Question

Explain why environmental damage would be classified as an externality.

Answer 1

Externalities are involuntary side effects of an activity that affect persons other than those directly involved in the activity. A negative externality is one that causes side effects which may be detrimental either directly to the general population or through the environment. An example would be a polluting factory as a result of its production process. This pollution may pose health risks to neighboring residents, or may degrade air or water quality. That way, the owner of the factory does not incur the extra costs directly to deal with any environmental issues or to help preserve air or water cleanliness However, the injured parties can in some cases use legal remedies to obtain damage compensation.

Many economists believe that putting Pigovian taxes on pollution is a much more effective way to address pollution as an externality than regulatory standards imposed by the government. Taxes leave it to individual sources to decide how to deal with pollution by appraising a fee or "tax" on the amount of pollution generated. Hence, in theory, a source seeking to maximize its profit will reduce or control its emissions of pollution whenever it is cheaper to do so.

Cap and trade and individual transferable quotas (ITQs) include two methods of controlling negative externalities that are loosely related to property rights. The cap and trade approach sets a maximum amount of emissions over a specified time period for a group of sources. The various sources are then given pollution allowances that can be exchanged, bought or sold, or banked for future use, but total emissions do not surpass the sum of the limit and can even decrease over the specified period of time. Individual sources or installations can therefore determine their production level and/or the use of pollution reduction technologies or the purchase of additional allowances