When my colleagues and I meet new people and they find we are with the School of Economics, we often get the same response. We are asked for investment advice or to answer some question on when Federal Reserve will raise interest rates. My answer is that I am not going to be much help because I am not that kind of economist; I do environmental economics. Most people are either disappointed or puzzled. Economics and the environment are not words they think can be logically joined.
In the coming months I will pause from time to time from topical posts to this blog and will discuss some ideas from economics that are useful for thinking about public policy on resources and the environment. One point of this is to make clear that economics is about much more than business and finance, though those are important areas of study. While I tell people my area of economics is environmental economics, that is shorthand for what I really do, which is ecological economics. I studied the way in which decisions we make in the economy are constrained by and affect the larger natural environment. I have colleagues at UMaine who do other types of economics such as behavioral economics, evolutionary economics, resource and environmental economics, energy economics, and several other areas as well. The point is that the discipline is broad and principles from each of these areas are helpful in public policy.
When we teach economic principles in college courses, we usually start by describing a model of how competitive markets function. You may recall learning about the “law” of supply and demand. This is because we live in a market-based economy and understanding how markets might work in a pure case is helpful in understanding the real. It turns out that competitive markets, like those in introductory text book models, are rare. Markets often fail to live up to the attributes described in the pure case. Understanding market failure is a central theme in many different areas of economics, particularly environmental economics.
This is not to say that markets are of no interest to environmental economists. In my blog post on climate change I advocated for harnessing the power of markets to address this most important problem facing humanity today. That policy of using a carbon tax to address climate change is based on the idea of externalities, a common type of market failure. I will use burning gasoline in our automobiles to explain. We all have a problem with gas.
When you and I buy a gallon of gasoline for our cars we pay a market price that covers the costs of drilling for oil, shipping crude oil to a refinery, refining the oil into its components, including gasoline, shipping the gasoline to storage tanks and then to the local convenience store, a few pennies for the store itself, and some profit for various firms involved along the way. We call these internal costs and they make up the supply part of that law of supply and demand you remember. They go into the price you see from the roadside when you decide just how much gasoline you are going to buy today.
The idea of externalities is that there are costs in addition to these internal costs that are not covered in this market price you pay at the pump. The word externalities comes from the idea that these costs are outside of or external to the market, so you do not have to pay them when you buy and burn the gas in your car. They are real costs but external to the market. These include a number of health and environmental costs. For example, burning gasoline generates in the exhaust gas a car emits nitrogen oxides that are precursors for ozone in the lower levels of the atmosphere (tropospheric ozone). This ozone contributes to respiratory diseases in the U.S. like asthma, creating healthcare costs and personal misery for tens of thousands of Americans. You and I impose these costs on others every time we drive, but since they are “external” to the market we do not have to pay for them.
Climate change is another good example. Every gallon of gas we burn in our cars generates about 19 pounds of carbon dioxide, the most important of several so-called greenhouse gases. And that carbon dioxide can stay in the atmosphere for decades after we put it there. While not all climate change is caused by human-produced greenhouse gases, a significant portion of it is. So the costs of more extreme weather events, of global sea level rise, and the other climate change effects from human behaviors, are in part from our gasoline use. But we do not pay these costs, they are externalities. Ocean pollution from petroleum transport, highway congestion, and roadside noise are examples of other types of externalities, though not are large compared with the air pollution effects.
Economists call the existence of external costs a market failure because the market does not include them. The local gas station or the big oil companies are not going to raise prices to reflect these costs because that would put them at an obvious competitive disadvantage. So the person who suffers asthma or the residents of the Maldives Islands who are projected to be under water due to climate change pay the costs rather than you and I who are driving the car. Since we do not have to pay the costs we buy more gasoline and drive more miles than we would if we were held responsible for all the costs or our consumption. The market has failed one of its basic functions – determine how much of a good or service to produce. In this case, the market produces more than it would if we all were paying our full costs.
So the concept of externalities is one powerful tool for thinking about the economics of environmental problems. It is the root of the preference that many economists have for taxes and fees to address some environmental problems. If you can estimate correctly the external costs per gallon of gasoline burned, a tax per gallon of that amount will fix the market failure. Of course it matters what you do with that tax revenue to be fair, but the tax will make the market more efficient in economic terms.
Should we not all take responsibility for the costs we impose on others?