Neoclassical economists view environmental disruption as a problem of negative externalities.1 A negative externality occurs whenever an agent has to bear a part of the cost of another agent's activity without being compensated. The agent causing the externality does not take this into account. She bears only the private costs of the activity. The social costs, i.e. the total costs that are home by society, exceed the private costs. Since a part of the social costs is external and does not enter the agent's optimization calculus, too much of the activity is performed. Too much pollution is generated and environmental disruption exceeds its socially acceptable level. This is illustrated by Figure 1.1 where a market of a commodity is considered whose production causes environmental damage.2 Thus, the social costs exceed the private costs of production. Let p and q denote the price and quantity of the commodity under consideration, and let D be the demand curve. The private and social supply of the good are given by the private and social marginal cost curves, PMC and SMC. The social marginal cost exceeds the private marginal cost since damages that accrue to the rest of society are not taken into account by the individual supplier. There is a private equilibrium, P, and a social equilibrium, S. It is obvious that the equilibrium supply and demand are smaller when the total cost of production is taken into account by the producer. Moving from equilibrium P to S causes losses of consumer and producer surplus equalling the area of the triangle b. On the other hand, there is a welfare gain a + b due to improved environmental quality. The net effect is positive, i.e. the internalization of external effects is beneficial to society as a whole. Those who gain from internalization can compensate the losers without spending the total gains.
The question arises why external effects are not internalized in free-market economies. There are two potential reasons: ill-defined property rights and the absence of perfect markets. They will be discussed briefly.____________________