Ch 13 - Environmental Protection

1. Ch 13 - Environmental Protection The use of solar energy has not been opened up because the oil industry does not own the sun. Ralph Nader

2. Market Failure: External Costs • People tend to maximize their personal welfare, balancing private benefit against private cost. • They ignore costs that are external to them. • Cost externalities (external costs) are costs of a market activity borne by a third party.

3. Externalities in Production • Whenever external costs exist, a private firm will not allocate its resources and operate its plant in such a way as to maximize social welfare. • If pollution costs are external, firms will produce too much of a polluting good.

4. Externalities • Supply curve represents marginal private cost (MPC) paid by producers. • If producer is the only party to pay costs from transactions in this market, marginal private cost = marginal social cost. (MPC = MSC) • If third parties outside of the market also pay costs from transactions taking place in this market, even though they aren’t consuming or producing the good or service, MPC < MSC. • If MPC < MSC, there are negative (or cost) externalities in productionin this market. Supply P S = MPC Q

5. MSC (MPC + Externality) Externality Externalities • EXAMPLE • MARKET FOR PAPER • There are costs to parties other than the producers (the process of producing paper creates dirty air and water, affecting neighbors of plant). • Negative (cost) externalities in production, so MPC<MSC. Difference is the externality. • This supply curve does not measure all of the costs associated with transactions taking place in this market. • Since market doesn’t know about all costs, resources will be overallocated in this market (too much paper will be produced by this factory). Supply P S = MPC Q

6. Externalities • EXAMPLE • MARKET FOR PAPER • These demand and supply curve are measuring only the private benefits and private costs associated with this market. • Consumption and production take place at equilibrium point A. • However, there are costs being borne by third parties in this market (pollution created in air and water of neighborhood around factory). These are negative externalities of production. Demand and Supply P S = MPC A PE D=MPB QE Q

7. Externalities • EXAMPLE • MARKET FOR PAPER • New supply curve represents • MPC+ externalities=MSC. • Equilibrium in this market SHOULD be at point B. • Increase in equilibrium price, decrease in equilibrium quantity. • Until externalities are internalized and reflected in the market, there is an overallocation of resources in this market (too much paper being produced). Demand and Supply MSC P S = MPC B A PE D=MPB QE Q

8. Externalities When externalities exist, equilibrium does not yield desired resource allocation. Social well-being is not maximized. (Externalities are also called social spill-overs) This is Market Failure ! Government needs to intervene and correct for market failure by internalizing the externalities, to ensure proper allocation of resources

9. MSB = MSC MSC > MSB MSB > MSC Economics of Pollution • What are appropriate levels of control? • Cost-Benefit Analysis • Control pollution up to where MSC = MSB. MSC Cost of Abatement MSB Pollution Control

10. Pollution Control Policies • Direct Controls • Ban production • Regulate production • Indirect Controls • Taxation • Cost-benefit analysis shows a tax rate that would get optimal results (MSC=MSB) • Pollution Rights Market • Firms allowed to buy and sell government issued licenses granting right to create certain amount of pollution. EXAMPLE Pollution right costs $1000. If Firm A can cut pollution for less than $1000, they do so, then sell right to pollute to Firm B, who cannot cut pollution as cheaply.