Internalization of externalities

During the last lecture we have discussed characteristics of sustainable business models. One of these characteristics is the internalization or elimination of externalities. In particular, the cost of those externalities should be internalized. What does this mean?

Externalities can be positive or negative. Thus, an externality can be a cost or benefit. It results from an activity or transaction of one economic actor and affects an uninvolved party (positively or negatively). This uninvolved actor did not choose to incur that cost or benefit.

When a company makes a decision and does not have to pay the full cost of the decision, a negative externality exists. If a product has a negative externality, then the cost to society is greater than the cost consumers pay for it. Consumers do not take cost of externalities into account. In unregulated markets, where producers are not forced to take the responsibility for external costs or if they do not take the responsibility voluntarily, society is left with the costs.

Pollution and CO2 emission are typical examples of negative externalities. A company manufacturing a certain good causes the emission of pollutants into the air. The company pays for materials, for its electricity bill and so on, but people living in the surroundings of the factory pay for the air pollution. They might get ill more frequently and be forced to buy more medicine. The manufacturing company causes cost to those people. The firm does not have to pay the bill for the higher medical expenses. The reason for this is that nobody owns the air. Once property rights are clearly defined, and no transaction costs are present, the market will solve the problem. If the manufacturing company has the property rights for air, people surrounding the company might want to pay the company for not polluting. The company will consider this offer as opportunity costs reducing the optimal amount of production. Another approach is taxation. Depending on the amount of pollution the company has to pay taxes, increasing costs. Other options are tradable emission rights and subsidies.

Many socio-ecological problems result from negative externalities. Thus, in order to reduce those problems, external costs have to be internalized, i.e. the company has to pay for them. As indicated above, internalization can be accomplished either via governmental action or via the market. However, I think last lecture clarified that today the responsibility is on the companies’ side. As governmental actions and the market do not seem to solve negative externalities in a satisfying manner, sustainable business models have to take care of it. If the company voluntarily decides to internalize external costs, sustainable business will be possible.

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