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ECON 1910 Spring 2004.
Lecture notes
Interaction economic activity and the environment
Production of man-made goods and environmental services:
Pollutant
2
1
Environmental
indicator
Economic
activity
3
4
Environmental
service
Figure 1
Quadrant 1:
Relation between economic activity and generation of residuals
(Amount of sulphur dioxide generated by producing electricity in a fossil fuel plant)
Quadrant 2:
Relationship between environmental indicator and amount of residual discharged to the
environment
(The acidity level measured by pH following the emission of sulphur dioxide)
Quadrant 3:
Relationship between environmental indicator and environmental service
(Relationship between stock of fish and acidity)
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Quadrant 4:
Implied relationship between environmental service and economic activity
(Relationship between stock of fish and electricity)
Valuing the environment
Due to discharge of residuals there is a trade-off between the output of man-made goods and
environmental services:
The relationship in quadrant 2:
Environmental
service
A’
One
unit
A
Man-made
goods
Absorption
capacity
Figure 2
Definition: A residual is a pollutant when the absorption capacity (self-cleaning capacity) of the
environment is exhausted and further discharge of the residual reduces the amount of (or quality
of ) the environmental service.
Definition: The social valuation of the environment is measured by the value of the man-made
goods that have to be given up in order to obtain one unit more of the environmental service
(example in the figure: moving from A to A’ we gain one unit of the environmental service but
give up some units of the man-made good).
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Environmental damage in money
The social experiment: Start at the maximal (natural) level of environmental service and then
reduce the environmental service successively (going from left to right along the curve in Figure
2). For each level of the environmental service ask the consumers how much they are willing to
pay to get the environmental service back to the natural (maximal) level.
Definition: Environmental damage is the total willingness of consumers to pay for restoring the
environment to its natural (maximal) condition.
Damage
costs
2
Total
damage
curve
1
Discharge
of residual
Maximal supply of the
environmental service
Figure 3
The consumers’ marginal evaluation of the environment
Marginal willingness to pay for one unit more of the environmental service: As the supply of
environmental service is decreased the consumers are willing to pay more for one unit of the
environmental service. The change in total damage at situation 1 is much smaller than the change
in total damage at situation 2.
Definition: The demand curve for environmental service is the curve for the marginal change in
the total damages.
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Costs
Marginal
willingness
to pay
Discharge
of residual
Absorption
capacity
Figure 4
Abatement costs
The possibilities of reducing discharge of residuals:
1) Reducing the production of the man-made goods
2) A change in the input mix (the relative amounts)
3) A change in production technology
4) Recirculation of waste back to the production process
5) Purification of residuals (end of pipe)
6) A change of the product (but still giving the same service to the consumers)
7) Relocation the production activity (utilizing different absorption capacity of the
environments)
Definition: A merit ordering of the possibilities for abatement is to start to reduce discharges
by using the cheapest option, and then continuing with the second cheapest, etc., ending up
with the most expensive option
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Total abatement
costs
2
1
Discharge
of residual
Free
discharge
Figure 5
The marginal abatement cost is increasing (remember merit order), as shown by the change in
total costs at 1 and at 2.
Marginal
abatement costs
Discharge
of residual
Free
discharge
Figure 6
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The social decision problem
With only a reduction of production of man-made goods as an abatement option the social
decision problem is to choose a point on the curve in Figure 2. Green preferences will imply a
point nearer the maximal value for the environmental service to the left in the figure, while
dirty preferences will imply a point closer to a low level of the environmental service to the
right in the figure.
With several abatement options we can state the social decision problem using the
environmental damage and total abatement cost curves:
Definition: A social solution to a pollution problem is obtained when the sum of abatement
costs and damage costs is as low as possible:
Minimise {total abatement costs + total damage costs}
Costs
Total
abatement
B’ B
A
Total
damage
B’’
A’
Discharge
of residual
Figure 7
Total social costs are minimized at point B. The sum of the two cost components are the
curve from the abatement cost curve to the damage cost curve. The total social cost curve
starts at the abatement curve to the left. When total damage costs becomes positive (after
absorption capacity is exhausted) this cost is added to the total abatement costs to yield the
total social cost curve, i.e. use a specific value for residuals discharge on the horizontal axis
and add the value of damages to the value of abatement. When the total discharge without any
regulation is reached then the total social cost curve coincides with the total damage curve.
The optimal solution cannot be located at a falling part of the total curve (B’), because then
total costs will become smaller if discharge is increased. The optimal point cannot be located
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at a point where the total social cost curve is increasing (B’’) because then total costs can be
reduced by reducing the discharge of residuals.
The use of the marginal concepts
By using the marginal abatement cost curve and the marginal damage cost curve we can
derive a simple geometric solution to the social decision problem. From figure 7 we have that
at the optimal solution point B the marginal abatement cost must be equal to the marginal
damage cost. The marginal change in the total social cost is the sum of the marginal change in
the abatement costs (negative) and the marginal costs of the damage (positive). At the
minimum point of the social cost curve the sum of these two marginal values is zero, i.e. the
total social cost curve is flat at point B (the line AA’ is a tangent to point B).
The equalization of the marginal costs:
Costs
Marginal
abatement
Marginal
damage
B
Discharge
of residual
Optimal
discharge
Figure 8
The Coase theorem
Definition: Assume that property rights to the environment are uniquely defined. If parties
can negotiate to zero costs and the benefit and damage curves are known, then a solution will
be reached that is socially optimal and independent of who has the property right.
8
Euro
Marginal
”benefit” No 1
Marginal
damage No 2
B
Discharge
of residual
No 2 has
property
right
Optimal
discharge
No 1 has
property
right
Figure 8
Assumptions:
1) Property rights are defined
2) Negotiations are done to zero costs
3) The parties know everything about the cost curves of each other.
If No.1, the polluter, has the property right he pollutes as he likes, i.e. he is discharging the
maximal amount where his abatement cost (negative benefit) is zero. But the damage costs for
No. 2 , the pollutee, is then much higher than the abatement costs for No.1 for one unit reduction
of discharge from the maximal level, therefore No 2 can offer to more than pay for No.1’s
abatement cost if he reduces the discharge . No.2 can continue to offer No. 1 profitable deals until
his marginal damage is equal to No. 2’marginal abatement cost.
If No.2, the pollutee, has the property right he can enforce so low discharge from No. 1 that there
is no damage to him, i.e. we start at the right-hand part of the figure where his damage cost is
zero. But the abatement costs for No. 1 , the polluter, is then much higher than the damage costs
for No.1 for one unit increase of discharge from the minimal level, therefore No 1 can offer to
more than pay for No.2’s damage cost if he is allowed to increase the discharge . No.1 can
continue to offer No. 2 profitable deals until his marginal abatement cost is equal to No.
2’marginal damage.
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The regulation of pollution
Policy instruments:
1) direct regulation, control and command
2) indirect regulation, using economic incentives’
Green tax, tax on discharge of residuals , Pigou tax
The decision problem of the firm:
Minimise sum of total abatement costs and the green tax:
Minimise {total abatement costs + tax payment}
Euro
Marginal
abatement
Marginal
damage
B
Tax
rate
Discharge
of residual
Optimal
discharge
Figure 9
It is optimal for the firm to set tax rate equal to marginal abatement costs. Imagine that at the
solution point B marginal abatement costs are greater than the tax rate. Then the total costs
will be reduced if the firm abates less and discharges more. Point B cannot then be optimal.
Imagine that at the solution point B marginal abatement costs are smaller than the tax rate.
Then the total costs will be reduced if the firm abates more and discharges less. Point B
cannot then be optimal.