Transcript Fourth Edition - Virginia Community College System

Chapter 12: Environmental Protection and
Negative Externalities
Across the country, countless people have protested, even risking arrest, against
the Keystone XL Pipeline. (Credit: modification of image by “NoKXL”/Flickr
Creative Commons)
Market Failure
A market failure is when a
market fails to
coordinate choices in a
way that achieves
efficient use of
resources.
Possible sources of market
failure
Externalities
Public goods
Monopoly
Smoke from a factory is an example
of an externality that may lead to
market failure
Externalities (Spillovers)
Externalities - the market fails to register fully costs and benefits.
• External costs:
• When the actions of an individual or group incur a
cost to 3rd party.
• External benefits:
• Present when the actions of an individual or group
generate benefits for 3rd parties.
sweater factory
beach
brewery
The Effect of Externalities
Private cost The cost borne by the producer of a
good or service.
Social cost The total cost of producing a good or
service, including both the private cost and any
external cost.
Private benefit The benefit received by the
consumer of a good or service.
Social benefit The total benefit from consuming a
good or service, including both the private benefit
and any external benefit.
External Cost (Spillover)
• All of the costs of production are not fully
registered, so the supply curve understates
the true cost of production. (Shifts left)
Price
S2(including external costs)
Ideal price
and output
S1
P2
Actual price
and output
P1
D
Q2
Q1
Quantity/time
• Too many units are produced.
• Pollution problems are often a side effect.
Example 1: Electric Utilities
The price of electricity
will rise from Pmarket
—which does not include
the cost of acid rain—
to PEfficient—which does
include the cost.
Consumers pay the price PEfficient,
while producers receive a price P,
which is equal to PEfficient minus the amount of the tax.
How a Negative Externality in Production Reduces Economic Efficiency
The Effect of Pollution on Economic Efficiency
Because utilities do not
bear the cost of acid rain,
they produce electricity
beyond the economically
efficient level.
Supply curve S1 represents
just the marginal private
cost that the utility has to
pay.
How a Negative Externality in Production Reduces Economic Efficiency
The Effect of Pollution on Economic Efficiency
Supply curve S2 represents the
marginal social cost, which
includes the costs to those
affected by acid rain.
If the supply curve were S2,
rather than S1, market
equilibrium would occur at price
PEfficient and quantityQEfficient,
the economically efficient level
of output.
But when the supply curve is S1, the market equilibrium occurs at
price PMarket and quantity QMarket, where there is a deadweight loss
equal to the area of the yellow triangle.
Because of the deadweight loss, this equilibrium is not efficient.
When There Is a Negative Externality, a Tax
Can Lead to the Efficient Level of Output
The market equilibrium
quantity changes from
QMarket, where an
inefficiently high level
of electricity is
produced,
to QEfficient, the
economically efficient
equilibrium quantity.
External Costs
If the firm takes only its own
costs of production into
account, then its supply curve
will be Sprivate, and the market
equilibrium will occur at E0.
Accounting for additional
external costs of $100 for every
unit produced, the firm’s supply curve will be Spublic.
The new equilibrium will occur at E1.
Price
Quantity
Demanded
Supply without
pollution cost
Supply after paying
external cost
$600
$650
$700
$750
$800
$850
$900
50,000
45,000
40,000
35,000
30,000
25,000
20,000
40,000
45,000
50,000
55,000
60,000
65,000
70,000
30,000
35,000
40,000
45,000
50,000
55,000
60,000
Supply and Demand Data for Trumpet Players
Price
Demand
Supply without
external cost
Supply paying external
cost
20
18
15
12
10
5
0
1
2.5
4
5
7.5
10
9
7.5
6
5
2.5
8
7
5.5
4
3
0.5
20
1. Graph Demand and Supply when
only private costs are considered. 15
2. Find equilibrium P and Q when
only private costs are considered. 10
3. Graph Supply when external
costs are considered.
4. Find equilibrium P and Q
when all costs are considered.
5
0
1
2
3
4
5
6
7
8
9
10
Can Government Policies Help Protect the Environment?
• Government policies to reduce pollution have proven to
be controversial.
• Command and control—
• Can be costly and inefficient
• lower costs if they are allowed to choose the
method.
• Cap-and-trade –
• a market-based approach such as RGGI,
• relies on economic incentives rather than on
administrative rules.
Pollution Charge
If a pollution charge is set equal to $1,000, then the firm will
have an incentive to reduce pollution by 30 pounds because the
$900 cost of these reductions would be less than the cost of
paying the pollution charge.
Example 2: Toilet Paper
Some toilet paper plants discharge bleach into rivers and
lakes, causing substantial environmental damage.
The graph shows that
at the optimal level of
production,
the difference
between the marginal
private cost and the
marginal social cost is
$50.
Therefore, a tax of
$50 per ton is
required to shift the
supply curve up from
S1 to S2.
3. How Can We Do Better?
Today, the current method of environmental protection is
command-and-control regulation
Government mandates the adoption of certain abatement
technologies
Widely criticized as centralized and inflexible, and more costly
than necessary
Incentive-Based Regulation
set emission reduction targets and leave it to industry to
decide how best to comply
The government provides firms with incentives to reduce
emissions (e.g. a tax on pollution, or a cap-and-trade
system)
Marketable Permits
Promoted by US Economists during the Clinton
Administration
Caps rich country emissions; provides incentives to
develop clean technologies
Funds the transfer of technology to poor countries
Europeans have successfully implemented cap-andtrade
How Marketable Permits Work
Alpha
Beta
Gamma
Delta
Current permits
200 tons
400 tons
600 tons
0 tons
Pollution allowed
100 tons
200 tons
300 tons
0 tons
Actual emissions
150 tons
200 tons
200 tons
0 tons
Buyer or Seller of
permits
Classify the following pollution-control policies
as command-and-control or market incentive
based.
a. A state emissions tax on the quantity of carbon
emitted by each firm.
b. The federal government requires domestic
auto companies to improve car emissions by 2020.
c. The EPA sets national standards for water
quality.
d. A city sells permits to firms that allow them to
emit a specified quantity of pollution.
e. The federal government pays fishermen to
preserve salmon.
What Causes Externalities?
Property rights The rights individuals or businesses
have to the exclusive use of their property, including
the right to buy or sell it.
Externalities and market failures result from
incomplete property rights or from the difficulty of
enforcing property rights in certain situations.
Private Solutions to Externalities: The Coase Theorem
Ronald Coase of the University of Chicago, winner of the
1991 Nobel Prize in Economics,
under some circumstances, private solutions to the
problem of externalities will occur.
The Coase Theorem
Coase theorem - if transactions costs are low,
and property rights well defined, private
bargaining will result in an efficient solution
to the problem of externalities.
Do Property Rights Matter?
In discussing the bargaining between the utilities and
the people suffering the effects of their pollution, the
victims could not legally enforce the right of their
property not to be damaged.
Would it make any difference if the utilities were
legally liable?
The only difference would be that the utilities would
have an incentive to pay their victims for the right to
pollute rather than the victims having to pay the
utilities to reduce pollution.
Either way, either side would pay to reduce pollution up
to the point where the marginal benefit of the last ton
of reduction is equal to the marginal cost.
The additional or the marginal benefit—received from
eliminating another ton of sulfur dioxide declines as its
emissions are reduced.
The net benefit to society from reducing pollution is
equal to the difference between the benefit of reducing
pollution and the cost.
To maximize the net benefit to society, pollution
should be reduced up to the point where the marginal
benefit from another ton of reduction is equal to the
marginal cost.
The Economically Efficient Level of Pollution Reduction
The Marginal Benefit
from Pollution Reduction
Should Equal the
Marginal Cost
If the reduction of sulfur
dioxide emissions is at 7.0
million tons per year, the
marginal benefit of $250
per ton is greater than the
marginal cost of $175 per
ton.
Further reductions in
emissions will increase the
net benefit to society.
The Economically Efficient Level of Pollution Reduction
The Marginal Benefit
from Pollution Reduction
Should Equal the
Marginal Cost
If the reduction of sulfur
dioxide emissions is at
10.0 million tons, the
marginal cost of $225 per
ton is greater than the
marginal benefit of $150
per ton.
An increase in sulfur
dioxide emissions will
increase the net benefit
to society.
The Economically Efficient Level of Pollution Reduction
The Marginal Benefit
from Pollution Reduction
Should Equal the
Marginal Cost
Only when the reduction is
at 8.5 million tons is the
marginal benefit equal to the
marginal cost.
This level is the economically
efficient level of pollution
reduction.
Production possibilities
Economic Output
Result of combination:
A- More output –
10
9
produces more
necessities
A
7
4
0
C
B
B- More protection
– already have
basic necessities
C- Undesirable – not
using resources
1
2
3
4
Environmental Protection
fully