Marginal prices affect externalities

Tags: economics externalities

When designing "externality charges", the important price to consider is the marginal price, not the average price[1].

For example, an externality charge for carbon (a carbon tax) should tax each additional "unit" of carbon used. In contrast, a bad solution would be to, e.g. raise the "up front" cost of driving or using carbon, which would raise the average cost but have no impact on the marginal cost.

The problem with targeting average prices is that when the marginal cost of something is zero, there is no incentive to limit the externality. For example, if the cost of annual vehicle registration is doubled, the average cost of driving per mile would increase, but each additional (marginal) mile driven would not cost anything. Instead, leave the up front cost the same, but change the marginal price.

References

  1. Harford, Tim. The Undercover Economist: Exposing Why the Rich Are Rich, the Poor Are Poor--and Why You Can Never Buy a Decent Used Car! Oxford ; New York: Oxford University Press, 2006.