Dealing with negative externalities

Congestion is an excellent example of an externality. 

By driving along a road you actually hold up other road users. You consider only the benefits of making the journey to yourself and the cost of the journey to you*. However you impose on other road users the cost of a longer journey for them and impose on the world at large the costs of noise and pollution from your car.

The market will allow far too many cars to use a road. You only need to look at the queues of traffic heading into the City in the morning, or out again in the evening.

The reason why there are too many cars on the road is the failure of drivers to consider the full social cost of their journey. The way to correct this market failure is to 'internalise the externality' by imposing a charge on the drivers. This will raise the cost of the journey to them and fewer will want to use the road (simply the 'Law of Demand').

Economists have long recommended 'road pricing' as a solution to the problem of congestion. It meets with a lot of opposition and was recently rejected by the Abbot government when recommended by the Productivity Commission. 

Road pricing means charging road users according to the time of day and level of congestion. It is a variable charge that tries to smooth out the 'peaked demand' of rush hours. By using such a system the market is moved closer to allocative efficiency, the journey times of those prepared to pay is reduced, pollution is lower as less fuel is used and money is raised to subsidise public transport.

Despite the economic sense of road pricing it is unlikely to be introduced anytime soon. There might be a London style congestion charge or a small charge per kilometer on drivers in small areas at peak times. Only Singapore has so far introduced electronic road pricing with variable fees. 

The Telegraph covers proposals for Sydney here

*Actually drivers only tend to consider their fuel costs and not the cost of maintenance, insurance and wear and tear that they have to pay as well. Therefore they underestimate their true costs and drive even more than they would if the full cost of motoring was considered.