Externalities: c) Environmental externalities

The idea

Environmental externalities occur when economic activities create unintended environmental costs or benefits for third parties. A common negative environmental externality is greenhouse gas emissions from a coal power station. The firm pays for coal and labour, but society bears the cost of climate change and poor air quality. Because these external environmental costs are not reflected in the electricity price, the market overproduces carbon-intensive energy, leading to market failure. Conversely, positive environmental externalities exist, such as a farmer planting trees that prevent soil erosion and improve local biodiversity. Governments often intervene using taxes or regulations to internalise these environmental impacts.

What earns the marks

• Definition of environmental externalities as third-party costs or benefits affecting the natural environment.
• Identification of negative environmental externalities, such as air pollution, water contamination, or carbon emissions.
• Identification of positive environmental externalities, such as reforestation improving air quality or biodiversity.
• Explanation of how negative environmental externalities lead to overproduction of polluting goods and market failure.
• Evaluation of methods to internalise environmental externalities, such as carbon taxes, subsidies, or tradable pollution permits.

Common mistakes and how to put them right

• Believing that all environmental externalities are negative.

  Put it right: Acknowledge that positive environmental externalities exist, such as a business creating a wetland that supports local wildlife.

• Confusing the cause of the externality with the externality itself.

  Put it right: The externality is the cost or benefit to the third party (e.g. health issues from smog), not the activity itself (e.g. driving a car).

• Assuming environmental externalities only occur in manufacturing.

  Put it right: Recognise that agriculture, transport, and even consumer behaviour (like waste disposal) generate environmental externalities.

Exam tips

• Be prepared to discuss both local environmental externalities (like noise pollution) and global ones (like climate change).
• Link environmental externalities directly to the concept of market failure and the over-allocation of resources to polluting activities.
• When discussing government intervention, evaluate the effectiveness of different policies like taxation versus regulation in reducing environmental damage.