BUS604: Innovation and Sustainability

An externality occurs when a so-called third party who is not directly involved in an economic transaction is affected by that market transaction. For example, when pollution produced by a private company negatively impacts the air quality and natural environment and harms the health of others. Externalities typically are considered in a negative context but can have either a positive or a negative impact on the third party. Government can constructively intervene when an externality in a private market transaction has a negative impact on a third party and the third party does not receive any compensation for the negative impact.

In the absence of government intervention, when externalities exist, market prices do not reflect the full costs or benefits in the production or consumption of a good. In the case of external costs, such as pollution, producers may not bear all the societal costs of production, and this would translate to lower prices to consumers than they should pay. For market efficiency purposes consumers should pay the full costs, private and social, of the products and services they consume. If an individual or business does not pay the full (private and social) costs of goods and services they consume, this would cause a good to be overproduced and overconsumed while pushing additional costs on to individuals not involved in the transaction. In the case of pollution, a company could profit by not paying the true cost of managing its waste, and others (i.e., the broader public) would be burdened by the costs - including loss of natural resources, loss of pleasure from the environment because of environmental degradation, and public health problems caused by the pollution.

Oil and oil sales and consumption can have high external costs to society beyond the price charged by the oil company. The pollution from oil use has external costs. And oil use can increase dependency on foreign resources, including on foreign countries with repressive governments.

Public policy through a tax on the use of a product or service that produces a negative externality like foreign oil can work to internalize the cost of the externality and improve the workings and efficiency of the market. Since carbon dioxide contributes to greenhouse gas emissions and global warming, and global warming has costs to society, a carbon tax on a product or service that when produced or consumed emits CO2 (such as the generation of electricity with high-sulfur coal, gasoline, or oil) can address a negative externality. It does this by putting a price on the externality and by having companies and consumers internalize the costs associated with what were unpriced externalities in the private market. This can help move private companies focused on profits to activities that better reflect their net social value, such as energy companies providing more renewable energy.

On the other hand, if there is an external benefit to a product, the producer may not be able to capture those societal benefits in the price of the product resulting in underproduction and under consumption of the good. In this case, a public policy argument might be made to subsidize the good to help increase consumer demand for the good or help improve the producer's prospects for profitability. An example of such a subsidy would be the government assisting with the development of clean energy or a new technology that helps to reduce greenhouse gas emissions and the societal costs associated with greenhouse gas emissions. The government support could encourage greater entrepreneurial pursuit and investment in innovation and new technologies in renewable energy and energy efficiency, and society could benefit.