Externalities: Calculating the Hidden Costs of Products

What's a mispriced externality you mentioned at some point during our podcast? An externality is when there is an additional cost that is imposed by whatever product is being produced or consumed that is not accounted for in the price of the product. Sometimes, you can fix that by putting the price back into the product.

One of the most ardent ways people attack capitalism these days is that 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.

So rather, there is an externality because the environment is finite. The environment is precious, and we have to price it properly and fold it back in. If people are wasting water or putting hydrocarbons in the atmosphere or polluting things, you want to charge them what it costs to clean up that pollution and return it to a pristine state. Perhaps that price has to be very, very, very high. If you raise that price high enough, you knock out pollution.

It's much better than feel-good measures where we're just going to ban plastic bags and say, "Don't take showers on Saturdays and Sundays when we’re having a drought." California likes to run declarations and ads to scare you into not taking showers at times when there's a drought, when it would be just much better to raise the price of fresh water.

Your average consumer might pay a few pennies more for a shower, but then the almond farmers who consume a lot of the water will cut back on using fresh water. 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 think about how to be effective when you want to do things like save the environment, rather than feel-good things that won't actually amount to anything.