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The Carbon Externality


Our lifestyles consist of carbon-intensive goods and services. Carbon emissions place a burden on society because they fuel climate change and damage the environment. Climate change in return has a detrimental impact on the economy, especially regarding the trade-offs in wellbeing and natural income between present and future generations.

The graph illustrated above shows the negative externality of carbon arising from the production of carbon-intensive goods and services. Over and above a good’s costs of production, there is an additional cost that spills over to society in the form of pollution through the emissions of carbon dioxide. The social optimum level of equilibrium is given when the marginal social cost is equal to the marginal social benefit. At this point, society is better off as the external costs of emissions are incurred by the producing firm.


However, this scenario is far away from reality because the external costs are not reflected by the free market price. Therefore, the free-market equilibrium is given when the marginal private cost is equal to the marginal private benefit. At this point, there is an over-allocation of resources to the production of carbon-intensive goods and services relative to the socially optimum level of equilibrium as Q1 is greater than Q2.


The yellow triangle highlighted represents the deadweight loss (DWL) meaning the loss of welfare for society. Therefore, the emissions from carbon dioxide place a burden on the environment which is borne by everyone in the form of climate change. This economic problem is worsening as the price of fossil fuels decreases.


As this is the root of the problem, pricing carbon stands as the most viable method to ensure we pay for the external costs, eliminate this externality, and begin a rapid transition towards decarbonization.