Across the country, countless people have protested, even risking arrest, against the Keystone XL Pipeline. (Credit: modification of image by “NoKXL”/Flickr Creative Commons)

Chapter 12: Environmental Protection and Negative Externalities

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 failureExternalitiesPublic goodsMonopoly Smoke from a factory is an

example of an externality that may lead to market failure

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.

Externalities (Spillovers)

sweater factory

beach

brewery

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.

The Effect of Externalities

• All of the costs of production are not fully registered, so the supply curve understates the true cost of production. (Shifts left)

• Pollution problems are often a side effect.

External Cost (Spillover)

Price

Quantity/time

P2

P1

Q1

D

S1

Q2

S2(including external costs)Ideal price and output

Actual price and output

• Too many units are produced.

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.

The Effect of Pollution on Economic Efficiency

How a Negative Externality in Production Reduces 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.

The Effect of Pollution on Economic Efficiency

How a Negative Externality in Production Reduces 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

OutputThe 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 QuantityDemanded

Supply without pollution cost

Supply after paying external cost

$600 50,000 40,000 30,000

$650 45,000 45,000 35,000$700 40,000 50,000 40,000$750 35,000 55,000 45,000$800 30,000 60,000 50,000$850 25,000 65,000 55,000$900 20,000 70,000 60,000

20

15

10

5

01 2 3 4 5 6 7 8 9 10

Price Demand Supply without external cost

Supply paying external cost

20 0 10 8 

18 1 9 715 2.5 7.5 5.512 4 6 410 5 5 35 7.5 2.5 0.5

Supply and Demand Data for Trumpet Players

1. Graph Demand and Supply when only private costs are considered.2. Find equilibrium P and Q when only private costs are considered.3. Graph Supply when external costs are considered.4. Find equilibrium P and Q when all costs are considered.

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

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.

Some toilet paper plants discharge bleach into rivers and lakes, causing substantial environmental damage.

3. How Can We Do Better?

Today, the current method of environmental protection is command-and-control regulationGovernment mandates the adoption of certain

abatement technologiesWidely 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 PermitsPromoted by US Economists during the Clinton

AdministrationCaps rich country emissions; provides incentives to develop

clean technologiesFunds the transfer of technology to poor countriesEuropeans have successfully implemented cap-and-trade

How Marketable Permits Work

Alpha Beta Gamma DeltaCurrent 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 ReductionThe Marginal Benefit from Pollution Reduction Should Equal the Marginal CostIf 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 ReductionThe Marginal Benefit from Pollution Reduction Should Equal the Marginal CostIf 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 ReductionThe Marginal Benefit from Pollution Reduction Should Equal the Marginal CostOnly 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.

Result of combination:

A-

B- C-

Production possibilitiesEcon

om

ic O

utp

ut

Environmental Protection

109

7

4

1 2 3 40

B

A

C

More output – produces

more necessities

More protection – already have

basic necessities Undesirable – not using

resources fully