The Economics of Externalities

For the non-economists out there, I want to clarify some of the critiques of economics I made in my post on the philosophy of economics. Below is a graph of the way in which most economists think about externalities. Don’t worry if it doesn’t immediately make sense, I’m going to carefully explain it and then critique the assumptions underlying it and show why public policy decisions would be different if we had better underlying assumptions.


The green and blue lines are the basic supply and demand curves, and they meet at Q0 and P0, the equilibrium point in a free market. The red line is the cost to society, the negative externality that is part of the cost of producing the good, but isn’t paid for by the producer. Pollution is a good example of a negative externality. The purple line, the total cost of the good, is determined by vertically adding the green line (the cost the producing firm pays) and the red line (the cost society at large pays). The problem with externalities is that when the good is being produced at quantity Q0 it’s actually costing society more to produce than the benefits that society gets out of production. To fix that problem, we add in the cost to society to our supply curve (by adding a tax on pollution), so that supply is now the purple line that represents the total cost of supplying the good.

Now that the purple line is our functional supply curve, we move to Q1 and P1, where we produce less of the good and the price is higher. This saves society a lot of money (no longer paying to clean up pollution), which is represented on the graph as the area shaded in red. But it also stops people from making trades they would have otherwise made. Economists assume that those trades make people better off (increase their utility). The green shaded area is the surplus of additional utility that accrued to the producer of the goods before we implemented a pollution tax, and the blue shaded area is the utility that accrued to the consumer of goods.

(If you’re not into economics, don’t worry about the purple area. Of course, if you’ve read this far, you probably are at least mildly interested. Because the total cost is the producer cost + societies cost, the blue, green, and purple areas all add up to be the same as the red area. This means the purple area represents the benefits we get from reducing pollution minus the reduced utility for consumers and producers. In other words, the purple area is how much better off society is as a whole after moving from Q0 to Q1.)

In my critique of the philosophy of economics I argued that the consumer preferences that form the basis of the demand curve aren’t the proper basis of utility. If I’m correct in that argument, then the goal of economics shouldn’t be to maximize consumer and producer surplus. In the above example, that means there are significantly more benefits to society to reducing externalities than those reflected in the graph, and so instead of reducing the quantity supplied from Q0 to Q1 we ought to reduce it even farther. You’ll have to decide for yourself if you think my critique of the economic conception of utility is forceful enough to matter, but, if it is, this is just one of the many places it would affect public policy decisions.


3 thoughts on “The Economics of Externalities

  1. Pingback: Coal Mining and Population Loss | Faith and Public Policy

  2. Pingback: Three Reasons Economists Should Oppose Advertising | Faith and Public Policy

  3. Pingback: Rational Fools: Amartya Sen’s Critique of Economic Theory | Some Things Considered

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