Externalities and the Environment

Resources • Exhaustible resource: does not renew itself • Renewable resource: when used conservatively, it can be drawn on indefinitely • Some renewable resources are open-access goods • Open-access resource is rival in consumption but exclusion is costly • Common-pool problem: results when people consume a good until the marginal value of additional use drops to zero • they are often overused

Renewable Resources • Private property rights allow individuals to use resources or to charge others for their use • Pollution and other negative externalities arise because there are no practical, enforceable, private property rights to open-access resources such as air and water • Market prices usually fail to include the costs that negative externalities impose on society

Exhibit 1: Negative Externalities: The Market for Electricity in the Midwest • If producers base decisions on their costs, the equilibrium price and quantity are $0.10 and 50 million KWH at point a • But the production of electricity involves an external cost of $0.04 per KWH • The only way of reducing emissions is to reduce generation of electricity • Marginal social cost is shown by the vertical distance between the marginal private and marginal social cost curves • The last KWH of electricity costs society $0.14, but yields a benefit of only $0.10  market failure  too much pollution is produced • Total social gain is the blue shaded box Marginal social cost c b $0.14 a 0.10 Dollars per kwh Marginal private cost D 0 35 50 Millions of kilowatt hours of electricity per month

Negative Externalities: Fixed Technology • How could output be restricted to the socially efficient level? • If government policy makers knew the demand and marginal cost curves, they could simply restrict electric utilities to produce that optimal level • Alternatively, they could impose a pollution tax on each unit of output equal to the marginal external cost which leads to a socially efficient outcome

Exhibit 2: The Optimal Level of Air Quality Marginal social benefit Marginal social cost • The total social waste associated with imposing a greater-than-optimal level of air quality is shown by the pink shaded triangle, abc. • Marginal social benefit curve reflects the additional benefit from improving air quality • The optimal level of air quality for a given level of production is found at point a, where the marginal social benefit of cleaner air equals the marginal social cost • Suppose the government decrees that A' is the minimum acceptable level: the marginal social cost, c, exceeds the benefit, b • Note that some pollution is consistent with efficiency Dollars per unit c a b Poor A' A Excellent Air quality

Exhibit 3a: Effect of Changes in Costs a) Lower cost of air quality • A technological breakthrough occurs that reduces the marginal cost of cleaning the air, as shown by the shift in the marginal social cost curve to MSC'. • The net effect is to increase the optimal level of air quality from A to A' the lower the marginal cost of reducing pollution, other things constant, the greater the optimal level of air quality. Marginal social benefit Marginal social cost Dollars per unit MSC' Air quality 0 A A'

Exhibit 3b: Effect of Changes in Benefits b) Greater benefits of air quality • An increase in the marginal benefit of air would have a similar effect. The increase in the marginal benefit is shown by the shift upward in the marginal social benefit curve to MSB' – the optimal level of air quality would increase • the greater the marginal benefit of cleaner air, other things constant, the greater the optimal level of air quality. Marginal social benefit MSB' Marginal social cost Dollars per unit 0 A A" Air quality

The Coase Theorem • Traditional analysis of externalities assumes that market failures arise because people ignore the external effects of their actions • Consider the following example • A research laboratory that tests delicate equipment locates next to a manufacturer of heavy machinery • The vibrations caused by the manufacturing process throw off the delicate machinery in the lab • The negative externality in this case is not necessarily imposed by the machinery producer on the testing lab • Rather, it arises from the incompatible activities of the two parties

The Coase Theorem • The efficient solution depends on which party can avoid the problem at the lower cost • Suppose the following • It would cost $2 million to reduce vibrations enough to allow the lab to function normally • The testing lab concludes that it cannot alter its equipment to reduce the effects of the vibrations  its only recourse is to move at a cost of $1 million • Thus, the least-cost, or most efficient resolution to the externality problem is for the testing lab to relocate

The Coase Theorem • Coase argued that when property rights are assigned to one party or another, the two parties will agree on the efficient solution to an externality problem as long as the transaction costs are low  the efficient solution will be achieved regardless of which party gets the property rights

The Coase Theorem • If the lab is granted the right to operate free of vibrations  it has the right to ask the factory to reduce its vibrations • Rather than cut vibrations at a cost of $2 million, the factory can offer to pay the lab to relocate • Any payment by the factory owners that is greater than $1 million but less than $2 million will make both better off  the lab will move, which is the efficient outcome

The Coase Theorem • Alternatively, suppose the factory is granted the right to generate vibrations regardless of any effects on the testing lab  business as usual • The lab may consider paying the factory to alter its production method, but since the minimum payment the factory would accept is $2 million, the lab would rather move at a cost of $1 million • A particular assignment of property rights determines only who incurs the externality cost not the efficient outcome

Exhibit 4: Optimal Allocation of Pollution Rights • With no restrictions there will be 250 tons dumped per day • Suppose engineers determine that the river can neutralize 100 tons per day: vertical supply curve at this level of discharge • If government regulators can easily identify polluters and monitor their behavior, authorities can allocate permits to discharge 100 tons per day • If the government sells 100 tons of pollution permits at the market clearing price of $25 per ton, the optimum level of discharge is achieved • Those who value the discharge rights the most will end up with them, others will find cheaper ways of resolving their waste problems S 35 Dollars per ton 25 D 100 250 0 Tons of discharge per day

Exhibit 4: Optimal Allocation of Pollution Rights S What if additional firms spring up along the river and want to discharge wastes? This added demand is shown by D'. This increase in demand would bid up the market price of pollution permits to $35 a ton. Some existing permit holders will sell their rights to those who value them more. 35 Dollars per ton 25 D' D 100 250 0 Tons of discharge per day

Markets for Pollution Rights • Prior to 1990, traditional command-and-control environmental regulations were the norm • This approach required polluters to introduce particular technologies to reduce emissions by specific amounts • These regulations were based on engineering standards and did not recognize unique circumstances across generating plants

Markets for Pollution Rights • Economic efficiency approach • Reflected by the pollution rights approach • Offers each polluter the flexibility to reduce emissions in the most cost-effective manner given its unique costs • Firms with the lowest emission control costs have an incentive to implement the largest reduction in emissions, and then sell unused allowances to those with greater control costs

Air Pollution • In the Clean Air Act of 1970, Congress set national standards for the amount of pollution that could be emitted into the atmosphere  recognized the atmosphere as an economic resource with alternative uses • Smog is the most visible form of air pollution • Automobile emissions account for 40% of smog • 40% from consumer products • 15% from manufacturing

Air Pollution • Kyoto accord would require the 38 industrial countries to reduce emissions by one-third over ten years  cost to U.S. of $300 billion a year • Problem is that this accord requires nothing from developing countries like China and India which are major polluters

Exhibit 5: Fossil-Fuel Carbon Dioxide Emissions

Water Pollution • Two major sources of water pollution • Sewage • For decades, U.S. cities had an economic incentive to dump their sewage directly into waterways • Federal money over the years has funded sewage treatment plants that have cut water pollution substantially  nearly all cities now have modern sewage control systems • New York City is the exception and still dumps raw sewage into the Atlantic Ocean • Chemicals • 10% comes from point pollution  pollution from factories and other industrial sites • Two-thirds comes from nonpoint pollution  runoff from agricultural pesticides and fertilizers

Water Pollution • The EPA has turned pesticide regulation over to the states which gave the job to their departments of agriculture • However, these state agencies usually promote the interests of farmers, not restrict what they can do • The EPA now reports that pesticide residues on food pose more health problems than do toxic waste dumps or air pollution

Hazardous Waste and the Superfund • The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 – Superfund law – now requires any company that generates, stores, or transports hazardous wastes to clean up any wastes that are improperly disposed of • Gives the federal government authority over sites contaminated with toxins

Solid Waste: Paper or Plastic • About 70% of the nation’s garbage is bulldozed and covered with soil in landfills • As the cost of solid-waste disposal increases, state and local governments are charging for trash pickups and requiring recycling  the process of converting waste products into reusable material

Solid Waste: Paper or Plastic • Some recycling is clearly economical, but recycling imposes its own cost on the environment • Curbside recycling requires fleets of trucks that pollute the air • Newsprint must first be de-inked, creating a sludge that must be disposed of • Cost of more efficient packaging material

Exhibit 6 Paper and Cardboard Recycling: Top 20 Advanced Economies

Positive Externalities • Positive externalities occur when the unpriced by-products of consumption or production benefit other consumers or other firms • For example, people who get inoculated against a disease reduce their own likelihood of contacting the disease, but in the process they also reduce the risk of transmitting the disease to others  external benefits to others

Positive Externalities • Education also confers external benefits on society as a whole because those who acquire more education • Become better citizens • Are better able to support themselves and their families • Less likely to require public assistance • Less likely to resort to crime • Thus, education confers private benefits and additional social benefits to others

Exhibit 7: Education and Positive Externalities • Adding the marginal external benefits we get the marginal social benefit of education curve • If education were a strictly private decision, E would be produced • At this level, marginal social benefit exceeds marginal cost: net social welfare will increase if education expands past E • Social welfare is maximized at point e' where E’ units of education are provided with the yellow triangle showing the net increase in social welfare

Positive Externalities • When positive externalities are present, decisions based on private marginal benefits result in less than the socially optimal quantity of the good • Hence, they typically point to a market failure, which is why government often gets into the act • When there are external benefits, public policy aims to increase the level of output beyond the private optimum

Externalities and the Environment