Chapter 17(1)

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

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Externalities

and the Environment

1


Resources

• Exhaustible resource– A resource in fixed supply

• Renewable resource– A resource that regenerates itself

– Can be used indefinitely if used conservatively

2


Renewable Resources

• Open-access resources– Rival in consumption and nonexclusive

– Subject to the common-pool problem

– No private property rights

– Negative externalities arise

3


Renewable Resources

• Common-pool problem– People exploit a resource

• Personal marginal benefit > personal marginal cost

– Personal marginal cost• Ignores costs imposed on others

4


Resolving Common-Pool Problem

• Government regulation– Output restrictions

– Taxes

– Use resource: socially optimal rate

– Improve allocative efficiency

5


Optimal Level of Pollution

• External costs with fixed technology– Fixed-production technology

• Cut emissions: cut production

– Marginal social cost• Marginal private cost• Marginal external cost

6



• Socially efficient production– Demand (marginal benefit) intersects

marginal social cost curve

– Government regulation• Limit production• Tax = marginal external cost

– Marginal social cost = marginal benefit

– Total social gain • Total social cost (firms ignore external cost)

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Exhibit 1

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Negative Externalities: The Market for Electricity in the Midwest

0.10

$0.14

Dol

lars

per

kilo

wat

t-ho

ur

Marginal

social cost

350

Millions of kilowatt-hours of electricity per month

50

Marginal

private cost

D

a

c

If producers base their output on marginal private cost, 50 million kilowatt-hours of electricity are produced per month. The marginal external cost of electricity is the cost of pollution imposed on society. The marginal social cost curve includes both the marginal private cost and the marginal external cost. If producers base their output decisions on marginal social cost, only 35 million kilowatt-hours are produced, which is the optimal output. The total social gain from basing production on marginal social cost is reflected by the blue-shaded triangle.

Total social gain

b



• External costs with variable technology– Variable technology

• Reduce emissions: alter the production process

• Cleaner technology

– Production of cleaner air• Diminishing returns

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• Reducing greenhouse gases– Marginal social cost curve

• Upward-sloping

– Marginal social benefit curve• Downward-sloping• Diminishing marginal benefit to society

– Optimal level of air quality• Marginal social benefit = marginal social cost

– Higher than optimal level of air quality

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Exhibit 2

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The Optimal Reduction in Greenhouse Gas EmissionsD

olla

rs p

er u

nit

Total

social

gain

Marginal

social cost

Marginal

social benefit

AHigh

Greenhouse gas emissions

A’ Low

a

b

c

The optimal level of greenhouse gas emissions is found at point a, where the marginal social benefit of reducing such emissions equals the marginal social cost. If some lower level of emissions were dictated by the government, such as A’, the marginal social cost would exceed the marginal social benefit, and social waste would result. The total social waste resulting from a lower than optimal level of emissions is shown by the pink-shaded triangle.



• Shift in marginal social cost curve– Technological breakthrough

• Lower marginal cost of cutting greenhouse gas

– Downward shift of MSC curve– Lower optimal level of emissions

12



• Shift in marginal social benefit curve– Higher marginal benefit of reducing

emissions• Upward shift of MSB curve• Lower optimal level of emissions

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Exhibit 3

14

Effect of Changes in Costs or Benefits of Reducing Greenhouse Gas Emissions

Marginal social benefit

Marginal social cost

Dol

lars

per

uni

t

A0 A’ Higher

quality air

Marginal social benefit

Marginal social cost

Dol

lars

per

uni

t

A0 A’’ Higher

quality air

MSC’

(a) Lower cost of reducing emissions (b) Greater benefit of reducing emissions

MSB’

Either a reduction in the marginal social cost of cleaner air, as shown in panel (a), or an increase in the marginal social benefit of cleaner air, as shown in panel (b), increases the optimal level of air quality.


The lungs of the planet

• Tropical rainforests = open-access – Recycle carbon dioxide: oxygen and

wood• 6-7% of Earth’s land surface• Half of world’s plant and animal species

– In relatively poor countries• Burn forest

– Pasture– Farmland

– Growing demand for timber

15



• ‘Slash and burn’

– Add greenhouse gas to atmosphere

– Reduces atmosphere’s ability to clean itself

– Flash floods

– Mud slides

– Soil erosion, lost nutrients

– Lost ecosystem

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• Tropical rainforest– Benefits around the globe

– Little immediate personal cost

– Costs of deforestation: around the globe

• Solution– Property rights

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• The Coase theorem– For low transaction costs

– Efficient solution• Least cost solution • Assign property right to one party• One side bears the externality cost

– Inefficient outcome• If high transaction cost• If large number of parties involved

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• Market for pollution rights – Government

• Sells pollution rights• Limits maximum level of pollution per day

– Firms• D = marginal value of pollution• Buy pollution rights

– Value of pollution permits• Fluctuates

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Exhibit 4

20

Optimal Allocation of Pollution Rights

1000 250

Tons of discharge per day

Dol

lars

per

ton

25

$35

D’D

S

Suppose the demand for a river as a discharge service is D. In the absence of any environmental controls, polluters dump 250 tons per day, where the marginal benefit of discharge is zero. If regulatory authorities establish 100 tons as the maximum daily level of discharge and then sell the rights, the market for these pollution rights clears at $25 per ton. If the demand for pollution rights increases to D’, the market-clearing price of pollution rights rises to $35 per ton.


Pollution Rights & Public Choice

• Pollution regulation– Special interest of polluters

• Before 1990– Command-and-control environmental

regulations• Particular technologies to reduce emissions

• Market for pollution rights– Economic efficiency approach

• Reduce emissions: Cost-effective

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Environmental Protection

• Environmental Protection Agency EPA• Clean air act of 1970• Clean water act of 1972• Resource conservation and recovery act

of 1976• Superfund law of 1980

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Air Pollution

• Atmosphere– Economic resource

– People value clean air; willing to pay more

• Smog– 40% from automobile emissions

– 40% from consumer products

– 15% from manufacturing

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Air Pollution

• Clean air act of 1970– 90% reduction in auto emissions

– By 1990, average emissions fell• Lead: 97%• Monoxide: 41%• Sulfur dioxide: 25%

• U.S. air quality: good• U.S. – major source of fossil-fuel carbon

dioxide emissions24


Exhibit 5

25

Fossil-Fuel Carbon Dioxide Emissions per Capita: The 25 Worst Nations


Air Pollution

• We need to cut air pollution by:– Sharply improving energy efficiency in

buildings, vehicles, and machines

– Shifting from fossil fuels to nuclear, wind, solar, and other renewable energy sources

– Preserving forests as absorbers of carbon dioxide, or as “carbon sinks”

– Capping agricultural emissions

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Water Pollution

• Sources– Sewage

– Chemicals

– Oil

• Sewage– Dumped into waterways; no cleaning

• Negative externality

– Federal money: treatment plants

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Water Pollution

• Chemicals– 10% from point pollution

• Factories, industrial sites

– Two thirds – from nonpoint pollution• Runoff from agricultural pesticides and

fertilizers

– In most states: pesticides have fouled some groundwater

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Water Pollution

• Oil – Cleanup of oil spills on land – overseen

by the EPA

– 600,000 underground storage tanks for oil and chemicals• Potential threat of contamination for

groundwater

– Cleanup of offshore oil spills - overseen by the U.S. Coast Guard

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BP’s Oil Spill in the Gulf

• April 20, 2010, Deepwater Horizon oil rig – Exploded in the Gulf of Mexico

– Drilling accident that killed 11 workers and hospitalized many

– Accident a mile down – devastating

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• Explosion and resulting oil spill– Accidental byproducts of BP’s efforts to

supply oil

– Threatened the livelihood of tens of thousands around the Gulf

– Could impose lasting damage on the habitat

– BP spent billions on cleanup

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• BP:– 150 class-action lawsuits

– Environmental groups – lawsuits

– Justice Department - criminal probe• Possible violations of the Clean Water Act

and other environmental laws

• Was this oil spill a negative externality?– Not truly an externality

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• Impacts the oil spill– BP - profoundly affected

• Tarnished brand name• Costly lawsuits• Costly cleanup • Share price – sank 50% (loss in the market

value of the company of $90 billion)• 200 millions gallons of crude oil lost

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• Impacts the oil spill– Transocean - profoundly affected

• 11 workers died• Many more hospitalized• Lost the drilling rig ($375 million)• Share price – sank 50% (loss in the market

value of the company of $15 billion)

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• Impacts the oil spill– Residents in the Gulf region - harmed by

the spill• Some of the damage will last for years

• BP and Transocean– Internalized the externality

• Compensating people for their losses

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Hazardous Waste

• Before 1980– Firms - Pay others to haul and dispose

• Not responsible for cleaning

• Superfund law of 1980 – Comprehensive Environmental Response,

Compensation, and Liability Act

– Companies - Pay others to haul and dispose• Pay for clean up

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Solid Waste:”Paper or Plastic?”

• U.S. households– 4 pounds of garbage per resident per day

• Mostly packaging

– 200 million tons per year

• 70% of garbage - landfills• Recycled: 15% of garbage

– 75% paper products

• 15% - incinerated – Trash-to-energy plants

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Exhibit 6

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Paper and Cardboard Recycling: Top 25 Among Advanced Economies


Solid Waste:”Paper or Plastic?”

• 2 out of 3 aluminum cans: recycled• Returnable deposit laws

– Increase recycling

• Recycling: imposes environmental costs– Curbside recycling

• Trucks

– Newsprint• De-inked

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Positive Externalities

• Beneficial externalities – Consumption or production benefits other

consumers or other firms

• Vaccination – Personal benefits

– Benefits to society• Positive externality

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• Public policy– To increase quantity beyond private

optimum

• Marginal social benefit– Includes all the benefits for society

• Private benefits• External benefits

• Marginal social benefit curve– Above the private demand curve

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Exhibit 7

42

Education and Positive Externalities

E0 E’

Quantity of education per period

Dol

lars

per

uni

t

DMarginalprivate benefit

D’

Marginalsocial benefit

SMarginal

cost

e’

e

In the absence of government intervention, the equilibrium quantity of education is E, where the marginal private benefit of education equals the marginal cost as reflected by the supply curve. Education also confers a positive externality on the rest of society, so the social benefit exceeds the private benefit. At quantity E, the marginal social benefit exceeds the marginal cost, so more education increases social welfare. In this situation, government tries to increase education to E’, where the marginal social benefit equals the marginal cost.



• Positive externalities– Decisions based on private marginal

benefits• Result in less than the socially optimal

quantity of the good

– Point to market failure

– Public policy: increase quantity beyond the private optimum

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Chapter 17(1)

Economy & Finance

Transcript of Chapter 17(1)