The World Bank

Economic Analysis of Environmental Externalities


Courtesy of The World Bank

' Economic analysis of pollution prevention and abatement measures requires estimating the potential benefits from controlling pollution as well as the better-known costs of new equipment or processes. This note discusses the economic analysis of environmental externalities, using a wide range of valuation techniques.'

Industrial activities often produce various pollutants; these include air and water pollution as well as solid and/or toxic wastes. Since these pollutants may impose costs on society and individuals, the identification and quantification of these pollutants, and the assessment of their impacts, both monetary and non-monetary, are important elements in a broader economic analysis of the benefits and costs of various production alternatives. Information on the costs of pollution is also important in helping decide what level of pollution control is economically justified.

The impacts of pollution can generally be classified into four major categories: health impacts, productivity effects (both direct and indirect), ecosystem impacts, and aesthetic effects. All of these are commonly encountered examples of economic externalities of industrial production activity, i.e., the externality occurs because the individual or resource affected is not part of the decision making process. For example, a factory may emit soot and dirty surrounding buildings, increasing their maintenance costs. The higher maintenance costs are a direct result of the factory’s use of a resource, air, that from its point of view is free, but which has a cost to society. The same analogy applies to air pollution linked health impacts. Sometimes a project makes certain groups better off, but the nature of the benefits is such that the project entity cannot extract a monetary payment for them. A sewage and water supply project, for example, 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 externalities are real costs and benefits attributable to the project and should be included in the economic analysis as project costs or as project benefits.

Conceptually, the externalities problem is quite simple. Consider Figure 1, where MPC is the marginal cost of producing a good (e.g., power produced by a coal-fired boiler) as perceived by the project entity. Suppose that the process produces a negative externality, for example, it emits soot that increases the maintenance costs of adjacent buildings. Because the production process also produces an externality, the marginal social cost is higher and given by the line MSC. For any given level of output, q*, the total cost of producing that level of output is given by the area under the curve. 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, in order to account for the externality is simply necessary to work with social rather than private costs. In practice, the measurement difficulties are tremendous because often the shape of the MSC curve, and hence its relationship to the MPC curve, is unknown. Also, it is not always feasible to trace and measure all external effects. Nevertheless, an attempt should always be made to identify them and, if they 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 project¾ that is, to draw the 'project boundary' to include them. For example, 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 that is reflected in the accounts of the factory.

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