Externalities
As a by-product of their activities, paper mills produce the chemical dioxin. It forms when the chlorine used for bleaching wood pulp combines with a substance in the pulp. Once dioxin is released into the environment, it ends up in everyone’s fat tissue and in the milk of nursing mothers. According to some scientists, dioxin causes birth defects and cancer, among other health problems.
Economists often claim that markets allocate resources efficiently (see Chapter 3). Dioxin is the outcome of the operation of markets. Does this mean that having dioxin in the environment is efficient? To answer this question, it helps to distinguish different ways in which people can affect each other’s welfare.
Suppose large numbers of suburbanites decide they want to experience urban life. As they move to the city, the price of urban land increases. Urban property owners are better off, but renters are worse off. Merchants in the city benefit from increased demand for their products, while their suburban counterpats lose business. By the time the economy settles into a new equilibrium, the distribution of real income has changed substantially.
In this migration example, all the effects are transmitted via changes in market prices. Suppose that before the change in tastes, the allocation of resources was Pareto efficient. The shifts in supply and demand curves change relative prices, but competition guarantees that the relevant marginal rates of substitution will all be equal to the marginal rates of transformation. Thus, while the behavior of some people affects the welfare of others, there is no market failure. As long as the effects are transmitted via price, markets are efficient.
The dioxin case embodies a different type of interaction from this example. The decrease in welfare of the dioxin victims is not a result of price changes. Rather, the output choices of the paper mill factories directly affect the utilities of the neighboring people. When the activity of one (a person or a firm) directly affects the welfare of another in a way that is not reflected in the market price, that effect is called an externality (because one entity directly affects the welfare of another entity that is “external” to the market). Unlike effects that are transmitted through market, externalities reduce economic efficiency.
In this chapter, we analyze these inefficiencies and possible remedies for them. One of the most important applications of externality theory arises in the debate over environmental quality, and much of our discussion focuses on this issue.