Quantifying Equilibria Shifts due to Externalities

As environmental sustainability becomes increasingly integrated into the mainstream values, previously ignored externalities may be expected to enter into the economic valuation process. This is already evident, as an illustration, in the price that several entities are beginning to attach to carbon (with examples including cap-and-trade, carbon taxes, etc). In this paper, we present a basic economic partial equilibrium model to evaluate such externalities within the context of a particular industry. We begin by discussing how economic values may be attached to different externalities, and focus our analysis on carbon as an example of an environmental impact which may need to get internalized within the cost structure of a given organization. With such a new cost structure in place, we use historical estimates of the elasticity of supply and demand within a given industry to evaluate how the costs may propagate up and down the value chain. For example, how much of the costs are likely to get absorbed internally within a supply chain? What fraction of costs might a manufacturer reasonably expect to pass along to downstream consumers? With such estimates in place, we then predict using microeconomic theory how the supply-demand equilibrium within a particular market may shift. We discuss how such a simple approach to evaluating externalities may be used to simulate the effects of different policy choices, and illustrate the approach through an example case study of the electric utility industry. We conclude with a discussion of future work that seeks to expand considerations beyond the electric utility industry and methods to extend this simplified modeling framework.