Chapter 2: Externalities and the Environment 2 - 1 Chapter 2 Externalities and the Environment Copyright © 2009 by The McGraw-Hill Companies, Inc. All

Chapter 2: Externalities and the Environment

2 - 1

Chapter 2

Externalities and the Environment

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


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Introduction

Applications: Acid rain and global warming

Economic analysis of a pollution tax and tradable permits

The economist’s approach to pollution


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Externalities and the Environment

Positive externality

Negative externality Exists whenever a producer or consumer does not have to pay for a cost he generates.

Exists whenever a producer or consumer does not receive a payment for a benefit he generates.

• Examples: air pollution, water pollution, or noise pollution

• Examples: immunizations or improving your home.


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The Economist’s Approach to Pollution

Pollution is an example of a market failure. • An allocation of resources that is not socially optimal.

When externalities exist, there is a failure of property rights.

Solution? Establish property rights and charge a price for its use.

Who can have property rights?• government • private firms • individuals


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The Economist’s Approach to PollutionIf the government has property rights,

how do they charge a price?

TAXES PERMITS

Charging polluters a price forces them to internalize the externality.

A private solution (Coase’s prescription) is possible if:1. Property rights exist2. A small number of citizens are harmed3. There are low transaction costs


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Trade-off between Environmental Quality and Output

Environmental Quality

Output

a

b

c

d

e

f

Figure 2.1

Maximum environmental quality

Maximum output with zero environmental quality

Increase in environmental quality and a decrease in output


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Trade-off between Environmental Quality and Output

Objections to pollution prices and economist’s responses

Allocation problem

• Tax method• Command and control method

• Polluters with different technological options• Permit method

The Virtues of Pollution Prices

• Pollution price is a “license to pollute”• Pollution prices will raise product prices• Pollution taxes will raise the tax burden on the population


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Charging a Price vs. Mandating or Subsidizing Clean Technologies

Economists recommend using pollution prices and oppose mandating or subsidizing clean technologies.

• Pollution prices stimulate clean technologies

• Mandates lead to high costs for consumers - CAFE standards

• Subsidies lead to a distorted playing field among potential alternatives

• Political lobbying for subsidies cause distortion• Clean alternatives is not always the socially optimal response

• Subsidies require raising taxes

WHY?


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A Pollution Tax

MD

Figure 2.2

80 100 Gasoline

P

$2.50

S (MPC)

D (MB)

The right tax generates the right quantity of a polluting good

H

J

I

K

MSC

MSC = MPC + MD


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A Pollution Tax

Levy a corrective tax (Pigouvian tax) equal to the MD

Figure 2.3

T Social optimum quantity is where MSC = MB at 80 units of gasoline

S` (MSC`)

H

J

I

K

80 100 Gasoline

P

$2.50

S (MPC)

D (MB)


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A Pollution Tax

An optimal tax confers a net benefit to society

Net gain to society = HIJK – HIK = IJK

Gain in environmental benefit = HIJK

Loss of output = HIK

MSC

H

J

I

K

Figure 2.4

80 100 Gasoline

P

$2.50

S (MPC)

D (MB)


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A Pollution Tax

Use pollution tax revenue to cut other taxes

Tax emissions, not the polluting good

• Pollution taxes as revenue replacers

• Whenever feasible, levy the tax per unit of pollution – per emission – not per unit of polluting good

• Different ways of returning the tax revenue to the private sector will have different effects


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A Pollution Tax

• To minimize cost, levy the same tax on all firms emitting pollutant X

$60

$100

$20$25

$40$50

$200

10 25 30 35 40 45 50

Emissions

MACH

MACL

2 firms with different MACs

Without government policy, each firm pollutes 50 units.

Figure 2.5


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A Pollution Tax• To minimize cost, levy the same

tax on all firms emitting pollutant X

MACL

MD = T

• Marginal damage and tax rate is constant at $40

$60

$100

$20$25

$40$50

$200

10 25 30 35 40 45 50

Emissions

MACH Figure 2.5

• After the tax is levied, MACH will abate 10 units and MACL will abate 40 units

• After tax, total emission is

50 units

• Firms will abate until MAC = T• Equi-marginal principle


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1. Government sells permits2. Government gives the permits away

CAP and TRADE

• Cap – supply of emissions permits is fixed • Trade – permits can be bought and sold in the market throughout the year

How do firms get the permits?

Tradable Permits


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$60

$100

$20$25

$40$50

$200

10 25 30 35 40 45 50 75 Permits

DH

D

DL

Tradable Permits – Government sells permits

S

• The government decided to supply 50 pollution permits

• Each firm’s permit demand curve is its MAC curve

= MACH

= MACL

= market demand


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• Price where S = D

• Tax vs. permit• A hybrid policy

Tradable Permits – Government sells permits

What is the optimal permit price?

$60

$100

$20$25

$40$50

$200

10 25 30 35 40 45 50 75 Permits

DH

D

DL

S

• P = $50 is too high

P=$50

• P = $20 is too low

P=$20

• P = $40 results in the desired outcome

P=$40

Tentative prices


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giving permits to polluting firms will reduce pollution.

Tradable Permits – Government gives the permits away

• The supply curve for each polluting good will shift to the left

• The price of polluting goods will increase

Just like selling permits or levying a tax,

• Taxpayers want the government to sell permits

Which is best?• Firms want the government to give permits

But, giving the permits away can lead to higher output and emissions than is socially optimal in the long run.


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Application: Tradable Permits for Sulfur Dioxide to Reduce Acid Rain

Old policy – a maximum sulfur dioxide emission rate for new coal-burning electricity generating firms.

• Clean Air Act Amendments of 1990

• Total emissions have fallen with the new policy• Two issues: long run issue, and tax revenue issue

New policy – tradable permits are given to electric power plants

• Plants can then buy and sell permits an needed

Sulfur dioxide causes acid rain


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Application: A Carbon Tax or Tradable Permits to Reduce Global Warming

• A carbon tax treaty• A carbon tradable permits treaty

• A hybrid carbon treaty: a permit system with a safety valve• The political challenge

Carbon emissions cause global warming

Policy decision – carbon tax or carbon permits?

Policy decision – how can low-income countries be induced to participate?


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Summary

Applications: Acid rain and global warming

Economic analysis of a pollution tax and tradable permits

The Economist’s approach to pollution


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Preview of Chapter 3:

Public Goods and Political Economy

Political economy

The concept of a public good

The behavior of the government

Documents

Chapter 2: Externalities and the Environment 2 - 1 Chapter 2 Externalities and the Environment Copyright © 2009 by The McGraw-Hill Companies, Inc. All