Externalities: Calculating the Hidden Costs of Products

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Externalities let you account for the true cost of products by including hidden costs like environmental damage.

Nivi: What’s a mispriced externality? You mentioned it on a previous episode.

Naval: An externality is where there’s an additional cost imposed by whatever product is being produced or consumed, that’s not accounted for in the price of the product. This can happen for many reasons. Sometimes you can fix it by putting the cost back into the price.

Some of the most ardent critics of capitalism argue it’s destroying the environment. If you throw away capitalism because it’s destroying the environment, then guess what—we’re all headed back to pre-industrial times. That’s not going to be a good thing.

Pricing externalities properly is more effective than feel-good measures

Because the environment is finite and precious, we have to price it properly and fold that back into the cost of products and services.

If people are wasting water, releasing hydrocarbons into the atmosphere or polluting in other ways, society should charge them what it costs to clean up the pollution and return the environment to a pristine state. Perhaps that price has to be very, very, very high.

If you raise the price high enough, you’ll knock out pollution. That’s much better than feel-good measures like banning plastic bags or restricting showers during a drought.

Properly pricing externalities can save resources in a tremendous way

California likes to run declarations and ads to scare people into avoiding showers during droughts. It would be better to raise the price of fresh water. The average consumer might pay a few pennies more for a shower; but the almond farmers—who consume a lot of water—will cut back and almond farming may move to a part of the country where water is more abundant.

Properly pricing externalities can save resources in a tremendous way. It’s a good framework to use when you want to do things like save the environment, rather than doing feel-good things that won’t actually amount to anything.