17 ECONOMICS OF THE ENVIRONMENT 2012 Pearson Education We burn huge quantities of fossil fuelscoal, natural gas, and oilthat cause acid rain and global warming. We dump toxic waste into rivers, lakes, and oceans. These environmental issues are simultaneously everybodys problem and nobodys problem. The fish stocks in the worlds oceans are not owned by anyone. They are common resources that everyone is free to use. But we are overusing our fish stocks and brings some species into extinction. What can be done to conserve the worlds fish stocks? 2012 Pearson Education Negative Externality: 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. 2012 Pearson Education Negative Externality: Pollution Sources of Pollution Economic activity pollutes air, water, and land, and these individual areas of pollution interact through the ecosystem. The three biggest sources of pollution are road transportation, electricity generation, and industrial processes. 2012 Pearson Education Negative Externality: Pollution Effects of Pollution While the facts about the sources and trends in air pollution are not in doubt, there is disagreement about the effects of air pollution. The least controversial is acid rain caused by sulphur dioxide and nitrogen oxide emissions from coal- and oil- fired generators of power stations. Acid rain begins with air pollution, and it leads to water pollution and damages vegetation. 2012 Pearson Education Negative Externality: Pollution Many scientists believe that carbon dioxide emissions are a major cause of global warming and climate change. The effects of pollution mean that production and consumption decisions impose costs that are not taken fully into account when decisions are made. You are now going to see how economists analyse these decisions and solve the pollution problem. 2012 Pearson Education Negative Externality: Pollution Private Cost and Social Cost of Pollution 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. 2012 Pearson Education Negative Externality: Pollution Marginal social cost (MSC) is the marginal cost incurred by the entire societyby 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. 2012 Pearson Education External Cost and Output Figure 17.1 illustrates the MC curve, the MSC curve, and marginal external cost as the vertical distance between the MC and MSC curves. Negative Externality: Pollution 2012 Pearson Education Negative Externality: Pollution Production and Pollution: How Much? In the market for a good with an externality that is unregulated, the amount of pollution created depends on the equilibrium quantity of the good produced. 2012 Pearson Education Figure 17.2 shows the equilibrium in an unregulated market with an external cost. The quantity of the good produced is where marginal private cost (MC) equals marginal social benefit (MSB). Negative Externality: Pollution 2012 Pearson Education 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 of the good and creates a deadweight loss. Negative Externality: Pollution 2012 Pearson Education Negative Externality: Pollution Property Rights Sometimes externalities arise because of the absence of 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. 2012 Pearson Education Figure 17.3 illustrates how the establishment of property rights achieves an efficient outcome. The producer of the good bears all the costs. The market outcome is efficient because at the quantity of the good produced MSC equals MSB. Negative Externality: Pollution 2012 Pearson Education Negative Externality: Pollution The Coase Theorem The Coase theorem is a proposition that if property rights exist, only a small number of parties are involved, and transactions costs (defined below) 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. 2012 Pearson Education Negative Externality: Pollution The Coase solution works only if transactions costs are low. Transactions costs are the cost of conducting a transaction. An example is the transactions costs of buying a home include fees for a realtor, 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 doesnt work and governments try to deal with the externality. 2012 Pearson Education Negative Externalities: Pollution Government Actions in a Market with External Costs There are three main methods that the government uses to cope with external costs: Taxes Emission charges Cap-and-trade 2012 Pearson Education Negative Externalities: Pollution Taxes The government can set a tax equal marginal external cost. The effect of such a tax is to make marginal private cost plus the tax equal to marginal social cost, 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. 2012 Pearson Education 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 collect a tax revenue. Negative Externalities: Pollution 2012 Pearson Education Negative Externality: Pollution Emissions Charges The government sets a price per unit of pollution, so that the more a firm pollutes, the higher are its emissions charges. For the emissions charge to induce the firm to generate the efficient level of pollution, the government would need a lot of information that is usually unavailable. 2012 Pearson Education Negative Externality: Pollution Cap-and-Trade Each firm is assigned a permitted amount of pollution per period and firms trade permits. The market price of a permit confronts polluters with the social marginal cost of their actions and leads to an efficient outcome. This method was used successfully to decrease lead pollution in the United States. 2012 Pearson Education The Tragedy of the Commons The 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 and South Pacific whales. The traditional example from which the term derives is the common grazing land surrounding middle-age British villages. 2012 Pearson Education The Tragedy of the Commons Sustainable Use of a Renewable Resource Renewable resource is one that replenishes itself by birth and growth of new members of the population. Sustainable catch is the quantity of fish that can be caught year after year without depleting the stock. If the stock is small, the quantity of new fish born is small, so the sustainable catch is small. If the stock is large, many fish are born but they must to complete for food. so only a small number survive to reproduce and grow large enough for fishers to catch. 2012 Pearson Education The Tragedy of the Commons Figure 17.5 illustrates the sustainable catch. As the stock of fish increases, the sustainable catch increases. Beyond that number, more fish compete for food and the sustainable catch falls. If the catch exceeds the sustainable catch, the fish stock diminishes. 2012 Pearson Education The Tragedy of the Commons The Overuse of a Common Resource Figure 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. 2012 Pearson Education The Tragedy of the Commons 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. 2012 Pearson Education The Tragedy of the Commons Achieving an Efficient Outcome It 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). 2012 Pearson Education The Tragedy of the Commons 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. 2012 Pearson Education The Tragedy of the Commons Production Quotas By 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. 2012 Pearson Education The Tragedy of the Commons Individual Transferable Quotas An 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. 2012 Pearson Education The Tragedy of the Commons Figure 17.9 shows the situation with an efficient number of ITQs. The market price of an ITQ increases the marginal social cost to MC + price of ITQ. Users of the resource make MSB equal MC + price of ITQ, and the outcome is efficient. 2012 Pearson Education