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The Economics of Pollution

The problems posed by global warming and climate change are never far from the news these days. Much of the blame for the problem is attributed to pollution - particularly the emission of greenhouse gases. Pollution is an example of market failure. This resource will look at this aspect of market failure and the methods economists use to analyse the extent of the problems caused by this market failure.

What is a market?

It is important to remember some important features of a market. A market is any place that brings together a buyer and a seller with a view to agreeing a price. Markets are the principal way that many economies solve the economic problem of scarce resources and unlimited wants and needs. Prices act as a signal to both consumers and producers. For consumers, price tells them whether what they are being asked to give up in terms of money represents value or satisfaction. For producers, price is an indication of whether it is worth producing an item - whether the price they receive will be greater than the cost of production.

A market - here we have buyers and sellers - if you like the price being offered you might buy but if not there is always the chance to haggle! Markets can be simple like this or highly sophisticated. Whatever the situation, the basic principles are the same - a buyer, a seller and a price! Copyright: Henk Jan Kwant, from stock.xchng

If the market is working efficiently, it can be a very effective way of allocating scarce resources. Its dynamism means that shortages and surpluses are competed away. However, there are plenty of things that can occur which mean that prices do not accurately reflect either the true costs of production or the degree of utility (satisfaction) gained from consumption. When this occurs, the market is said to fail, and market failure leads to a less than efficient allocation of resources. Market failure can either result in too many goods being produced or not enough goods and services being produced.

Private and Social Costs

When a business enters into production, it incurs a variety of different costs. There will be set-up costs for the business in the first place. There will then be a range of fixed costs, costs which are not dependent on the amount produced (output), and variable costs, which vary directly with the amount produced. These are the private costs to the business of production. The private costs can generally be easily identified, calculated and accounted for.

However, there are certain costs generated in production that are not experienced first-hand by the producer. These costs are borne by a third party - someone not initially involved in the decision to produce. These costs are the social costs of production, the costs borne by society as a result of production. They are an example of externalities in production, the external costs borne by a third party of an economic decision.

Pollution is an example of a negative externality - the costs are not borne by the firm who produces it but by a third party - the cost is borne by society. Copyright: Claudia Meyer, from stock.xchng.

Consumer and Producer Surplus

These two concepts are similar but can be viewed from different perspectives. Biz/ed has produced another resource in this series covering the issue of consumer surplus.

Consumer and producer surplus are ways in which economic welfare can be measured. Any reduction in consumer surplus, for example, could be seen as a decrease in the welfare of consumers. Equally, changes in producer surplus are associated with a change in the welfare of producers.

Consumer surplus is a measure of the additional utility gained by a consumer in the purchase of a product when the price they would be willing to pay (which is an indication of the degree of satisfaction/utility/value they get) is greater than the price they actually do pay. Equally, producer surplus refers to a situation where producers receive a greater price for their product than the minimum which they would be prepared to accept to provide that product to the market.

We can use the concepts of producer and consumer surplus to look at the welfare effects of pollution as an example of market failure.

Please go to the Activity page for the rest of the lesson.