Externalities

In Relation to Cost Benefit Analysis

Krishna Prasad Pant, Ph. D.

 What are costs and benefits?

• Benefits are the monetary values of desirable consequences of

economic policies and decisions.
• Together with costs they reflect the changes in individual and
social welfare that result from implementing alternative
programs.
• Benefits are generally classified as direct, indirect, and intangible:
– Direct benefits are the values of desirable outcomes directly related to
the implementation of proposed interventions that can be estimated by
using market-based data.
– Indirect benefits are the averted costs and savings resulting from the
interventions but not related directly to them.
– Intangible benefits include the values of positive outcomes which cannot
be estimated from market data.
 Market Failure

The supply and demand model fails in absence

of a well-defined private-property rights.
– When property rights are not clearly defined, the
seller may be able to ignore some of the costs of
production, which will then be imposed on others.
– Alternatively, buyers may not get all the benefits
from purchasing a product; others may get some
of the benefits without payment.
 Reasons for Market Failures
1. Market power
– Ability of a firm (or group of firms) to raise and maintain price above the
level that would prevail under competition (reduced output and loss of
economic welfare).
2. Natural monopoly
– A type of monopoly that exists as a result of the high fixed or start-up
costs of operating a business in a particular industry.
3. Information asymmetry
– Situation in which a buyer and a seller possess different information
about a transaction.
4. Externalities
– Externalities are the most likely causes of the failure of private and public
sector institutions to correct resource damage.
 Externalities

• Externality is a situation in which an individual

or firm takes an action but does not
– bear all the costs (negative externality) or
– receive all the benefits (positive externality).
• Some costs or benefits that fall on third
parties (spill over).
 Examples of Externalities

• Examples of negative externalities:

– Exhaust from automobiles
– Barking dogs
• Examples of positive externalities:
– Gardening
– Restored historic buildings
– Research into new technologies
• Decision maker - fails to account for externalities
• Government: protect the interests of bystanders

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 Reasons for externalities
• High Transaction costs
– injured parties find difficulties to use legal or other
means to cause polluters to internalize the damage they
cause.
• Poorly defined Property rights
– media or resources harmed are in common or rights
poorly defined.
• Difficulty in tracing the causal connections
– Between activities that pose environmental risks to the resulting
damages and often involve long time periods
 Externalities and Inefficiency
• Externalities leads to inefficiency.
• Producers of externalities do not have an
incentive to take into account the effect of
their actions on others, the outcome is
inefficient.
• There are too much activity that causes
negative externalities such as pollution, and
not enough activity that creates positive
externalities.
 Externalities and Market Inefficiency

• Negative externalities
– Markets - produce a larger quantity than is socially
desirable
• Positive externalities
– Markets - produce a smaller quantity than is
socially desirable
• Government: internalize the externality
– Taxing goods that have negative externalities
– Subsidizing goods that have positive externalities
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 Negative Production Externalities
• side-effects of production activities
• an individual or firm making a decision does not have to pay the full cost
of the decision.
– Pollution created by firms due to production activities is an example.
• In an unregulated market, producers don't take responsibility for
external costs that exist--these are passed on to society.
• Thus producers have lower marginal costs than they would otherwise
have and the supply curve is effectively shifted down (to the right) of the
supply curve that society faces.
• Because the supply curve is increased, more of the product is bought
than the efficient amount--that is, too much of the product is produced
and sold.
• Since MB is not equal to MC, a deadweight welfare loss results.
 MSC
Price Demand (MPB=MSB)
80
Supply (MPC)

70

60 True E
50
E
Dead weight loss
40

30 Negative Externality
in Production
External
20 costs

10

Q* Q1 Quantity
0 1 2 3 4 5 6 7 8
kg
Corrective Negative Production externalities
• Legislation and regulations can prevent or reduce the effects of production
externalities by lowering the quantity of goods produced and bring it
closer to the optimal quantity Q* by shifting the MPC curve upward
towards the MSC curve
– Limit the emission of pollutants by setting limits to the extent of
pollutants produced by a firm.
– Limit the production to a certain level.
– Force polluting units to install technologies which reduce emissions.
• Putting Taxes either on per unit of production or per unit of pollutants
emitted.
– shift of MPC curve upwards towards the MSC curve and thus reducing
output and bringing it closer to socially optimal level i.e. Q*.
• Tradable permits- a cost-efficient, market-driven approach to reducing
GHG emissions.
– It will result in firms to lower the quantity of goods produced so that it
equals Q* and to raise the price of the goods.
 Negative Consumption externalities

• It occurs due to consumption of certain goods

and services.
• Examples:
– Smoking in public places, the consumer is creating
negative externalities, in the form of passive
smoking, for non-smokers.
– Using fossil fuels that pollute atmosphere,
– Playing loud music and disturbing neighbors
– Discarding garbage in public places.
 Marginal social cost
Price
80

70

60 Negative Externality
E of Consumption
50
True E Dead weight loss
40

30
External
costs
20

10 Marginal Private
Marginal Social
Benefit
Benefit
1 2 Q* Q1 4 5 6 Quantity
0 3 7 8
kg
 Correcting negative consumption externalities

• Advertising and awareness campaigns to alert the

consumers and influence them reduce their consumption.
– To shift MPB curve to the left thus reducing the gap between
socially optimal level of consumption Q* and Q1.
• Legislations and regulations (fines)
– ban on smoking in public places.
• Imposing indirect taxes (on the production of goods) can
reduce the supply.
– tax shifts the supply curve(MSC) upwards to MSC+tax reducing
the gap between Q* and Q1.
 Challenges on correcting externalities

• Defining property rights

• Quantifying the external costs
 Defining Property Rights

• Coase Theorem: An alternative to pollution taxes and

government regulation is for the polluters and those
affected to come to a bargaining solution where the
latter are compensated.
– Ronald Coase (University of Chicago)
• if property rights are fully assigned and if people can
negotiate at low cost with one another they will
arrive at efficient solutions to problems caused by
externalities without the need for explicit government
intervention in the form of regulation and/or taxation.
 Quantifying the External Costs

• Markets can not efficiently allocate public goods

or resources
– with pervasive externalities, or
– for which property rights are not clearly defined.
• Automobile drivers don’t care for emissions
• Fish harvesters do not care future of the fish in the river.
• Public actions are required to make the resource
allocation efficient
• Measurement changes in the values is required to
see whether a public action yields net benefits
– Resource allocation should have
sum of the benefits from the action > costs of the action
 Methods for Quantifying the External Costs

Methods for valuing changes in environmental

goods and services is based on sources of the
data.
1. Observations of people acting in real-world
setting (revealed preference)
– price of output before and after pollution
– resource productivity before and after degradation
2. People’s response to hypothetical questions
(stated preference)
– what would you do if.....?
– how much you would be willing to pay for ...?
 Methods for measuring values

1 Market Price Method

2 Productivity Method
3 Hedonic Pricing Method
4 Travel Cost Method (zonal, individual, random utility)
5 Averting Behavior (Damage Cost Avoided) Method
6 Replacement Cost Method
7 Substitute Cost Method
8 Cost of illness method
9 Contingent Valuation
10 Contingent Choice Method
11 Benefit Transfer Method
 Willingness to pay and willingness to accept

1. Willingness to pay (WTP) – the maximum

amount of income a person be willing to pay
– in exchange for an improvement in
circumstances or
– to avoid a decline in circumstances.
2. Willingness to accept (WTA) – the minimum
amount of income a person be willing to
accept
– for a decline in circumstances
– or to forego an improvement in circumstances.
 Minimum Willingness to Accept (WTA)

Value of environmental improvement can be somewhere in between

Maximum Willingness to Pay (WTP)

 Compensating variation and equivalent
variation
1. Compensating variation – amount of income
paid or received that leaves the person at
initial level of wellbeing.
2. Equivalent variation – amount of income
paid or received that leaves the person at
the final level of wellbeing.
 Relations between Equivalent/compensating
variations and WTP/WTA

Compensating Equivalent variation

variation
Keep the person at the Change the level of utility as
original level of utility the change in the utility of the
society
Utility increases WTP WTA
Utility WTA WTP
decreases
Costs arising from Negative Externalities

1. Human health costs,

2. Amenities costs,
3. Ecological costs,
4. Material damage
 1. Human health costs
• Mortality risks - Acute fatality
– Value of statistical life year
– How much are you ready to pay to increase
probability of living one more year?

• Morbidity risks – Cancer, Asthma, Nausea

– Treatment costs (doctor, diagnosis, medicine)
– Wage lost
– Pain and suffering
 2. Amenities costs

• Taste (tap water, vegetables, fruits)

• Odor (tap water, street corner, Bagmati river)
• Visibility (traffic, airport, mountain flight)
• Sun light, UV rays
 3. Ecological Costs (1/4)
(Market, Non-market, Indirect, Non-use)

a) Market (products)
– Food (commercial fishing, agricultural yield),
– Fuel, Fiber, Timber, Fur, Leather
 3. Ecological Costs (2/4)
(Market, Non-market, Indirect, Non-use)

b) Non-market (recreation and aesthetics)

– Recreational opportunities lost (viewing, fishing,
boating, swimming, mountaineering)
– Scenic vistas lost
 3. Ecological Costs (3/4)
(Market, Non-market, Indirect, Non-use)

c) Indirect (ecosystem services)

– Climate change,
– Flood,
– Soil erosion, soil fertility depletion, sediment,
– Groundwater depletion,
– Biodiversity loss, Pest spread
– Damage to pollinators,
– Water pollution,
– Damage to nutrient recycling,
 3. Ecological Costs (4/4)
(Market, Non-market, Indirect, Non-use)

d) Loss of non-use values (existence/bequest)

– Loss of utility from knowing that clean resources
do not exist
– Hurt to the desire to preserve clean resources to
future generations
 4. Material damage
• Air pollution damages to building exteriors
• Water pollution damages water pipes
• Silt in water corrode the turbine in hydro-
electricity
• Flood damages bridges, houses, farm lands
 Benefit categories and valuation methods
Human health costs Ameni Ecological costs Material
ties damage
Benefit valuation method Mortality Morbidity costs Mark Non- Indire Non- costs
risks risks et market ct use

a). Market method  

b). Productivity method 
c). Travel cost method 
d). Hedonic property value    
method
e). Averting behavior/      
Replacement/Substitute Cost
Method
f). Cost of illness 
g). Contingent valuation method      
h). Conjoint/choice method      
i). Benefit transfer method        
 Conclusions
• Externalities pose difficulties in CBA
• Externalities are the mother of all the environmental
problems
• Several command and control methods are used for
relocating the decisions
• Market approach is better than command and control
approach
• But, for the market approach we need careful analysis of
costs of externalities.
• Costs of externalities are necessary for a reliable CBA.
 Case Studies
• Group A: Externalities in rail project
• Group B: Externalities in landfill project
• Group C: Externalities in Forestry project
• Group D: Externalities in consumption