Lessons in Sustainability: Externalities

Market is a social arrangement that enables buyers and sellers to discover information and prices, and in turn carry out a voluntary exchange of goods and services. Property rights are the basis for the ability to sell of good and services in a market freely.
An efficient market assumes that:

  • Competition will lead the prices to equilibrium of supply and demand
  • Everyone pays for the goods and services they use
  • Equilibrium prices will be enough to pay for the costs of goods

Before we understand how market failures can occur, let us define property rights-

All economic activities including trade and production are the exchange of bundles of property rights — Furubotn and Pejovich, 1972

Property rights gives the owner the following rights:

  1. Ownership Right
  2. Usership Right
  3. Right to transfer
  4. Exclusion right
  5. Right to enforcement

Institutions like SEBI for securities and RTO for vehicles ensure that these property rights are held.

Property rights are defined by institutions and type of good. Goods can be of multiple types — Public, Private, Common goods. Goods can be characterized by:

  1. Degree of Excludability: The degree of control of access to goods by potential users. In some cases, it can be costly and even virtually impossible. For eg. Common goods such as natural resources
  2. Degree of Rivalry: When consumption by one consumer prevents simultaneous consumption by other consumers.
  3. Degree of Subtractability: The degree to which competing users are able to subtract the welfare of other users. Non subtractability can become a source of potential divergence between individual users and society

Summarizing the type of goods in the following diagram:

Source: https://www.e-education.psu.edu/geog432/node/277

For the sake of scoping this blog, we shall talk about Public and Common Goods and the problems associated with ill defined property rights that eventually lead to market failure — meaning inefficient allocation of resources:

  1. Low Nonexcludability leads to the problem of free rider when goods and services are open to use for everyone and some some entities are able to consume more than their fair share of the shared resource or pay less than their fair share of the costs. Free riding prevents the production of valuable goods and services through the conventional free-market route, a route where a sufficient amount of demand and willingness to pay would lead to production. And so, such valueable goods remain unproduced.
    Consider roads. Roads, 70 years back were a public good because it was difficult to exclude it. Now, with the advent of toll systems, smart cards, excludability is possible and subsequently engagement of private companies through the build, operate, transfer model.
  2. The cost of the good is indivisible — marginal cost is zero
  3. Due to the high degree of subtractability of welfare in case of a common good, The Tragedy of Commons occurs which means that the divergence between the individual and collective rationality is high.

Consider, the example of fish in international waters. Each individual fisherman, acting independently, will rationally choose to catch some of the fish to sell. This makes sense: there is a resource that the fisherman is able to use to generate a profit. However, when a lot of fishermen, all thinking this way, catch the fish, the total stock of fish may be depleted. When the stock of fish is depleted, none of the fishermen are able to continue fishing, even though, in the long run, each fisherman would have preferred that the fish not be depleted. The tragedy of the commons describes such situations in which people withdraw resources to secure short-term gains without regard for the long-term consequences. — Source


Externalities are the spillover effects associated with production and consumption of goods and services that impact a third party and when the relevant costs and benefits are not included in the market prices because of an inefficient market!

Economics of Negative Production Externalities from Production and Consumption Point of View

Negative Production Externality

Private marginal cost (PMC): The direct cost to producers of producing an additional unit of a good
Marginal Damage (MD): Any additional costs associated with the production of the good that are imposed on others but that producers do not pay
Social marginal cost (SMC = PMC + MD): The private marginal cost to producers plus marginal damage

Example: steel plant pollutes a river but plant does not face any pollution regulation (and hence ignores pollution when deciding how much to produce). That leads to overproduction of Quantity produced and a deadweight loss.

Source: Public Finance and Public Policy, 2/e, Jonathan Gruber

Negative consumption externality: When an individual’s consumption reduces the well-being of others who are not compensated by the individual. Private marginal cost (PMB): The direct benefit to consumers of consuming an additional unit of a good by the consumer. Social marginal cost (SMB): The private marginal benefit to consumers plus any costs associated with the consumption of the good that are imposed on others Example: Using a car and emitting carbon contributing to global warming

Negative Consumption Externality

Private marginal Benefit/Cost(PMB): The direct cost to consumers of consuming an additional unit of a good by the consumer.
Social marginal Benefit/Cost(SMB): The private marginal costs to consumers plus any costs associated with the consumption of the good that are imposed on others
Example: Using a car and emitting carbon contributing to global warming

Source: Public Finance and Public Policy, 2/e, Jonathan Gruber

Solutions for externalities:

Source: BSEM Project done at IIML

Ways to manage the harm that’s already been done: Mitigating GHGs

  1. Not letting any further increase or reducing the rate of increase in GHGs. Ideally, GHGs shouldn’t exceed 450 PPM in the enviroment
  2. Adaptation Measures: Devising ways to adapt to the changing climate. Example — heat resistant wheat variety
  3. Sinks: Creating sinks for carbon back into the places it came from — fossils, trees, sea (planktons)

Climate Change Deliberations and Negotiations


  1. 1979 — First every World Climate Change Conference in Geneva: They issued a declaration calling the world’s governments to prevent potenrial man made changes in climate that can have adverse impacts on humanity
  2. 1980–90 — Intergovernmental conferences on climate change
  3. 1990 — Second World Climate change conference in Geneva
  4. 1990 — Approval for treaty negotiations on UNFCC (UN Framework Convention on Climate Change), the first ever binding international instrument to address climate change
  5. 1992 — UNFCC opened for signature in Rio De Janeiro. Signatures by 154 countries
  6. 1994 — Convention initiated into action after its ratification by 50 states
  7. Feb 1995 — Conderences of the Parties became the convention’s governing authority

UNFCC Objective:

Stablize the concentrations of GHGs in the atmosphere to a level that would prevent dangerous antheopogenic interference with the climate system. And for that,

  • Sufficient time should be allowed to ecoystems to adapt naturally
  • Ensure food production is not threatened
  • Enable economic development in a sustainable manner

UNFCC Acts Differentially
The convention puts the majority of responsibility to developed countries and gives the right for the developing countries for economic development and thereby dividing the countries into three groups with their set of commitments:

While the ‘What’ was defined through UNFCC, the how was missing and that was because of goals that did not have SMART characteristics, meaning goals that were:

Specific, Measurable, Achievable, Realistic and anchored within a Time Frame.

Kyoto Protocol

Came into existance to address the inefficiencies in the UNFCC. It changed GHG emissions from being free to having a cost associated with them.
Goal: Worldwide reduction of emissions of GHGs by an average of 5.2 percent below 1990 levels. CP 1 was the commitment period 1 where the emissions were calculated as an average of years 2008–12. Second Kyoto Period1 was from Jan 2013 to Dec 2020 where parties committed to reduce GHG emissions by at least 18 percent below 1990 levels in the eight-year period from 2013 to 2020. The same Annex principles applied in KP as well.

Different countries adopted different emission reduction targets thereby assigning an allowance of carbon emissions to each participating country.

Paris Accord

In 2021, Paris Accord replaced KP. The agreement, signed in 2015, aims to “substantially reduce global greenhouse gas emissions in an effort to limit the global temperature increase in this century to 2 degrees Celsius above pre-industrial levels, while pursuing the means to limit the increase to 1.5 degrees.”

Paris Agreement requires that all countries — rich, poor, developed, and developing — do their part in mitigating GHGs. Greater flexoibility and ownership is built into the agreement with no guide specifying the commitments countries should make.

How do companies and countries manage their targeted allocations of carbon, especially in context of differing levels of technological capabilities, cost of reduction etc.

The next blog talks about Carbon Markets.

Part of the series Lessons in Sustainability based on Professor Sushil sir’s in class discussions for the elective BSEM at IIML

I believe in the sustainable way of living and giving back to the nature. Constantly on the lookout to reduce, replace and refurbish.