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Chapter 14 Environmental Economics

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2000 South-Western College Publishing

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In this chapter, you will learn to solve these economic puzzles:

Why do competitive markets produce too large a quantity and charge too low a price for products that pollute?

How can government legislation, taxes, and

permits achieve environmental efficiency?

Can government intervention reduce

environmental quality?

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What assumption is made in this chapter?

There is sufficient foreign and domestic competition to allow us to use the perfectly competitive model

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When does Economic Efficiency exist?

Efficiency exists when the price to consumers, reflecting marginal benefit, equals marginal cost

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Who is a Third Party?People outside the market

transaction who are affected by the product

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What are Private Benefits and Costs?

Benefits and costs to the decision maker, ignoring benefits and costs to third parties

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What are Externalities?Benefits or costs that are

not considered by market buyers and sellers

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What is an example of an Externality?

Air pollution is an externality that affects third parties not driving automobiles

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What is an example of a Positive Externality?

The enjoyment you derive from your neighbors well-kept yard

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What happens when Externalities are present?

Competitive markets are not likely to achieve economic efficiency

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What areSocial Benefits?

The sum of benefits to everyone, including both private benefits and external benefits

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What are Private Costs?Production costs of

capital, labor, land, and entrepreneurship

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What are Social Costs?The sum of costs to

everyone, including both private costs and external costs

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When is Social Welfare maximized?

It is achieved when marginal social benefit

equals marginal social cost

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Why can’t businesses acting on their own solve the problem of Pollution?The added costs of cleaning

up the environment will make them less competitive in the market place

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What may happen to a firm that takes on the added costs of Anti-pollution Devices?

They eventually will be driven out of business by lower cost firms

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The following graphs show the short-run marginal cost curves and the long-run average cost curves for two firms; one pays private costs (typical) and the other pays both private and external costs (green firm)

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PMC (typical)Short-run Marginal CostP

Q

SMC (green)

PSR=SRPMC

QS QP

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PAC (typical)

Long-run Average CostP

Q

SAC (green)

PLR=LRPAC

PLR=LRSAC

QLR

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What happens when External

Costs are ignored?Competitive firms produce

“too much,” and the market equilibrium price is “too low,” compared to a socially efficient industry

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D

Comparisons of Equilibriums for Typical Competitive and “Green Industries”P

Q

SS = SMC(green)

PS = PMC(typical)

QS QC

PS

PC

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Do Markets Fail when Externalities are present?

Externalities illustrate that private markets fail to produce society’s preferred outcome

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How can society achieve Efficiency when markets fail?Government has a

potential role when there is market failure

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What is an example ofGovernment Failure?Government can fail to

correct market failure by doing too little or too much about pollution

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What are two Government Approaches?• Incentive-based regulations• Command-and-control

regulations

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What is a Command-and-control Regulation?Government regulations

that set an environmental goal and dictate how the goal will be achieved

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What is an example of a Command-and-

control Regulation?Mandatory installation

of catalytic converters on automobiles

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What is an Incentive-based Regulation?

Government regulations that set an environmental goal, but are flexible in how buyers and sellers achieve the goal

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What is an Effluent Tax?A tax on the pollutant

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D

Using an Effluent Tax to Achieve Environmental EfficiencyP

Q

SS = (MC, t)(green)

PS = MC = PMC(typical)

QS QC

PS

PC

tax

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What isEmissions Trading?Trading that allows

firms to buy and sell the right to pollute

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What isNew-source Bias?

Bias that occurs when there is an incentive to keep assets past the efficient point as a result of regulation

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Is the Efficient amount of Pollution typically Zero?

No, the marginal social cost of achieving one more unit of clean air may be greater than the marginal social benefit

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What is theCoase Theorem?

The proposition that private market negotiations can achieve social efficiency, regardless of the initial definition of property rights

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How comprehensive is the Coase Theorem?

Only a small number of environmental problems qualify for Coase Theorem solutions

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Which cases qualify for the Coase Theorem?

• no transaction costs• no income effects• only two parties in

the negotiation

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What is aTransaction Cost?

The costs of negotiating and enforcing a contract

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What is theFree-rider Problem?If some people benefit

while others pay, few will be willing to pay for improvement of the environment or other public goods

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What is the result of the Free-rider Problem?

Goods affected are underproduced

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Key Concepts

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Key Concepts• When does Economic Efficiency exist?• Who is a Third Party?• What are Private Benefits and Costs?• What are Externalities?• What are Social Benefits?• What are Private Costs?• What are Social Costs?• Where is Social Welfare maximized?• Why can’t businesses action on their own s

olve the problem of pollution?

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Key Concepts cont.• How can society achieve Efficiency when

markets fail?• What is a Command-and-control Regulation

?• What is an Incentive-based Regulation?• What is an Effluent Tax?• What is Emissions Trading?• What is New-source Bias?• What is the Coase Theorem?

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Summary

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Externalities are benefits or costs that fall on third parties who are neither buyers nor sellers. Pollution is a negative externality or external cost that is a byproduct of many industrial production processes.

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Market failure is present when the market produces a socially inefficient outcome. One instance is when there are externalities All firms , including competitive firms, consider private costs, but disregard external costs, in making decisions..

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Government failure occurs when public-sector actions move us away from desired outcomes, such as efficiency. Government officials seeking campaign contributions and votes may choose environmental measures that favor wealthy contributors over society’s best interests.

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Command-and-control regulations occur when the government dictates the approach to achieving an environmental goal.

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Command-and-control (CAC) regulations are generally inefficient on three grounds: They do not distinguish between high and low pollution areas, they do not allow firms to choose lower cost technologies that could achieve the environmental standard, and they do not encourage improved technology to lower future emissions.

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Incentive-based regulations build on markets to achieve environmental efficiency. Effluent taxes are taxes that reflect external costs. Emissions-trading allows firms to buy and sell the “right to pollute.”

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The Coase Theorem maintains that markets can be efficient in the presence of externalities with minimal government intervention. Even in the presence of externalities, markets may produce efficient outcomes so long as property rights are clearly established.

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Transactions costs, income effects, and free-rider problems are obstacles to achieving environmental efficiency through markets. Transactions costs are the costs of negotiating an agreement, income effects are present when limited income prevents one party from being able to afford the efficient solution, and free-rider problems are present when participants are better off hiding than revealing their willingness to pay for an environmental improvement.

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Chapter 14 Quiz

©2000 South-Western College Publishing

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1. Recently the city of New Orleans discovered chemical compounds in its drinking water. The source is the waste discharges of industrial plants upstream. This is an example of a. an external cost imposed on the citizens of

New Orleans by the industrial plants upstream.

b. a market failure where the market price of the output of these industrial plants does not fully reflect the social cost of producing these goods.

c. an externality where the marginal social costs of producing these industrial goods differ from the marginal private costs.

d. all of the above.

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1.D. The upstream firm is releasing chemicals

into the water, an external cost to the citizens of New Orleans. The upstream firm is not including these costs when pricing its product; hence, the market price is too low. Marginal social costs would include the marginal private cost of the industrial product (their costs of labor, capital, materials, etc.) and the external cost of the chemicals released into the water. Choices (a), (b), and (c)each are correct, so that all of the above is the correct choice.

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2. A government policy that charges steel firms a fee per ton of steel produced (an effluent charge) where the fee is determined by the amount of pollutants discharged into the air or water will lead toa. a decrease in the market equilibrium

quantity of steel produced.b. a decrease in the market equilibrium

price of steel.c. an increase in the market equilibrium

price of steel.d. the results in (a) and (b).e. the results in (a) and (c ).

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2.E. Essentially, the government is employing an

effluent tax to reduce pollution. The tax increases the cost of production. Supply decreases, leading to a higher price and smaller quantity. So choice (e), where (a) quantity decreases and (c)price increases, is the best choice.

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3. Social costs are a. the full resource costs of an economic

activity.b. usually less than private costs.c. the costs of an economic activity borne by

the producer.d. all of the above.

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3. A. Social costs include both private costs (the

costs of the firm’s inputs, including labor, capital, land, etc.) and external costs (the costs to third parties, such as pollution emitted by the producer). Social costs are at least as large as private costs. Producers will not consider external costs, which are a part of social costs, unless they are forced to do so by government or court.

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4. As a general rule, if pollution costs are external, firms will produce a. too much of a polluting good.b. too little of a polluting good.c. an optimal amount of a polluting good.d. an amount that cannot be determined

without additional information.

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4. A. Private firms will make their production

decision using private costs. If there are external costs, social costs exceed private costs. If production decisions included external costs, supply would be smaller than when private costs alone are considered. So if external costs are ignored, the firm will produce too much, as compared to the social efficient level.

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5. Many economists would argue a. the optimal amount of pollution is

greater than zero.b. all pollution should be eliminated.c. the market mechanism can handle

pollution without any government intervention.

d. central planning is the most efficient way to eliminate pollution.

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5.A. The optimal amount of pollution is where

marginal social cost equals marginal social benefit. This amount typically exceeds zero. The marginal cost of eliminating all pollution would likely be very high. For example, we would have to eliminate all cars. However, firms tend to ignore external costs such as pollution, in an unfettered market. While government is likely to be needed, pollution has actually been worse in centrally planned economies.

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6. Which of the following used marketable pollution permits as an incentive for reducing pollution? a. The 1970 Clean Air Act.b. The Comprehensive Environmental

Response, Compensation, and Liability Act of 1980.

c. The 1990 Clean Air Act amendments.d. The Water Quality and Improvement

Act of 1970.

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6.C. The 1990 Clean Air Act was the first piece

of federal legislation to introduce emissions trading. It introduced this approach for sulfur emissions, thought to contribute to acid rain.

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7. The disposable diaper industry is perfectly competitive. Which of the following is true? a. Since the industry is perfectly

competitive, price and quantity are at the socially efficient levels.

b. Competitive price is higher and competitive quantity lower than the socially efficient point.

c. Competitive price is higher and competitive quantity higher than the socially efficient point.

d. Competitive price is lower and competitive quantity higher than the socially efficient point.

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7.D. Disposable diapers have an external cost, to

the extent that they are not biodegradable and sit in landfills. Producers in a competitive market consider only private costs, ignoring disposal issues. Similarly, consumers just want to prevent leaks that affect them, but ignore leaks that affect landfills. So producers and consumers use private costs and benefits. Social costs are higher, so that social supply is smaller. The competitive price, based on private costs and benefits, is lower than the social cost. Competitive quantity is larger, given the larger supply, than the socially efficient quantity.

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8. An example of the command-and-control approach to environmental policy is a. placing a tax on high-sulfur coal to

reduce its use and the corresponding sulfur emissions (which contribute to acid rain).

b. requiring electric utilities to install scrubbers to reduce sulfur dioxide emissions (which contribute to acid rain).

c. allowing coal producers to buy and sell permits to allow sulfur emissions.

d. allowing individuals to sue coal producers if sulfur emissions exceed government-set standard.

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8.B. Command-and-control is a regulation

whereby the government establishes a pollution target and dictates the method to achieve the target. An example is requiring scrubbers to reduce sulfur emissions. Sulfur emission permits and effluent taxes are example of incentive-based approaches. With taxes, for example, the firm can choose low-sulfur coal to avoid the tax.

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Private ATC

EXHIBIT 6Private

MC

Demand

Q2 Q4

Social ATC

Social MC

Q3Q1

A

E

HG

L

P1

CKJ F

B

P

Q

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9. The profit-maximizing firm in Exhibit 6 creates water and air pollution as a consequence of producing its output of beef cattle. If pollution costs are borne by third parties, the firm will maximize economic profit by choosing toa. voluntarily incur costs to reduce its

pollution.b. produce at output rate Q3

c. produce at output rate Q2

d. produce at output rate Q4..

D. The firm will produce at Q4 where demand (MR) intersects Private MC.

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10. Use Exhibit 6 to complete the following: To maximize social welfare, the firm should produce at output rate a. Q1

b. Q2

c. Q3

d. Q4

B. The firm will produce at Q2, where demand (MR) intersects Social MC.

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Exhibit 7Impact of Flights on House Value

Number of Flights

1

2

3

4

5

$10,000

18,000

24,000

28,000

30,000

TotalProfits

MarginalProfits

Value ofWilbur’s House

$10,000

8,000

6,000

4,000

2,000

$100,000

95,000

90,000

85,000

80,000

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11. As shown in Exhibit 7, if Orville has the property right to fly over Wilbur’s house, but Wilbur is allowed to negotiate with Orville on the number of flights, what will be the number of flights?a. 2.b. 3.c. 4.d. 5.

B. At 3 flights, marginal profits for Orville is $6,000 and the value of Wilbur’s property goes down by $5,000.

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12. As shown in Exhibit 7, Wilbur has the property right to have no planes flying over his house, but Orville is allowed to negotiate with Wilbur, what will be the number of flights?a. 2.b. 3c. 4d. 5

B. At 3 flights, marginal profits for Orville is $6,000 and the value of Wilbur’s property goes down by $5,000.

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13. As shown in Exhibit 7, at the socially efficient number of flights, what will be the market value of Orville’s house?a. $100,000.b. $95,000.c. $90,000.d. $85,000.

C. At 3 flights, this is the last number of flights that the marginal profits are greater than the marginal costs (ie. the amount that Orville’s house declines in value)

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END