Civil Engineering Reference
In-Depth Information
concerned with the protection and enhancement of the environment and, therefore,
we restrict ourselves to the other three common causes of market failure. These are:
• externalities
• free-riderproblems
• asymmetricinformation.
Externalities
We introduced the conceptual parameters necessary to understand externalities in
distinction that helps to explain a broad set of environmental problems. The related
analysis represents an important tradition in welfare economics, stretching back to
the beginning of the twentieth century.
The idea that economic efficiency should describe a situation in which nobody
can be made better off without making somebody else worse off dates back to
around 1890 in work by Vilfredo Pareto, an Italian social scientist. According to
Pareto, in a truly efficient competitive market all the exchanges that members of the
economy are willing to make have to be agreed at fair prices. In such a situation,
nobody can benefit unless they take advantage of someone else. There is a general
equilibrium. All members of the economy face the true opportunity costs of all their
market-driven actions.
In many real markets, however, the price that someone pays for a resource, good
or service is frequently higher or lower than the opportunity cost that society as a
whole pays for that resource, good or service. In short, it is possible that decisions
made by firms and/or consumers in a transaction will affect others not involved in
that particular transaction to their benefit or detriment. To put it more simply, in
the competitive marketplace, a deal is struck between a buyer and seller to exchange
a good or service at an agreed price; but, alongside this two-party activity, there are
possible spillovers to third parties - that is, people external to the specific market
activity. The spillover benefits and costs to third parties are termed
externalities
.
To clarify the concept further it might help to draw a distinction between the
full economic cost and the basic cost of a good or service. The basic cost takes into
account all stages of production, which could include extraction, manufacture,
transportation, research, development and other business costs such as marketing. In
other words, the basic cost covers all the costs that are usually added up to account
for a market price. The full economic cost, however, includes all the possible basic
costs plus the externalities; or, to put it another way, the full economic costs are the
true burdens carried by society in monetary and non-monetary terms. In short:
full economic costs = basic costs + externalities
An example of an externality is the pollution of a river, the air or an open public
space caused by a construction process. This leads to a general loss of welfare for
a community. If this community is not compensated for its loss, then the cost is
external to the production process. The construction firm has created a negative
externality. In producing a building, the firm has paid for inputs such as land,
