An externality is a situation in which the choice of production or consumption of a particular product involuntarily affects the utility of a third party (Chenkov-Shaw, 2019). An externality can either be negative or positive and the focus of this paper will be on negative externality. Climate is inevitably an example of a negative externality since it results from company production choices that lead to the buildup of greenhouse gases such as carbon dioxide, water vapor, methane, and nitrogen oxide. Also, some of these gases are poisonous leading to the degradation of the environment which in turn jeopardizes the utility of future generations.
Four characteristics qualify climate change as a negative externality. Firstly, it is impossible to quantify the implications and causality of climate change due to the interconnectedness and the interdependence of ecosystem components. Secondly, the challenges of climate change are felt globally and no single government can solve the challenges through intervention (Chenkov-Shaw, 2019). Moreover, the uncertainties of climate change implications raise further economic uncertainties on the effect it will have on enterprises as well as the opportunities for intervention regulations and policies. Finally, the prediction and foreseeing of the potential impacts of climate change are difficult since its effects are usually long-term.
Analysis of climate change as a negative externality
Markets experience inefficient and unpreferable market failures due to negative externalities. Relative to climate change, it is a negative externality since it depicts the overallocation of the limited resources to processes that accumulate greenhouse gases into the atmosphere beyond the social capacity for wellbeing (Chenkov-Shaw, 2019). Figure 1 below shows the climate change externality of climate change.
Fig 1: Coal production Market (Source: (Chenkov-Shaw, 2019))
The above graph demonstrates that if left in the free market without regulations, negative externality goods experience higher productions. The argument is true since the private cost that businesses incur while producing coal at quantity QP is much lower compared to the cost the future generations will incur from the adverse effects (Chenkov-Shaw, 2019). To operate within optimal allocations, QS would need to be reduced until social and private costs match.
What can be done to solve the problem of climate change
Figure two below presents a graphical solution to the climate change problem.
Figure 2: Pigouvian Taxation for Coal Production (Source:(Chenkov-Shaw, 2019))
Through the application of a tax, producers can increase the private marginal cost (PMC) to meet the actual social cost (PMC) that the future generations will have to endure. As a result, the equilibrium quantity reduces from Xm to match the socially optimal level at X0. This strategy would act progressively as carbon tax while incentives are offered to larger carbon produces to reduce their waste level. Conversely, the offenders should be made to pay harsh penalties that will make it impossible for them to remain competitive in the market. Ultimately, the solution above would put a price on climate change as a negative externality forcing producers to comply by reducing levels. Besides the carbon tax, incentives can be offered for sustainable development, for instance by applying the Pigouvian subsidies. Such subsidies would use part of the carbon tax collected to incentivize the production of renewable energy. Therefore, the externality can be limited by taxing and incentives to promote the culture of sustainability among producers.
References
Chenkov-Shaw, G. (2019). Climate Change: humanity’s biggest externality – Economics Student Society of Australia (ESSA). Economics Student Society of Australia (ESSA). Retrieved 27 January 2022, from http://economicstudents.com/2019/09/climate-change-humanitys-biggest-externality/.
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