The Global Economy – Environment, Development & Globalisation

Lecture: Internalising the Externalities

Efi KyriakopoulouEfthymia.Kyriakopoulou@slu.se

Introduction to Environmental Economics

Environmental economics is concerned with

• the impact of the economy on the environment

• the significance of the environment to the economy

• the way of regulating the economy to balanceenvironmental, economic and other goals

Introduction to Environmental Economics

Typically three agents

• Firm/Polluter: produces a good and pollution as a by-product

• Consumer: consumes the good and the pollution

• Government: regulates production to balancethe different interests

Market Economy• Consumers and producers meet at goods

markets and there is exchange in the form ofselling and buying.

• The market price and quantity sold aredetermined by equilibrium between consumers’ demand and firms’ supply.

Competitive markets and efficiency

Supply and demand interact to determine theequilibrium price.

The price changes until supply and demand matcheach other and a market equilibrium is achieved.

The market equilibirum is Pareto optimal (efficient).

The market works if it is competitive.

Producer surplus

Producer surplus: difference between revenues received and cost of production

Consumer surplus

Quantity0

Price

S

D

P0

Q0

Consumer surplus: difference between what a consumer would be willing to pay and the amount the consumer actually has to pay

D = inverse demand= marginal willingness to pay

S = inverse supply= marginal cost of production

Total surplus is maximized at{P0, Q0}

Competitive markets and efficiency

Competitive markets and efficiency

Competitive markets lead to efficiency

But all assumptions of a competitive market needto be fulfilled.

If all markets were competitive (and efficiency was the only goal) there would be no need forgovernment intervention.

In reality, however, the assumptions are oftenviolated, leading to market failures.

Competitive markets and efficiency

When does the market fail?

1. Externalities Costs or benefits that are not signaled by the market price Example: pollution (polluter does not bear all the

cost of pollution)

2. Asymmetric Information One market side has inferior information Example: ingredients in food products

Competitive markets and efficiency

When does the market fail?

3. Market power One market side can affect the price Example: Price agreements in cartels

4. Natural monopoly One firm can supply the good at a higher price than

multiple firms Regulation is needed to prevent inefficiencies due

to market power Examples: railroad, systembolaget

Competitive markets and efficiency

Take Home Message 1

Competitive markets :

No need for government intervention!

Market failures → Inefficiencies:

Need for government policy!!!

Externalities

An externality is present when the well-being (utility) of an individual or the production possibilities of a firm are directlyaffected by the actions of another agent in the economy.

• Negative– An action of one agent generates costs for another

agent – without compensation for the costs

• Positive– An action of one agent generates benefits for

another agent – without compensation for thebenefits

Example: Road Transportation

Transportation accounts for several external costs, for example:

• Pollutants • Damages and injuries from accidents• Noise• Barrier effects (humans and animals)• Congestion (loss of time)

However, also large benefits to society from transportation

External Effects

External costs: Pollution & Congestion

External costs

• With negative externalities, the number of vehicles exceed the efficientnumber (too many vehicles and too much pollution / congestion).

• Damages vary dramatically with respect to:• Location

• Emissions disperse quickly, which makes the exact location of emissions a crucial factor in determining the extent of the damage.

• Density of population.• Geographical and climatologic conditions.

• Vehicle• Vehicle age and emissions• Fuel composition

• Other factors• Driving style

Policy Instruments

Price-based instruments• Road pricing

• Area pricing (fee to enter the region or the city center, e.g. congestion charge in Stockholm and Gothenburg).

• Road tolls• Differentiated vehicle taxes (taxes levied on vehicle sales as

well as on annual registration fees) • Fuel taxes

Direct regulation• Emission standards • Zoning • Technology standards for fuel and vehicles

Road Transportation

• No policy:

– The car drivers pay only for the car use and the fuel price. – They do not pay for the pollution, the use of the road, the noise and

the accidents they might cause. – The efficient use requires all the costs to be included in the choice

to use the vehicle.– The rest of the drivers, the pedestrians and the residents bear these

costs. This is why we call them external costs.

Take Home Message 2

Policy Instruments for road transportation are neededin order to have efficient use / number of vehicles.

Emissions of greenhouse gases

Climate Change

• Climate change represents the greatest and widest-ranging market failure ever seen.

• It is global in its origins and impacts.

• Reducing emissions is an extreme ”global public good”, meaning that no single nation can capture for itself a substantial part of the benefits from its own emission reductions (free riding incentives)

• There is uncertainty in different steps of the scientific chain

• The effects are very large and irreversible.

Climate Change – Challenges for Economists

• Deal with risk and uncertainty

• Understand links between economics and ethics (trade-offs and distribution both within and between generations), aswell as notions of distribution across nations (responsibilityof rich vs poor countries)

• International economic policy and cooperation to formulatepolicies

• Policy formulation is impeded by free riding and distributional issues

Climate Change - Regulation

• The increase in global temperature relates to the stock of greenhousegasses (GHGs), thus the actievement of temperature targets requiresstabilization of stocks.

Two types of instruments to regulate externalities:

• Quantity instruments: emission reduction (mitigation) by quantityrestrictions so that the target is attained. → Quantity instruments could lead to the creation of markets for emission permits with the overall quantity constraint being satisfied(e.g. European Union Emissions Trading System – EU ETS)

• Price instruments: reduce emissions by pricing carbon according to the marginal damages induced by GHGs (e.g. carbon tax).

EU ETS

• Covers around 45% of the EU's greenhouse gas emissions.

• Limits emissions from: – More than 11,000 heavy energy-using installations in

power generation and manufacturing industry. – Flights to and from the EU.

• Target: 1. In 2020, emissions from sectors covered by the

EU ETS will be 21% lower than in 2005.2. In 2030, they would be 43% lower.

Take Home Message 3

Current governement policies are not sufficientto achieve long-term global climate goals!

Action is needed now!