Economics of Pollution

Indoor cooking with charcoal stoves harms our lungs; any extra ton of carbon monoxide released in our households increases negative effects like lung disease. When we decide to cook with charcoal, we would consider the private cost - both the cost of buying the charcoal and also the health damage to us. But this pollution would also affect our neighbors if we live close enough. The marginal health damage to the neighbors is a marginal external cost. The marginal social cost in this case is the sum of the marginal private cost to us plus the marginal external cost to our neighbors.

Another example is a polluting factory that dumps its wastewater into a nearby river. In the factory's production decisions, it only considers the private marginal cost of producing one more unit of product - using more energy, materials, and workers. It doesn't consider the marginal external cost of dumping more wastewater into the river, which would cause more harm to the people who live downstream along the river and those who would like to use the river. The marginal social cost of producing one more unit of product here is the marginal private cost to the factory plus the marginal external cost of more water pollution.

A factory is polluting the air with certain gas emissions. If emissions of this particular gas are very difficult to tackle, then the resource expense on reduction of such emissions would be substantial. Imagine now that the government instead allowed the factory to emit additional X amount of tonnes of emissions of this particular gas, but would impose an obligation for the factory to invest these resources into a technology that would reduce the emissions of all other gases by Y amount into the atmosphere. As long as Y>X, this scenario would result in a marginal social benefit to society from the overall pollution reduction.

Let's illustrate this with the example of a polluting factory in Figure 1 below. There is a factory that makes jeans which produces a lot of water pollution. The factory dumps this wastewater into a river. The water pollution is an external cost that the factory does not consider. In its production decision, the factory considers its marginal private cost (MPC) and marginal private benefit (MPB). To maximize profit, it produces up to the point where MPC equals MPB at Qf - this is the free-market equilibrium when the external cost is not taken into account.

We are assuming that there is no external benefit in manufacturing jeans, so the marginal social benefit (MSB) curve is the same as the MPB curve. Because water pollution is an external cost, the MSC curve is higher than the MPC curve. The socially optimal quantity of pollution occurs when these two curves intersect at Qs. We can see that when there is an external cost, the socially optimal quantity is less than the free-market equilibrium.

Figure 1. Socially optimal quantity of pollution, StudySmarter Originals

A classic example is the oil spill in the Gulf of Mexico, where British Petroleum (BP) cut corners and procured cheap off-shore drilling equipment that helped the company maximize profit over a longer time horizon. Unfortunately, this profitability drive led to huge external and social costs. BP couldn't compensate coastal communities when a catastrophic oil spill upended livelihoods along the coast of Louisiana, U.S.A.

Millions of sea animals died or remain contaminated to this day. The seafood industry supply curve shifted to the left as fish quantity dwindled and prices skyrocketed. The Louisiana fish industry is still dealing with negative effects that economists call negative externalities. On the other hand, China enjoyed unexpected external benefits due to positive externalities as the seafood market reached out to Chinese suppliers to fulfill the desired quantity.

The conflict between Russia and Ukraine delivered negative and positive externalities when the United States and its allies imposed sanctions on Russian oil.

This conflict disrupted the oil industry and pollution in two ways:

1. The oil supply curve shifted to the left, as the quantity supplied diminished, and prices rose substantially. Economic actors responded by increasing gas prices at the pump; American drivers had to abandon private cars and use public transport in some cities. You can argue that this economic outcome had some environmental benefits since driving fewer cars reduced the overall pollution quantity and lowered the social costs.
2. Russia offered considerable discounts to countries willing to buy its oil as it needed the money to sustain its economy. China and India sidestepped the sanctions and continued trading with Russia with the view that this economic outcome was a positive externality unleashing cost benefits from every extra oil barrel they bought from Russia. You can also submit that if China and India continue accessing such cheap crude oil, they will drive more, manufacture more, and increase their pollution quantity and environmental and therefore social costs.¹

Imagine a community that planted trees to help reduce pollution in an area. Suddenly, these same trees are at the heart of a local dispute involving two neighbors. The tree owners need those trees to act as a carbon monoxide absorption mechanism. But unfortunately, one of the neighbors argues that some trees are too close to his property and can easily fall on his house, destroy the property or kill the occupants.

Both parties have a legitimate argument for or against the trees, but the law is not enough to determine whose rights are more important. The tree owners have a right to grow anything on their property, and the next-door neighbor has a right to protect his house occupants from tree limbs that may come down with hurricane or tornado force winds.

For example, the tree owners can keep their trees and agree to reimburse the neighbor when tree limbs damage his house. Also, the neighbor can consent to incur any expenses involving trimming branches, cutting down trees, and replanting the tree in another location.

If the benefits enjoyed from keeping the trees outweigh the costs of repairing a damaged house, then the trees will stay, and neighbors will have some peace. Conversely, neighbors will coexist strife-free if cutting down trees and replanting them away from properties offers benefits that outweigh the property damage compensation.

One neighbor may argue that the cost of replanting, growing, and maintaining the tree overtime was much higher than anticipated. The other party may argue that carrying the cost of repairing a damaged rooftop is unreasonable and suggest that neighbor needs to get their property insured and stop worrying about tree damage. These arguments would increase the transaction costs and tank the deal.