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Externalities and the Environment

Chapter 17

© 2006 Thomson/South-Western

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Resources

Exhaustible resource: does not renew itselfRenewable 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 costlyCommon-pool problem: results when people

consume a good until the marginal value of additional use drops to zero they are often overused

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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

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Exhibit 1: Negative Externalities: The Market for Electricity in the Midwest

0.10

0

D

Marginalprivate cost

a

$0.14 b

Marginalsocial cost

35 50

Do

lla r

s p

er k

wh

Millions of kilowatt hours of electricity per month

If producers base decisions on their costs, the equilibrium price and quantity are $0.10 and 50 million KWH at point aBut the production of electricity involves an external cost of $0.04 per KWHThe only way of reducing emissions is to reduce generation of electricityMarginal social cost is shown by the vertical distance between the marginal private and marginal social cost curvesThe last KWH of electricity costs society $0.14, but yields a benefit of only $0.10 market failure too much pollution is producedTotal social gain is the blue shaded box

c

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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

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Exhibit 2: The Optimal Level of Air QualityD

olla

rs p

er u

nit

Poor

Marginalsocial cost

Marginalsocial benefit

a

Air quality ExcellentA A'

c

b

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 qualityThe 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 costSuppose the government decrees that A' is the minimum acceptable level: the marginal social cost, c, exceeds the benefit, bNote that some pollution is consistent with efficiency

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Exhibit 3a: Effect of Changes in Costs

0 Air quality

Marginalsocial benefit

Marginal social cost

Do

llar

s p

er u

nit

A A'

MSC'

•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.

a) Lower cost of air quality

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Exhibit 3b: Effect of Changes in Benefits

0Air quality

Marginalsocial cost

Marginalsocial

benefit

Do

llar

s p

er u

nit

A"

MSB'

A

•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.

b) Greater benefits of air quality

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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 labThe 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

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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

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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

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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

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The Coase TheoremAlternatively, 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

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Exhibit 4: Optimal Allocation of Pollution Rights

25

0 100

D

S

Tons of discharge per day

Do

llar

s p

er t

on 35

250

With no restrictions there will be 250 tons dumped per daySuppose engineers determine that the river can neutralize 100 tons per day: vertical supply curve at this level of dischargeIf government regulators can easily identify polluters and monitor their behavior, authorities can allocate permits to discharge 100 tons per dayIf the government sells 100 tons of pollution permits at the market clearing price of $25 per ton, the optimum level of discharge is achievedThose who value the discharge rights the most will end up with them, others will find cheaper ways of resolving their waste problems

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Exhibit 4: Optimal Allocation of Pollution Rights

25

0 100

D

S

Tons of discharge per day

Do

llar

s p

er t

on35

D'

250

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.

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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

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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

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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 pollutionAutomobile emissions account for 40% of smog40% from consumer products15% from manufacturing

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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

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Exhibit 5: Fossil-Fuel Carbon Dioxide Emissions

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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

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Water PollutionThe 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

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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

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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

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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

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Exhibit 6 Paper and Cardboard Recycling: Top 20 Advanced Economies

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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

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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

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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 producedAt this level, marginal social benefit exceeds marginal cost: net social welfare will increase if education expands past ESocial welfare is maximized at point e' where E’ units of education are provided with the yellow triangle showing the net increase in social welfare

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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