Pigou and Externatilities

   The tradable permits market, also known as cap-and-trade policy, is based on a significant economic concept developed by a British economist, Arthur Cecil Pigou, in the early 20th century. Pigou pointed out that the total cost of a product should not only be the costs of production and materials but also the negative social effects of the products on human beings or environment. To incorporate this idea into an economic model, Pigou developed the concept of externality, which is the net social cost (social cost - social welfare) of a product, that is not transferred to price.

As the graph shows, when a product is put on the market, the market price is decided by the marginal cost (private cost) of businesses producing the product and marginal benefit (demand) that consumers can enjoy from the consumption. However, for some products, the consumption or the production process would generate negative effects on the society, and therefore increase the social cost which is not considered by businesses or the market. As show in the graph, the triangle intersected by Qs,Qp, Ps, Pp, above Pp line is the externality that the society suffer from.


In order to protect the social benefit, this externality must be transferred to the businesses to meet the ideal balance/equilibrium on the market. Theoretically, the price would be pushed higher with quantity produced lower. At the new point, the social costs would be covered in full by social benefits generated from the product, and therefore the society as a whole would not lose from producing the product.

Pollution is often considered an externatlity for most businesses. The social cost of pollution, such as diseases, costs on health care, shorter life span and decrease in life quality, are considerably high. Command-and-control policies, which regulate the pollution standard of businesses force the businesses to choose a higher price level. As shown in the right, this method creates a shortage in supply and consumers would pay for the standard by offering higher price for the product.





Another way to transfer the cost is by taxing the pollution. As shown in the graph on the left, the tax can push private cost up to meet the social equilibrium point. However, it is really difficult to determine the tax rate to achieve it, as different industries respond differently to tax and pollution control technologies.

Cap-and-Trade policy is a market approach based on the pollution standards set by Command-and-Control policy yet allow the flexibility of permits to be transferred from firms to firms. It can effectively transfer the costs to the businesses yet allow businesses and the permits market to decided the most cost efficient way to allocate pollution.

Pigou's concept is the basis of the environmental economics studies which, for the first time in economics field, combines the social interests and financial interests. I'm looking forward to learn more about the research done regarding how well this system transfer the externalities to businesses.