REVIEW #17: Taxing Global Warming: Externalities and Dealing with Them

Olga Łabendowicz for

Free markets tend to provide optimal allocation of resources, but this outcome depends on a set of assumptions. Of course, these assumptions are never fully met, but the distortions arising from deviations from optimal conditions are usually small and do not warrant intervention to correct them. This policy is confirmed by general higher effectiveness of free-market economies over centrally planned ones. This phenomenon was conclusively proven by the collapse of centrally planned economies of socialist countries when pitted against free-market-driven capitalist systems – which came as a surprise even to some western economists as late as 1984.

There are, however, cases when violations of conditions that are required for markets to function properly are so severe that we observe market failure. It is a situation when there are people willing to make transactions, but for some reason they cannot. This is clearly a highly inefficient outcome and may be caused, for example, by asymmetry of information between parties in transaction and causes problems in healthcare market (like high prices and worse outcomes). The less regulated healthcare market in the United States performs far worse than the much more regulated market in Europe


Yet another problem is posed by externalities. These arise in situations in which activities bring harm (or benefit) to the parties not directly involved in them. Vaccinations that build herd immunity create positive externalities because ‘my decision to vaccinate’ benefits society as a whole – in addition to my own benefit. Widely defined pollution (ranging from industrial waste to secondhand smoking) is the most commonly used example of a negative externality. The polluter benefits from polluting, but the community pays the price in terms of health outcomes or the quality of life.

In the case of positive externalities, people will do too little of the beneficial actions, as they do not accrue full benefits. In the case of negative externalities people do too much of the bad activity as they do not bear the full cost. In such a situation, the intervention may aim to bring the intensity of these activities to optimal levels.

One approach is command and control of outright banning or mandating certain behavior. Vaccine mandates or compulsory education are meant to create as many positive externalities as possible. On the other hand, some actions are considered indefensible and are thus outright banned – like burning trash in one’s stove. In other cases, limits are imposed, or certain additional actions required (like installing filters or creating treatment plants). These systems have the inherent problem of setting the parameters right, as they are mostly arbitrary and politically driven.

Therefore, one cannot be certain whether a given ban is not creating more harm than good in the end. In most cases, no outside verification of parameters is performed, and it is difficult to imagine how this might be done. Also, the circumstances may change. In the incoming winter, due to energy crisis, burning trash may be one of the few options remaining in order to avoid freezing for certain families. The dilemma is very real.

Taxation of Externalities

The alternative to command-and-control systems is trying to transfer external benefits or costs back to perpetrators in monetary form. In case of positive externalities, subsidies are introduced to convince people to undertake more beneficial actions. For example, in order to make people more likely to vaccinate, the state provides various incentives: free vaccinations, lifting isolation requirements for vaccinated, and even a lottery for the vaccinated with significant winnings.

One of the arguments for free education also arises from the positive externalities argument. The goal is to transmit more of the benefits to decisionmakers, so they engage in an optimal level of a given activity.


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