When Costs Outweigh Benefits: Accounting for Environmental Externalities

Even the renowned neoliberal economist Friedrich Hayek admitted that prices in free markets fail to account for pollution and environmental degradation. Government thus has a legitimate claim to “direct regulation” when the price system fails. However, recent efforts to impose environmental regulations of any sort have been met with fierce resistance by many, including certain Republican presidential candidates.

In their paper Environmental Accounting For Pollution in the United States Economy, economists Nicholas Z. Muller, Robert Mendelsohn, and William Nordhaus give us some perspective on the issue by demonstrating that the cost of environmental externalities in several industries exceeds the value they add to the economy.

The aim of the paper is to estimate the gross external damages (GED) of air pollution for each industry and subtract them from the industry’s value-added (the difference between the cost of the output and the cost of non-labor, capital, and land inputs) for the year 2002. The authors posit that “damage-based pricing” is necessary because industrial pollution is a series of “uncompensated transactions” that limit the productivity of other industries and individuals. With a proper accounting system, these additional costs would appear on polluters’ balance sheets, making air pollution simply “another cost of doing business.” Perfectly efficient environmental regulations would make the cost of polluting equal to the cost borne by society as a result of emissions.

The authors measure six pollutants from 10,000 emissions sources: sulfur dioxide, nitrogen oxides, volatile organic compounds, ammonia fine particulate matter, and coarse particulate matter. In addition, the authors include an estimated social cost of carbon emissions for the utilities industry. The cumulative effects of these pollutants on health outcomes, visibility, and other measures are used to determine GED. Total GED for 2002 is $184 billion. The utility and agriculture/forestry industries generate 51% of these costs.

Crucially, the paper observes that seven industries inflict more damage through air pollution than the value they add to the economy. The net negative value industries are solid waste combustion, petroleum-fired electric power generation, sewage treatment, coal-fired electric power generation, stone mining and quarrying, marinas, and petroleum and coal products.

The authors conclude that consumers are paying far too low a price for these industries’ services because current market prices do not account for their huge external costs. The analysis implies the need for more efficient emissions regulation of these industries.

It is too early to tell what impact this article will have on how government treats the cost of environmental pollution, but its early reception has been positive. Nevertheless, the paper gives us an incomplete picture of the costs of industrial pollution. Water and soil pollution are not measured. The costs of CO2 are included for only one industry, largely because CO2 emissions data is not widely available. Therefore, the authors’ conclusions are conservative. The true costs of environmental pollution are likely greater than they indicate.