Ch17-LectureNotes (1)

17 EXTERNALITIES AND THE ENVIRONMENT

© 2014 Pearson Addison-Wesley

After studying this chapter, you will be able to:

Explain why external costs bring market failure and too much pollution and how property rights and public choices might achieve an efficient outcome

Explain the tragedy of the commons and its possible solutions


How can we use less coal, natural gas, and oil to reduce the air pollution and global warming we’re causing?

What can we do to conserve the ocean’s fish stocks and save endangered species from extinction?

These questions arise because some of our choices impose costs on others—external costs—that we don’t think about when we make those choices.

How can we be made to take these costs into account?


Negative Externalities: Pollution

An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer.

A negative externality imposes an external cost.



Sources and Consequences of Air Pollution

The problems of local air quality and the global problem of climate change are related, but distinct problems.

Local air quality is influenced by 180 airborne substances. Most important are carbon monoxide, lead, nitrogen dioxide, ground level ozone, particulate matter, and sulfur dioxide.

Global temperature is influenced by human emissions of greenhouse gases. Most important is carbon dioxide (CO2).



CO2 emission is a global phenomenon and problem.

The United States and China each account for about one quarter of the CO2 emitted into the global atmosphere in a year.

Electric power utilities, highway vehicles, and industrial processes are the main sources of both local air pollution and global CO2 emissions.

The effects of pollution mean that production and consumption decisions impose costs that are not taken fully into account when decisions are made.



Production and Pollution: How Much?A private cost of production is a cost that is borne by the producer.

Marginal private cost (MC) is the private cost of producing one more unit of a good or service.

An external cost of production is a cost that is not borne by the producer but is borne by others.

Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.



Marginal social cost (MSC) is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls.

Marginal social cost is the sum of marginal private cost and marginal external cost.

MSC = MC + Marginal external cost

We express costs in dollars but remember that the dollars represent the value of a forgone opportunity.

Marginal private cost, marginal external cost, and marginal social cost increase with output.



Valuing an External Cost

Suppose that there are two similar rivers, one polluted and the other clean with 10 identical riverside homes.

The homes on the clean river rent for $2,000 a month, and those on the polluted river rent for $1,500 a month.

If the pollution is the only detectable difference between the houses, then the rent difference of $500 per month is the pollution cost per home.

With 10 homes on the side of a polluted river, the external cost of pollution is $5,000 a month.


Negative Externalities: PollutionExternal Cost and Output Figure 17.1 shows the relationship between external cost and output in a paint industry that pollutes a river.The MC curve shows the marginal private cost of producing paint.

It costs producer $1 a gallon to produce 3 million gallons of paint.


Negative Externalities: PollutionIf a firm pollutes a river, it imposes an external cost that is borne by other users of the river.

The figure shows the marginal social cost of producing paint, the MSC curve.

The vertical distance between the MC and MSC curves is marginal external cost of the pollution.

MSC = MC + External cost


Negative Externalities: PollutionEquilibrium and Amount of PollutionEquilibrium in the market for paint determines the amount of pollution. Figure 17.2 shows the equilibrium in an unregulated market.

The quantity of the good produced is where marginal private cost (MC) equals marginal social benefit (MSB).



At the market equilibrium, MSB is less than MSC, so the market produces an inefficient quantity of the good.

At the efficient quantity of the good, MSC = MSB.

With no regulation, the market produces too much paint and creates a deadweight loss.



Three approaches to overcoming the inefficiency areEstablish property rightsMandate clean technologyTax or price pollution

Establish 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.

Establishing property rights can confront producers with the costs of their actions and provide the incentives that allocate resources efficiently.



Producers with property rights have two possible responsesUse an abatement technologyProduce less and pollute less

An abatement technology is a production technology that reduces or prevents pollution.

A producer will consider these two alternatives and adopt the least-cost alternative.



Figure 17.3 illustrates how property rights achieve an efficient outcome.

The producer of the good bears all the costs, so MC equals MSC.

The market outcome is efficient because at the quantity of the good produced MSC equals MSB.

The producer bears the cost of pollution or abatement.

Efficient Market Equilibrium



The Coase TheoremThe Coase theorem is a proposition that if property rights exist, only a small number of parties are involved, and transactions costs are low, then private transactions are efficient.

There are no externalities because all parties take into account the externalities involved.

The outcome is independent of who has the property rights.



The Coase solution works only if transactions costs are low.

Transactions costs are the cost of conducting a transaction.

For example, the transactions costs of buying a home include fees for an agent, a mortgage loan advisor, and legal assistance.

When a large number of people are involved in an externality and transactions costs are high, the Coase solution of establishing property rights doesn’t work and governments try to deal with the externality.



Mandate Clean TechnologyWhen property rights are too difficult to define and enforce, public choices are made.

Regulation is the government’s likely response.

Tax or Cap and Price Pollution

Two main methods that the government uses to cope with external costs:

Taxes

Cap-and-trade



Taxes

The government can set a tax equal to the marginal external cost.

The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost. That is,

MC + tax = MSC.

This tax is called Pigovian tax, in honor of the British economist Arthur Cecil Pigou, who first proposed dealing with externalities in this fashion.



Figure 17.4 shows how a pollution tax equal to the marginal external cost can achieve an efficient outcome.

At the quantity of the good produced MSC = MSB.

The government collects a tax revenue.



Cap-and-Trade

A cap is an upper limit—each firm is set a pollution quota.

A government that uses this method must first estimate the efficient quantity of pollution and set the overall cap at that quantity.

In the efficient allocation of pollution quotas, each firm has the same marginal social cost.

To make an efficient allocation, the government needs to know each firm’s marginal cost of production and marginal abatement cost.


Negative Externalities: PollutionThe government solves the allocation problem by making an initial distribution of the cap across firms and allowing them to trade in a market for pollution permits.

Firms with low abatement costs sell permits and make big cuts in pollution.

Firms with high abatement costs buy permits and make smaller cuts, or no cuts, in pollution.

The market price of a permit confronts polluters with the marginal social cost of their actions and leads to an efficient outcome.

A cap-and–trade can achieve the same efficient outcome as a Pigovian tax.


Negative Externalities: PollutionCoping with Global Externalities

The United States has made its own air cleaner by adopting the measures you’ve just seen.

But to solve the global warming problem requires public choices at a global level.

A lower CO2 concentration in the world’s atmosphere is a global public good. And like all public goods, it brings a free-rider problem.

Carbon reduction also faces carbon leakage—a tendency for non-participants in carbon reduction to increase emissions.


Negative Externalities: PollutionThe only major attempt at international coordination of carbon reduction is the Kyoto Protocol, signed by 37 countries, not ratified by the United States, and renounced by Canada.

Some governments (Australia and British Columbia in Canada) have introduced a carbon tax.

Some governments (the United Kingdom) have the equivalent of a partial carbon tax on gasoline.

Without a mechanism to compel participation in a global carbon reduction program, countries have an incentive to leave the task to others.


The Tragedy of the CommonsThe tragedy of the commons is the overuse of a common resource that arises when its users have no incentive to conserve it and use it sustainably.

Examples include the overfishing of Atlantic Ocean cod, Pacific Yellowfin tuna, and South Pacific whales.

The traditional example from which the term derives is the common grazing land surrounding British villages in the middle ages.

The tragedy of the commons arises from

Unsustainable use of a common resource

Inefficient use of a common resource


The Tragedy of the CommonsUnsustainable Use of a Common Resource

Many common resources are renewable—they replenish themselves by the birth and growth of new members of the population.

A common resource is being used unsustainably if its rate of use persistently decreases its stock.

A common resource is being used sustainably if its rate of use is less than or equal to its rate of renewal so that the stock either grows or remains constant.


The Tragedy of the CommonsFigure 17.5 illustrates the sustainable catch curve SCC.

As the stock of fish increases, the sustainable catch increases to a maximum.

As the stock increases further, the fish must compete for food and the sustainable catch falls.


The Tragedy of the CommonsIf the catch is less than the sustainable catch at a given stock, such as point Z, the fish stock grows.

If the catch exceeds the sustainable catch at a given stock, such as point A, the fish stock shrinks.

The SCC shows the sustainable catch and an unsustainable catch for a given stock that keeps the stock unchanged.


The Tragedy of the Commons

Inefficient Use of a Common ResourceFigure 17.6 shows why overfishing occurs.

The supply is the marginal private cost curve, MC.

The demand is the marginal social benefit curve, MSB.

Market equilibrium occurs at 800,000 tons per year and $10 a pound.



The marginal social cost curve is MSC.

The efficient quantity is 300,000 tons per year.

At the market equilibrium, there is overfishing and a deadweight loss arises.



Achieving an Efficient OutcomeIt is harder to achieve an efficient use of a common resource than to define the conditions under which it occurs.

The three main methods used to achieve the efficient use of a common resource are:

Property rights

Production quotas

Individual transferable quotas (ITQs)



Property Rights

By converting the common resource to private property, fishers face the full social cost of their actions.

The marginal social cost curve becomes the supply curve and the resource is used efficiently.



Production QuotasBy setting a production quota at the efficient quantity, the resource might be used efficiently.

Figure 17.8 shows the profit on the marginal ton of fish.

A fisher who cheats will increase his profit. There is an incentive to overfish.



Individual Transferable QuotasAn individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer (sell) the quota to someone else.

A market in ITQs emerges.

If the efficient quantity of ITQs is assigned, the market price of an ITQ confronts resource users with a marginal cost equal to MC + price of ITQ.

With MC + price of ITQ equal to MSB, the quantity produced is efficient.



Figure 17.9 shows the situation with an efficient number of ITQs.

The market price of an ITQ equals the marginal social benefit minus the marginal cost.

The marginal cost of fishing equals MC + price of ITQ.

Fishers make MSB equal MC + price of ITQ, and the outcome is efficient.

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Ch17-LectureNotes (1)