Chapter 17
Externalities and the
Environment
© 2006 Thomson/South-Western
1
Resources
Exhaustible resource: does not renew itself
Renewable resource: when used conservatively,
it can be drawn on indefinitely
 Some
renewable resources are open-access goods
 Open-access resource is rival in consumption but
exclusion is costly
Common-pool problem: results when people
consume a good until the marginal value of
additional use drops to zero

they are often overused
2
Renewable Resources
Private property rights allow individuals
to use resources or to charge others for
their use
Pollution and other negative externalities
arise because there are no practical,
enforceable, private property rights to
open-access resources such as air and
water
Market prices usually fail to include the
costs that negative externalities impose on
society
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Exhibit 1: Negative Externalities: The Market for
Electricity in the Midwest
$0.14
Marginal
social cost
b
c
a
0.10
Marginal
private cost
D
0
35
50
Millions of kilowatt hours of electricity per month
If producers base decisions
on their costs, the equilibrium
price and quantity are $0.10
and 50 million KWH at point a
But the production of
electricity involves an external
cost of $0.04 per KWH
The only way of reducing
emissions is to reduce
generation of electricity
Marginal social cost is
shown by the vertical distance
between the marginal private
and marginal social cost
curves
The last KWH of electricity
costs society $0.14, but yields a
benefit of only $0.10  market
failure  too much pollution
is produced
Total social gain is the blue
shaded box
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Negative Externalities: Fixed Technology
How could output be restricted to the
socially efficient level?
If government policy makers knew the
demand and marginal cost curves, they
could simply restrict electric utilities to
produce that optimal level
Alternatively, they could impose a
pollution tax on each unit of output equal
to the marginal external cost which leads
to a socially efficient outcome
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Exhibit 2: The Optimal Level of Air Quality
Dollars per unit
Marginal
social benefit
Marginal
social cost
Marginal social benefit curve
reflects the additional benefit from
improving air quality
The optimal level of air quality
for a given level of production is
found at point a, where the
marginal social benefit of cleaner
air equals the marginal social cost
Suppose the government decrees
that A' is the minimum acceptable
level: the marginal social cost, c,
exceeds the benefit, b
Note that some pollution is
consistent with efficiency
c
a
b
Poor
A
A'
Air quality
The total social waste
associated with imposing a
greater-than-optimal level of air
quality is shown by the pink
shaded triangle, abc.
Excellent
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Exhibit 3a: Effect of Changes in Costs
a) Lower cost of air quality
Marginal
social benefit
Dollars per unit
Marginal
social cost
MSC'
0
A
A'
Air quality
•A technological
breakthrough occurs that
reduces the marginal cost
of cleaning the air, as
shown by the shift in the
marginal social cost curve
to MSC'.
•The net effect is to
increase the optimal level
of air quality from A to A'
 the lower the marginal
cost of reducing pollution,
other things constant, the
greater the optimal level of
air quality.
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Exhibit 3b: Effect of Changes in Benefits
b) Greater benefits of air quality
MSB'
Marginal
social cost
Dollars per unit
Marginal
social
benefit
0
A A"
Air quality
•An increase in the marginal
benefit of air would have a
similar effect. The increase
in the marginal benefit is
shown by the shift upward in
the marginal social benefit
curve to MSB' – the optimal
level of air quality would
increase
•the greater the marginal
benefit of cleaner air, other
things constant, the greater
the optimal level of air
quality.
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The Coase Theorem
Traditional analysis of externalities assumes
that market failures arise because people
ignore the external effects of their actions
Consider the following example
A research laboratory that tests delicate equipment
locates next to a manufacturer of heavy machinery
The vibrations caused by the manufacturing process
throw off the delicate machinery in the lab
The negative externality in this case is not
necessarily imposed by the machinery producer
on the testing lab
Rather, it arises from the incompatible
activities of the two parties
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The Coase Theorem
The efficient solution depends on which party can
avoid the problem at the lower cost
Suppose the following
It would cost $2 million to reduce vibrations enough to
allow the lab to function normally
The testing lab concludes that it cannot alter its
equipment to reduce the effects of the vibrations  its
only recourse is to move at a cost of $1 million
Thus, the least-cost, or most efficient resolution to
the externality problem is for the testing lab to
relocate
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The Coase Theorem
Coase argued that when property rights are
assigned to one party or another, the two
parties will agree on the efficient solution to an
externality problem as long as the transaction
costs are low  the efficient solution will be
achieved regardless of which party gets the
property rights
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The Coase Theorem
If the lab is granted the right to operate free of
vibrations  it has the right to ask the factory to
reduce its vibrations
Rather than cut vibrations at a cost of $2 million,
the factory can offer to pay the lab to relocate
Any payment by the factory owners that is
greater than $1 million but less than $2 million
will make both better off  the lab will move,
which is the efficient outcome
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The Coase Theorem
Alternatively, suppose the factory is granted
the right to generate vibrations regardless of
any effects on the testing lab  business as
usual
The lab may consider paying the factory to
alter its production method, but since the
minimum payment the factory would accept is
$2 million, the lab would rather move at a cost
of $1 million
A particular assignment of property rights
determines only who incurs the externality cost
not the efficient outcome
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Exhibit 4: Optimal Allocation of Pollution Rights
Dollars per ton
S
35
25
D
0
100
250
Tons of discharge per day
With no restrictions there will be
250 tons dumped per day
Suppose engineers determine
that the river can neutralize 100
tons per day: vertical supply curve
at this level of discharge
If government regulators can
easily identify polluters and
monitor their behavior, authorities
can allocate permits to discharge
100 tons per day
If the government sells 100 tons
of pollution permits at the market
clearing price of $25 per ton, the
optimum level of discharge is
achieved
Those who value the discharge
rights the most will end up with
them, others will find cheaper ways
of resolving their waste problems
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Exhibit 4: Optimal Allocation of Pollution Rights
S
Dollars per ton
35
25
D'
What if additional firms
spring up along the river
and want to discharge
wastes? This added
demand is shown by D'.
This increase in demand
would bid up the market
price of pollution permits to
$35 a ton. Some existing
permit holders will sell their
rights to those who value
them more.
D
0
100
250
Tons of discharge per day
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Markets for Pollution Rights
Prior to 1990, traditional command-andcontrol environmental regulations were the
norm
This approach required polluters to introduce
particular technologies to reduce emissions by
specific amounts
These regulations were based on engineering
standards and did not recognize unique
circumstances across generating plants
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Markets for Pollution Rights
Economic efficiency approach
Reflected by the pollution rights approach
Offers each polluter the flexibility to reduce emissions
in the most cost-effective manner given its unique costs
Firms with the lowest emission control costs have an
incentive to implement the largest reduction in
emissions, and then sell unused allowances to those
with greater control costs
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Air Pollution
In the Clean Air Act of 1970, Congress set
national standards for the amount of
pollution that could be emitted into the
atmosphere  recognized the atmosphere as
an economic resource with alternative uses
Smog is the most visible form of air pollution
Automobile emissions account for 40% of smog
40% from consumer products
15% from manufacturing
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Air Pollution
Kyoto accord would require the 38 industrial
countries to reduce emissions by one-third
over ten years  cost to U.S. of $300 billion a
year
Problem is that this accord requires nothing
from developing countries like China and
India which are major polluters
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Exhibit 5: Fossil-Fuel Carbon Dioxide Emissions
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Water Pollution
Two major sources of water pollution
Sewage
For decades, U.S. cities had an economic incentive to dump their
sewage directly into waterways
Federal money over the years has funded sewage treatment
plants that have cut water pollution substantially  nearly all
cities now have modern sewage control systems
New York City is the exception and still dumps raw sewage into
the Atlantic Ocean
Chemicals
10% comes from point pollution  pollution from factories and
other industrial sites
Two-thirds comes from nonpoint pollution  runoff from
agricultural pesticides and fertilizers
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Water Pollution
The EPA has turned pesticide regulation over
to the states which gave the job to their
departments of agriculture
However, these state agencies usually promote
the interests of farmers, not restrict what they
can do
The EPA now reports that pesticide residues on
food pose more health problems than do toxic
waste dumps or air pollution
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Hazardous Waste and the Superfund
The Comprehensive Environmental
Response, Compensation, and Liability
Act of 1980 – Superfund law – now
requires any company that generates,
stores, or transports hazardous wastes to
clean up any wastes that are improperly
disposed of
Gives the federal government authority
over sites contaminated with toxins
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Solid Waste: Paper or Plastic
About 70% of the nation’s garbage is bulldozed
and covered with soil in landfills
As the cost of solid-waste disposal increases,
state and local governments are charging for
trash pickups and requiring recycling  the
process of converting waste products into
reusable material
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Solid Waste: Paper or Plastic
Some recycling is clearly economical, but
recycling imposes its own cost on the
environment
Curbside recycling requires fleets of trucks
that pollute the air
Newsprint must first be de-inked, creating a
sludge that must be disposed of
Cost of more efficient packaging material
25
Exhibit 6 Paper and Cardboard Recycling:
Top 20 Advanced Economies
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Positive Externalities
Positive externalities occur when the unpriced
by-products of consumption or production
benefit other consumers or other firms
For example, people who get inoculated
against a disease reduce their own likelihood of
contacting the disease, but in the process they
also reduce the risk of transmitting the disease
to others  external benefits to others
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Positive Externalities
Education also confers external benefits on
society as a whole because those who acquire
more education
Become better citizens
Are better able to support themselves and their
families
Less likely to require public assistance
Less likely to resort to crime
Thus, education confers private benefits and
additional social benefits to others
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Exhibit 7: Education and Positive Externalities
Adding the marginal
external benefits we get the
marginal social benefit of
education curve
If education were a
strictly private decision, E
would be produced
At this level, marginal
social benefit exceeds
marginal cost: net social
welfare will increase if
education expands past E
Social welfare is
maximized at point e' where
E’ units of education are
provided with the yellow
triangle showing the net
increase in social welfare
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Positive Externalities
When positive externalities are present,
decisions based on private marginal benefits
result in less than the socially optimal quantity
of the good
Hence, they typically point to a market failure,
which is why government often gets into the act
When there are external benefits, public policy
aims to increase the level of output beyond the
private optimum
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