensation for any losses it sustains. However, if the government imposed a tax or charge on the polluting parties, it would have to place a monetary value on the damage. In practice, this is difficult to do. How much for a human life lost to pollution? How much for a vista destroyed? How much for a plant or animal species brought to extinction ? Finally, the idea that pollution is all right as long as the polluter pays for it is unacceptable to many people.

In fact, the government has tried to control activities with associated externalities through regulation, rather than by supplementing the price system. It has set standards for specific industries and other social entities. The standards are designed to limit environmental degradation to acceptable levels and are enforced through the Environmental Protection Agency (EPA). They prohibit some harmful activities, limit others, and prescribe alternative behaviors. When market actors do not adhere to these standards they are subject to penalties. In theory, potential polluters are given incentives to reduce and treat their waste, manufacture less harmful products, develop alternative technologies, and so on. In practice, the system has not worked as well as it was hoped in the 1960s and 1970s, when much of the environmental legislation presently in force was enacted. Enforcement has been fraught with political and legal difficulties. Extensions on deadlines are given to cities for not meeting clean air standards and to the automobile industry for not meeting standards on fuel economy of new cars, for instance. It has been difficult to collect fines from industries found to have been in violation. Many cases are tied up in the courts through a lengthy appeals process. Some companies simply declare bankruptcy to evade fines. Others continue polluting because they find it cheaper to pay fines than to develop alternative production processes.

Alternative strategies presently under debate include setting up a trade in pollution permits . The government would not levy a tax on pollution but would issue a number of permits that altogether set a maximum acceptable pollution level. Buyers of permits can either use them to cover their own polluting activities or resell them to the highest bidder. Polluters will be forced to internalize the environmental costs of their activities so that they will have an incentive to reduce pollution. The price of pollution will then be determined by the market. The disadvantage of this system is that the government will have no control over where pollution takes place. It is thinkable that certain regions will have high concentrations of industries using the permits, which may result in local pollution levels that are unacceptably high. Whether marketable pollution permits address present pollution problems more satisfactorily than does regulation alone has yet to be seen.

See also Environmental economics

[Alfred A. Marcus and Marijke Rijsberman ]



Friedman, M. Capitalism and Freedom. Chicago: University of Chicago Press, 1962.

Marcus, A. Business and Society: Ethics, Government, and the World Economy. Homewood, IL: Irwin Press, 1993.

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Internalizing Costs

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Internalizing Costs