Economics can help us understand externalities and how to deal with them, and there are many possible ways. The focus of this blog is on taxation, because this is often used in my chosen field of alcohol economics.
The basic premise is set out below, at a national aggregate level. Any external benefit is ignored for simplicity – but it could instead be the case that the externality is the net externality (negative externality + positive externality).
To improve social welfare, the aggregate social cost should be equal to the aggregate social benefit. An economist would ideally like to set what is known as a “Pigouvian” tax, where the marginal tax is exactly equal to the marginal external cost, but this is not feasible because the marginal external cost is non-linear (the gap between aggregate social cost and aggregate private cost is not the same as units increases).
Consider two different people – one a light drinker and one a heavy drinker. For simplicity, assume that their cost functions are exactly the same and all that determines whether they are a heavy or light drinker is the benefits they receive from drinking.
So even being able to accurately define all three aggregate curves in figure 2 does not answer the question of what is “fair”. Whether the externality is £21 billion, £2.1 billion or even negative does not help.