The Carbon Tax: Understanding Negative Externalities

Negative Externalities

To understand carbon taxes, you need to first understand negative externalities. Producers can use and pollute the environment, while the cost of the pollution is not borne by anyone but shared. When a factory produces 100,000 tons of carbon dioxide, the air becomes dirtier not just for the factory’s owner but for everybody. This is the cost to society, which the private producers don’t pay alone, which is the definition of a negative externality.

In the most extreme cases of negative externalities, where the private cost is zero, the tragedy of the commons occurs. Say there is an open grass field, where villagers can graze their cows. If the field can only support a certain number of cows from each villager but there is no restriction on how many cows each villager can graze, then the villagers will bring too many cows and ruin the field. That’s because bringing a cow benefits every villager while costing very little to him but very much to group. Therefore, there is a tragedy in a system of common ownership.

Negative externalities cause a market failure because businesses decide how much to produce based on the cost they pay. The market only produces the greatest good for the greatest amount of people when the actual cost is accounted for.

Market Failure Resulting From A Negative Externality

Deadweight losses are the losses of economic benefits incurred on society

To see this market failure, let’s look at the classic graph of supply and demand shown above. There are two supply curves. The one on top represents the social cost. The one below represents the private cost. This cost is lower because the curve does not count the cost society shares. The real cost of production is the social curve, while businesses decide how much to produce based on the private curve.

Therefore the optimal quantity (where the supply and demand cross) for society is at Q_S. But, the real market equilibrium is at Q_P. The deadweight loss — the amount of economic benefit lost due to the externality — is equal to the triangle above the demand curve, below the social cost curve, and to the left of Q_P. Calculating the deadweight loss requires subtracting the rectangle between the cost curves and to the left of Q_P, as that is the unaccounted-for cost of production, from the area between the private cost curve and social cost curve. This results in the area between the social cost curve and demand curve less the triangle which shows the deadweight loss.

Solutions

To mitigate negative externalities, the government has two options. The first is to grant property rights. If a factory pours waste into a lake, the government can give ownership of the lake to a person, who can then sue to defend it. Likewise, the government can solve the overgrazing of cows by giving the land to someone who can charge villagers for grazing cows. However, this option isn’t viable for the environment. The environment is a public good. No one can effectively enclose a piece of the entire environment, and nothing can exclude people from using it, as you can do with land or a lake. That means no one can effectively own it and thus protect it. Anyone can breathe in air and conversely emit carbon dioxide.

The second option is to impose a tax on businesses, called a Pigovian Tax, to shift the private supply curve upward to the social supply curve. Then, the market adjusts to produce and consume only until the cost to society equals the benefit to society, thus harnessing the power of the invisible hand by government intervention. This is the concept behind the carbon tax, to make producers pay for the negative effects of carbon emissions.

Carbon Tax Rate

So, what should the tax rate on carbon be? Well, there’s not a consensus on that yet. Some estimates place the optimal carbon tax at little over $7 per ton of CO2 emissions, while Al Gore’s proposal would impose a tax that would rise to $100 per ton. To see how this would affect the consumer, a $40 per ton tax would on average raise gas by $0.36 per gallon of gasoline. Calculating the actual optimal carbon tax requires knowledge in environmental science, engineering, and economics. Both scientists and economists agree that we must all try to save our planet. That is why climate policy is quickly becoming the foremost issue in 2020.