The production and consumption of many other goods, however, generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others. As before, market forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers.
The upshot is that gasoline consumption is inefficiently high. Suppose that pollution costs are $2 for the last gallon consumed, but that its $4 price at the pump is just enough to cover its direct production costs. Reducing production and consumption by a gallon would then cause consumers to lose fuel that they value at $4, which would be exactly offset by the $4 in reduced production costs. The $2 in reduced pollution costs would thus be a net gain for society.
That simple example captures the classic breakdown in the invisible hand when a product’s market price doesn’t reflect all its relevant social costs and benefits. In such cases, the simplest solution is to discourage consumption by taxing it.
Doing so would not only raise revenue to pay for public services; it would also make the allocation of society’s resources more efficient — hence economists’ almost universal dismay when Senators John McCain and Hillary Rodham Clinton recently proposed eliminating the federal tax on gasoline for the summer.
The stated aim of their proposal was to ease the financial burden of sharply higher gasoline prices. But adopting inefficient policies is never the best way to help people in financial distress.
Efficiency is important because any policy that enlarges the economic pie necessarily lets everyone have a bigger slice than before. Economists opposed suspending the gas tax because doing so would make the economic pie smaller.
Robert Frank explains more here.
