Limiting Climate Change: Externalities and Solutions

2. How can we limit climate change?

3. 10 Externalities CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to • 1Explain why negative externalities lead to inefficient overproduction and how property rights, pollution charges, and taxes can achieve a more efficient outcome. • Explain why positive externalities lead to inefficient underproduction and how public provision, subsidies, and vouchers can achieve a more efficient outcome.

4. EXTERNALITIES IN OUR DAILY LIVES • An externality is a cost or a benefit that arises from: • Production that falls on someone other than the producer • Consumption that falls on someone other than the consumer • Negative externality • A production or consumption activity that creates an external cost. • Positive externality • A production or consumption activity that creates an external benefit.

5. EXTERNALITIES IN OUR DAILY LIVES • Four types of externalities: • Negative production externalities • Positive production externalities • Negative consumption externalities • Positive consumption externalities

6. EXTERNALITIES IN OUR DAILY LIVES • Negative Production Externalities • Pollution is the major example of this type of externality. • Others are noise and congestion. • Positive Production Externalities • Example: Orchards provide positive production externalities to honey producers, who in turn provide positive production externalities to orchards.

7. EXTERNALITIES IN OUR DAILY LIVES • Negative Consumption Externalities • Smoking tobacco in a confined space • Noisy parties • Positive Consumption Externalities • Education is a major example of this type of externality. • Others are a flu vaccination and restoration of an historic building

8. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Private Costs and Social Costs • Marginal private costis the cost of producing an additional unit of a good or service that is borne by the producer of that good or service. • Marginal external costis the cost of producing an additional unit of a good or service that falls on people other than the producer.

9. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Marginal social costis the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls. • Marginal social cost (MSC) is the sum of marginal private cost (MC) and marginal external cost. • MSC = MC + Marginal external cost

10. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Figure 10.1 shows the relationship between cost and output. When output is 4,000 tons of chemicals a month: 1.Marginal private cost is $100 a ton. 2.Marginal external cost is $125 a ton. 3.Marginal social cost is $225 a ton.

11. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Production and Pollution: How Much? • When an industry is unregulated, the amount of pollution it creates depends on the market equilibrium price and the quantity of the good produced. • If the industry creates an external cost, the market equilibrium is inefficient. Too much of the good is produced.

12. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Figure 10.2 shows inefficiency with an external cost. 1. The market is in equilibrium at a price of $100 a ton and 4,000 tons of chemical a month is inefficient. 2.Marginal social cost exceeds ... 3.Marginal benefit.

13. 10.1 NEGATIVE EXTERNALITIES: POLLUTION 4.The efficient quantity is 2,000 tons of chemical, where marginal social cost equals marginal benefit. 5. The gray triangle shows the deadweight loss created by the pollution externality.

14. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Property Rights • Property rights are legally established titles to the ownership, use, and disposal of factors of production and goods and services that are enforceable in the courts.

15. 10.1 NEGATIVE EXTERNALITIES: POLLUTION Figure 10.3 shows how property rights achieve an efficient outcome. 1.With property rights, the MC curve that excludes the cost of pollution shows only part of the producers’ marginal cost.

16. 10.1 NEGATIVE EXTERNALITIES: POLLUTION 2.The marginal private cost curve includes the cost of pollution, and the supply curve is S = MC.

17. 10.1 NEGATIVE EXTERNALITIES: POLLUTION 3.Market equilibrium is at a price of $150 a ton and a quantity of 2,000 tons of chemical a month and is efficient because… 4.Marginal social cost equals marginal benefit.

18. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • The Coase Theorem • Coase theorem is the proposition that if property rights exist, only a small number of parties are involved, and transactions costs are low, then private transactions are efficient and the outcome is not affected by who is assigned the property right. • Transactions costs are the opportunity costs of conducting a transaction.

19. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Application of the Coase Theorem • If factories own homes and river, the rent people willingly pay decreases as the amount of pollution increases. • If homeowners own the river, factories must pay homeowners for any pollution, and the more they pollute, the more they pay. • Regardless of who owns the river, so long as someone owns it, the factories bear the cost of pollution, and the quantity of production and pollution are efficient.

20. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Government Actions in the Face of External Costs • The three main methods that governments can use to achieve a more efficient allocation of resources in the presence of external costs are • Pollution limits • Pollution charges or taxes • Marketable permits (cap-and-trade)

21. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Pollution Limits A pollution limit seeks an efficient outcome by placing a quantity limit on a polluting activity. The 1990 Clean Air Act administered by the Environmental Protection Agency (EPA) employs this method.

22. 10.1 NEGATIVE EXTERNALITIES: POLLUTION Figure 10.4 shows the effects of a pollution limit. 1. A pollution limit is imposed that restricts production to the efficient quantity. 2. The efficient market equilibrium pollution limit is achieved.

23. 10.1 NEGATIVE EXTERNALITIES: POLLUTION 3.The market price is equal to marginal benefit, MB, and marginal social benefit, MSB. 4.Because the price exceeds marginal cost, producers get a producer surplus equal to the area of the blue rectangle.

24. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Pollution Charges or Taxes Pollution charges or pollution taxes confront the producers with the external cost of pollution and provide an incentive to seek technologies that are less polluting. To work out the pollution charge or pollution tax that achieves efficiency, the regulator needs a lot of information about the industry, which is generally not available.

25. 10.1 NEGATIVE EXTERNALITIES: POLLUTION • Marketable Pollution Permits (Cap-and-Trade) A marketable pollution permit seeks an efficient outcome by assigning or selling pollution rights to each producer in an industry. Producers can buy and sell permits in the market. Producers with a low marginal cost of reducing pollution will sell permits and producers with a high marginal cost of reducing pollution will buy. Producers will buy and sell permits until their marginal cost of pollution equals the market price of a permit.

26. 10.1 NEGATIVE EXTERNALITIES: POLLUTION Figure 10.5 shows the effects of a pollution charge or pollution tax. 1.A pollution charge or tax is imposed that is equal to the marginal external cost of pollution.

27. 10.1 NEGATIVE EXTERNALITIES: POLLUTION The supply curve becomes the marginal private cost curve, MC, plus the tax—the curve labeled S = MC + tax. Because the charge or tax equals the marginal external cost, the MSC curve becomes the supply curve.

28. 10.1 NEGATIVE EXTERNALITIES: POLLUTION 2.Market equilibrium at a price of $150 a ton and 2,000 tons of chemical a month is efficient because… 3.Marginal social cost equals marginal benefit.

29. 10.1 NEGATIVE EXTERNALITIES: POLLUTION 4. The government collects revenue equal to the area of the purple rectangle.

30. 10.2 POSITIVE EXTERNALITIES: EDUCATION • Private Benefits and Social Benefits • Marginal private benefit is the benefit of an additional unit of a good or service that the consumer of that good or service receives. • Marginal external benefit is the benefit of an additional unit of a good or service that people other than the consumer of the good or service enjoy.

31. 10.2 POSITIVE EXTERNALITIES: EDUCATION • Marginal social benefit is the marginal benefit enjoyed by society—by the consumer of a good or service and by everyone else who benefits from it. • Marginal social benefit (MSB) is the sum of marginal private benefit (MB) and marginal external benefit. • MSB = MB + Marginal external benefit

32. 10.2 POSITIVE EXTERNALITIES: EDUCATION Figure 10.6 shows an external benefit. When 15 million students attend college: 1.Marginal private benefit is $10,000 per student. 2. Marginal external benefit is $15,000 per student. 3. Marginal social benefit is $25,000 per student.

33. 10.2 POSITIVE EXTERNALITIES: EDUCATION Figure 10.7 shows inefficiency with an external benefit. 1.Market equilibrium is at a tuition of $15,000 a year and 7.5 million students and is inefficient because … 2.Marginal social benefit exceeds … 3.Marginal cost.

34. 10.2 POSITIVE EXTERNALITIES: EDUCATION 4.The efficient number of students is 15 million. 5. The gray triangle shows the deadweight loss created because too few students enroll in college.

35. 10.2 POSITIVE EXTERNALITIES: EDUCATION • Government Actions In the Face of External Benefits • Three devices that governments can use to achieve a more efficient allocation of resources in the presence of external benefits: • Public provision • Private subsidies • Vouchers

36. 10.2 POSITIVE EXTERNALITIES: EDUCATION • Public provision is the production of a good or service by a public authority that receives the bulk of its revenue from the government. • A subsidy is a payment that the government makes to private producers to cover part of the costs of production. • A voucher is a token that the government provides to households that can be used to buy specified goods or services.

37. 10.2 POSITIVE EXTERNALITIES: EDUCATION Public Provision Figure 10.8 shows how public provision can achieve an efficient outcome. 1. Marginal social benefit equals marginal cost with 15 million students enrolled in college. 2. The efficient quantity. 3. Tuition is $10,000 per year. 4.Taxpayers cover the remaining $15,000 of marginal cost per student.

38. 10.2 POSITIVE EXTERNALITIES: EDUCATION Private Subsidies Figure 10.9 shows how a subsidy achieves an efficient outcome of 15 million students. 1. A $15,000 subsidy per student shifts the supply curve to S = MC – subsidy. 2.The dollar price is $10,000 a student.

39. 10.2 POSITIVE EXTERNALITIES: EDUCATION 3. The market equilibrium is efficient with 15 million students enrolled in college. 4.Marginal social benefit equals marginal cost.

40. 10.2 POSITIVE EXTERNALITIES: EDUCATION Vouchers Figure 10.10 shows how vouchers can achieve an efficient outcome. The MSB curve becomes the demand curve because… 1. With vouchers, buyers are willing to pay MB plus the value of the voucher.

41. 10.2 POSITIVE EXTERNALITIES: EDUCATION 2. Market equilibrium is efficient with 15 million students enrolled. 3.Price, marginal social benefit, and marginal cost are equal. 4. Tuition equals the dollar price of $10,000 plus the value of the voucher.

42. How Can We Limit Climate Change? The average temperature of the Earth is rising and so is the atmospheric concentration of carbon dioxide, CO2. The figure shows these upward trends.

43. How Can We Limit Climate Change? Scientists debate the contribution of human economic activity to these trends, but most believe it to be a major source. Economists debate the costs and benefits of alternative ways of slowing CO2 and other greenhouse gas emissions, but most favor some action. Economists agree that lowering greenhouse gas emissions requires incentives to change.

44. How Can We Limit Climate Change? One idea is to cap emissions and issue tradeable emissions permits, a system called cap-and-trade. Carbon emission permits are already priced on a global carbon trading market. American Clean Energy and Security Act of 2009 would use a cap-and-trade scheme. With 2005 levels as the base, emissions would be capped at 97 percent by 2012, 83 percent by 2020, 58 percent by 2030, and 17 percent by 2050. The cost of the scheme would be about $175 per household per year.

45. How Can We Limit Climate Change? Another incentive might be a hike in the tax on gasoline. Americans pay a much lower gas tax than Europeans pay. The figure shows the stark difference between the United States and the United Kingdom.

46. How Can We Limit Climate Change? Why don’t we have more aggressive caps and stronger incentives to encourage a larger reduction in emissions? There are three reasons. First, many people don’t accept the scientific evidence that emissions produce global warming. Second, the costs are certain and would be borne now, while the benefits would come many years in the future. Third, if current trends persist, by 2050, three quarters of carbon pollution will come not from the United States but from the developing economies.