POLLUTION & PIGOU
Hidden Economics in the Daily News

Somewhere, A.C. Pigou is smiling.

The San Jose Mercury-News recently reported that regulators will begin charging businesses a fee of 4.2 cents per metric ton of carbon emissions.

Environmentalists called it a "watershed."
A Harvard professor called it "tremendously gutsy."
Economists would call it "nothing new."

Gutsy or not, the idea is hardly original. British economist Arthur C. Pigou first came up with this idea in 1912, in his seminal work Welfare and Wealth. Pigou addressed what economists now call "externalities"-- an additional cost or benefit not reflected in price or quantity. In short, consumers and producers tend to only consider private cost and private benefit, ignoring the external effects of their decision.

Externalities can be either positive or negative. An example of a positive externality is in the market for vaccines. When someone decides to get vaccinated, they do so for selfish reasons-- because it prevents them from getting sick. But it creates a positive externality by reducing the prevalence of the disease; even those who don't get vaccinated now face a decreased probability of becoming infected. Another example is education. Someone decides to go to college because it increases their earning power and creates new opportunities. This creates a positive externality in the form of a more educated populace-- in other words, more scientists and less dishwashers.

Externalities can also be negative, and pollution is the most common example. When deciding what quantity to produce, firms only consider private cost. They ignore the effects of their production, in this case the carbon dioxide they emit and the environmental damage it causes. Pigou's solution was for the government to subsidize positive externalities, like in education and vaccines, and to tax negative externalities resulting from things like pollution.

Non-economists point to pollution and see it as a failure of the market. But, in reality, the problem arises not from any market failure, but from not enough markets. There is no property right to air-- no one owns it. When property rights are well-defined, negative externalities are generally easy to solve. If my factory dumps waste into your back yard, then you are entitled to compensation equal to the damage I've done. But if I dump waste into a river or into the atmosphere, without property rights the damage goes without compensation.

In the article, one government official insists that the 4.2 cents is not a "carbon tax," but rather a "cost recovery fee." I would imagine this same person arguing that 50% is not one-half. While in semantics a difference may exist, the effects are identical. Pigou knew this, and so has very economist since, which is why we call these types of fee "Pigouvian taxes." The government charges a fee equal to the damage done by the pollution. This forces firms to consider the full cost of their production, nudging the market towards social efficiency.

To see how this works, consider a hypothetical market for coal, shown below in a simplified form. The quantity of coal produced is shown on the x-axis, while the price per ton is shown on the y-axis. The demand curve (D) slopes downward, naturally, because consumers demand more of a product at a lower price. The supply curve (S) slopes upward, because firms are willing to supply more units when their products can be sold at higher prices.

But there's a problem. Coal producers consider only the red supply curve, or the private cost (PC). In this case, they produce Q1 units of coal and sell them at a price of P1. But the green supply curve, or the social cost (SC), reflects the true cost of production, since it includes the actual expenses in producing the coal as well as the cost of the negative externalities imposed on society.

As we can see, without the Pigouvian tax, producers operate at an artificially low price, which naturally leads to over production. So the government steps in and charges a tax equal to T. This increases the cost of producing coal, which shifts the supply curve upward to coincide with social cost. This leads to the socially optimal price and quantity, shown as P* and Q*.

Problem solved, right? Well... sort of. This isn't an awful solution, but it's hardly perfect. Even Pigou himself, in a 1954 essay entitled "Some Aspects of the Welfare State," admitted that the idea of simply using government to coerce business to "internalize the externality" carried some serious complications. But the loudest voice speaking contrary to Pigou was that of Ronald Coase, the legendary scholar and professor at the University of Chicago, who wrote a subtly scathing critique of Pigou's analysis in 1960. His article, "The Problem of Social Cost," has become the single most cited article in the field of economics. Coase's article should be required reading for any politician, environmentalist, judge, or bureaucrat interested in finding an efficient solution to the problem of negative externalities.

But, for the sake of brevity, I'll reluctantly ignore Coase's critique. The goal here, I suppose, is not to highlight what's wrong with this plan, but to explain the logic behind it. And, of course, to gleefully point out that economists had this idea 85 years before Bay Area politicians, and to give Pigou the credit he deserves, credit that the Mercury-News did not afford him. In the interest of fairness, I suggest increasing the fee from 4.2 cents to 4.5 cents and sending a royalty check to the Pigou estate.