Question

Explain how the presence of externalities can affect the valuation of social projects. How would you go about monetizing an external cost such as environmental cost in a social project evaluation? Use an example to explain your response

Answer 1

An externality is when the decisions or actions of a person or a group imposes a cost or gives a benefit to second or third parties. Externalities can impose a net social cost or benefit on to social projects which the person or group undertaking the project does not have to directly pay for or get the benefit from the project. Third parties who are not involved with the project may end up bearing the cost or receive the benefit of these externalities.  

For example if a manufacturing plant is being setup near a small village and if the plant pollutes the water source of the village then the pollution of the water source is an externality and it leads to a social cost to the residents of the village as they now have to spend on medical expenses for drinking the contaminated water or on getting new water filters. This cost is borne by the villagers and not by the manufacturer, who was the one who caused the externality.

To make up for situations such as the one above, governments have set up various regulations and imposed taxes on companies that cause a net social cost to the society and have given subsidies to companies that give a net social benefit (Eg: companies that produce electric vehicles are given subsidies since electric vehicles reduce the number of fossil fueled cars on the road and thus reduce pollution).

To quantify something such as environmental cost, we must use the concept of marginal social cost and marginal social benefit. Marginal social cost is the total cost to society of producing an additional unit of a good or service. MSC is equal to the sum of the marginal cost of producing the product (such as labour, raw material etc.) and the correctly measured marginal external cost involved in the process of production. The marginal external cost can be estimated by the additional cost incurred by society due to the production of an extra unit.

For example if a steel plant produces steel at a given marginal cost P₁. However if there is estimated to be a $100 per unit MSC that is incurred by society due to the steel production, then the government can impose a $100 per unit tax on the steel plant thus increasing the marginal cost and shifting the supply curve leftward leading to a lower equillibrium quantity and/or higher price thus leading to lesser pollution in the environment. This is represented in the graph below, where the plant was initially producing Q₁ but the production reduces to Q₂ after the social cost of pollution is taken into consideration by taxing the steel plant.

Price of steel Social marginal cost, SMC = PMC + MD Deadweight loss S = Private marginal cost, PMC $100 = Marginal damage, MD + - - - - - - - - - - - - - - - D = Private marginal benefit, PMB = Social marginal benefit, SMB - - - - - - - - Q7 Q7 Quantity of steel Overproduction

Government must look to balance the social benefits and the social costs in such situations to ensure that there is no market failure.