Valuing Environmental Externalities

Sometimes an entity uses resources for a project without paying for them.

For example, a factory may emit soot into the air, dirtying surrounding

buildings and thereby increasing their maintenance costs. The higher

maintenance costs are a direct result of the factory’s use of a resource, air,

that from the factory’s viewpoint is free, but from society’s viewpoint

has a cost. Likewise, a new irrigation project may lead to reduced fish

catch or the spread of a disease. Sometimes a project benefits certain

groups in a way such that the project entity cannot extract a monetary

payment for them.

If a forest lowers the level of carbon dioxide in the world, the forest

owners cannot charge for the benefit. Or a sewage and water supply

project may not only improve water quality and yield direct health benefits,

but may also produce benefits from decreased pollution of coastal

areas, in turn increasing recreational use and property values. These

side effects of projects, known as externalities, are real costs and benefits

that should be included in the economic analysis as project costs or

as project benefits.

Externalities are easier to conceptualize than to measure. They occur in

production and consumption and in almost every walk of life. Involuntarily

inhaling another person’s smoke is an example of an externality. The

smoker’s pleasure produces displeasure in another person. To assess the

total pleasure derived from smoking, it would be necessary to reduce the

smoker’s pleasure by the displeasure of the person who involuntarily inhales

the smoke. Although it is easy to understand how smoking may produce

an externality, it is not as easy to assign a value to the smoker’s pleasure

or to the inhaler’s displeasure.

Externalities are easy to depict. Consider the production of a good, say,

electricity. Suppose that in producing electricity the plant emits soot that increases the maintenance costs of adjacent buildings. The utility company’s

costs would not reflect the costs to the neighbors of cleaning up the adjacent

buildings—unless the law requires it. Yet, the costs to society include

not only those that appear on the article of the utility company, but also the

additional maintenance costs of the adjacent buildings. MPC

is the marginal cost of producing electricity as reflected in the books of the

utility company, and MSC is the marginal cost of producing electricity and

cleaning up the buildings. MSC is the marginal social cost of producing

electricity. This cost would be higher than the private cost, which is the

cost to the utility company.

For any given level of output, q*, the area under the MSC curve gives the

total social cost of producing that level of output, while the area under the

MPC curve gives the perceived private cost. The difference between the areas

under the two curves gives the difference between the private and the social

cost. The financial costs of the project will not include the costs of the

externality, and, hence, an evaluation of the project based on MPC will

understate the social costs of the project and overstate its net benefits. In

principle, all we need to do to account for the externality is to work with

social rather than private costs. In practice, the shape of the MSC curve and

hence its relationship to the MPC curve is unknown, making measurement

difficult. Also, tracing and measuring all external effects is not always feasible. appear significant, to measure them. When externalities cannot be quantified,

they should be discussed in qualitative terms.

In some cases it is helpful to internalize externalities by considering a

package of closely related activities as one project, that is, to draw the project

boundary to include them. In the case of the soot-emitting factory, the externality

could be internalized by treating the factory and the neighboring buildings

as if they belonged to the project entity. In such a case, the additional

maintenance costs become part of the maintenance costs of the project entity

and are internalized. If the factory pays for the additional maintenance costs,

or if the factory is forced to install a stack that does not emit soot, the externality

also becomes internalized. In these cases, the formerly external cost

becomes an internal cost reflected in the accounts of the factory.

Nevertheless, analysts should always attempt to identify them and, if they

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