The Rhetoric of Negative Externalities

Negative externalities are costs imposed on third parties. The paradigmatic example is pollution. A firm manufactures a product that generates toxic waste, and dumps the waste; society pays for the associated cost, including, for instance, the community’s health problems caused by the waste. Profit is supposed to measure the firm’s revenues in excess of the associated costs; because this cost is not included, the firm’s profits are higher than they should be, and there is more pollution than there should be.

What is privately optimal diverges from what is socially optimal. The concept of negative externalities is intuitively appealing. It is firmly entrenched in economic analysis even though it is almost impossible to apply with any rigor in many important real-world contexts. What is the baseline from which “pollution” is measured?

How clean must the air and water surrounding the firm be? And whose costs must the firm take into account in order to internalize the externalities? Clearly, the firm’s next door neighbors harmed by the polluted air generated by the firm. But what about people who are more remotely affected?