Question 6: How can some of the externalities be captured in monetary terms?

Environmental economists value the environment in monetary terms through the technique
of cost-benefit analysis. The key concept in defining value according to environmental
economics is the willingness-to- pay (WTP) principle which is reflected through supply and
demand curves in a market interaction.

The concept of externalities is central to environmental economics. In economic terms, a

market transaction creates an externality when it impacts someone other than the buyer
and the seller. For example, a firm which pollutes a river while manufacturing paper harms
those who use the river for fishing, swimming, or drinking water. This negative externality
might be measured in monetary terms – for example, the lost revenues of professional
fishers. Some economic activities may bring benefits to people other than those involved in
the activity. These third parties benefit from what economists call positive externalities. An
example of a positive externality is the case of bee-keeping. A honey farmer raises bees for
his own benefit – in order to sell the honey they produce. This is a private activity with
private benefits and costs. However, bees contribute to the pollination of flowers in the
gardens and orchards of other people in the area, who benefit freely from this positive
externality. The owners of these gardens, harvesting flowers and fruits, receive an external
benefit from the fact that their neighbor produces honey.

In a basic economic analysis of markets, supply and demand curves represent costs and
benefits. A supply curve tells us the private marginal costs of production—in other words,
the costs of producing one more unit of a good or service. Meanwhile, a demand curve can
be considered a private marginal benefits curve because it tells us the perceived benefits
consumers obtain from consuming one additional unit. The intersection of demand and
supply curves gives the market equilibrium. We can add the externality costs to the
production costs to obtain the total social costs of automobiles. This results in a new cost
curve which we call a social marginal cost curve. The social marginal cost curve is above the
original market supply curve because it now includes the externality costs. Note that the
vertical distance between the two cost curves is our estimate of the externality costs of
automobiles, measured in dollars.