Why Externalities Are Bad

Here's another story which, like the one about the hurricane and the ice sellers, belongs in an introductory microeconomics class.

After gold was discovered at Sutter's Mill in Coloma, California, we all know that there was an influx of prospectors to the foothills of the Sierra Nevada mountains. The popular image is of solitary, rough-edged men kneeling in the shallows of mountain streams and panning for gold. There actually were many prospectors who fit this description, especially in the early days of the rush. However, once it became better established that there actually were large quantities of gold dispersed in the alluvium of the rivers, mining companies with the ability to outfit custom excavators and extractors moved into the gold fields. These companies with their mechanized equipment extracted gold much more efficiently than was possible by simpler means.

The equipment they used came in many varieties, but two kinds were particularly prominent due to their power and and effect on the landscape and rivers. The first of these, water cannons, were used to practice a kind of gold extraction know as "hydraulicking" in which sediments were blasted and washed into sluices where the gold would settle out. The second kind, dredgers, were used as platforms for processing large quantities of sediment in the alluvial plains at the base of the hills. Near Sacramento today there are still many places where you can see large fields full of lumpy hills of gravel and stones. These are the remnants of the work done by the dredgers.

All of this activity washed enormous quantities of sediment into the rivers that come down out the the Sierra Nevadas. For those of you not familiar with the physical geography of California, all of the drainage from those mountains comes into California's central valley. There is only one way out for all of that water, and that is through the San Joaquin Delta, into the San Francisco bay, and out to the Pacific. The sediments that were washed down from the hills dramatically impacted these waterways. One of the most noticeable effects was the great flood of 1850 that all but destroyed Sacramento. There is some argument about whether the flood was caused by the plug of sediments working its way through the river system, but it has been cited as a likely contributing factor. Another deleterious effect was the silting up of the San Francisco Bay. A considerable amount of usable area in the east bay was lost to infill from the sediments. Shipping lanes had to be dredged to keep them from becoming impassable. Less well documented, but doubtlessly significant, were the costs to wildlife in the affected wetlands.

It has been estimated that the economic damage to the San Francisco Bay alone was greater than the value of all of the gold that was extracted.

Economists call it an externality when the actions of one group cause consequences that are borne by others. The costs of the damage done downstream by the gold miners was real, but the miners were not held responsible for it. The result was that all of their efforts caused a net loss of wealth for California, even though they created wealth by extracting the gold.

The problem isn't that the miners wanted to extract the gold, or that they didn't care about what happened downstream (they may not have even known). The problem is that because they weren't forced to bear all of the costs associated with extracting the gold, they extracted too much gold, and used processes that were too costly - costly to others. If the miners had borne the costs, as well as the rewards, of their activity, they would have extracted less gold with cleaner processes, and the people of California as a whole would have reaped a net increase, instead of a loss, of wealth.