© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Environmental Protection Chapter 28

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Introduction n Three primary concerns in this chapter are: l How do (unregulated) markets encourage pollution? l What are the costs of greater environmental protection? l How can government policy best ensure an “optimal” environment?

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Environmental Threat n We have come to recognize that pollution impairs health, reduces life expentancy, and thus reduces labor-force activity and output.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Environmental Threat n Pollution entails real costs, as measured by impaired health, reduced life spans, and other damages.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Air Pollution n Smog is only one form of air pollution.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Acid Rain n Sulfur dioxide (SO 2 ) is an acrid, corrosive, and poisonous gas created when high- sulfur fuels are burned. n Electric utilities and industrial plants that burn high-sulfur coal or fuel oil are the prime sources of SO 2.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Smog n Nitrogen oxides (NO X ), another ingredient in the formation of acid rain, are also a principal ingredient in the formation of smog.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Smog n Automobile emissions account for 40 percent of urban smog. n Bakeries, dry cleaners, and production of other consumer goods account for an equal amount of smog.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Greenhouse Effect n Excess buildup of carbon dioxide (CO 2 ) is creating a gaseous blanket around the earth. n The potential effects of this blanket are intensely debated.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Greenhouse Effect n The burning of fossil fuels is a significant source of CO 2. n The destruction of rain forests, which absorb CO 2, also contributes to the greenhouse effect.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Water Pollution n Water pollution is another environmental threat.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Organic Pollution n The most common form of water pollution comes from the disposal of organic wastes from toilets and garbage disposals. n Sophisticated waste-treatment plants can reduce organic pollution up to 99 percent.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Organic Pollution n Inadequate treatment systems often result in the closure of waterways and beaches.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Organic Pollution n Over half of the volume of industrial discharge comes from paper, organic chemicals, petroleum, and steel industries.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Organic Pollution n If improperly managed, organic waste can contaminate water supplies and trigger algae blooms that choke waterways and kill fish.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Thermal Pollution n Thermal pollution is an increase in the temperature of waterways brought about by the discharge of steam or heated water. n Electric power plants account for over 80 percent of all thermal discharges.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Solid-Waste Pollution n According to EPA estimates, we generate over 5 billion tons of solid waste each year. n Most solid wastes originate in agriculture and mining.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Solid-Waste Pollution n The smaller amount of solid waste originating in residential and commercial use is considered more dangerous because it accumulates where people live.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Pollution Damages n Some monetary measure of environmental damage is important to our decision making. n We won’t get clean air unless we spend resources to get it.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Assigning Prices n In some cases it is fairly easy to put a price on environmental damage. n Scientists can measure increases in cancer, heart attacks, and other disorders.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Assigning Prices n Economists can estimate the dollar value of damage by assessing the economic value of lives, forests, lakes, and other resources.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Assigning Prices n It is difficult to measure the value of intangibles like lost views of sunsets, wildlife, and recreation opportunities.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cleanup Possibilities n One of the most frustrating things about all of this environmental damage is that it could be avoided.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cleanup Possibilities n The EPA estimates that 95 percent of current air and water pollution could be eliminated by known and available technology.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Market Incentives n Market incentives play a major role in pollution behavior.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Production Decision n Business managers seek to make a profit- maximizing production decision. l Production decision – The selection of the short-run rate of output (with existing plant and equipment).

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Production Decision n The rate of output which maximizes profits is where MR = MC.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Efficiency Decision n The efficiency decision requires a producer to choose that production process that minimizes costs for any particular rate of output. l Efficiency decision – The choice of a production process for any given rate of output.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost of Pollution Abatement n Unfortunately, this efficiency decision does not lead to a low production of pollution. n Pollution abatement can be achieved, but only at significant cost to the producer.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost of Pollution Abatement n The behavior of profit-maximizers is guided by comparisons of revenues and costs, not by philanthropy, aesthetic concerns, or the welfare of the environment.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Profit Maximization in Electric Power Production Price = MR A MC 1 ATC 1 Profit Price or Cost (dollars per kilowatt-hour) 0 Quantity (kilowatt-hours per day) 1000 Using cheap but polluting process P = MR A MC 2 ATC 1 Profit 0 Quantity (kilowatt-hours per day) 1000 B MC 1 ATC 2 Using more expensive but less polluting process Price or Cost (dollars per kilowatt-hour)

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Market Failure: External Costs n People tend to maximize their personal welfare, balancing private benefit against private cost. n Pollution does not generally appear on the profit-and-loss statement for a firm.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Market Failure: External Costs n These external costs (pollution) are called externalities. l External costs – Costs of a market activity borne by a third party: the difference between the social and private costs of a market activity.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Externalities in Production n Whenever external costs exist, a private firm will not allocate its resources and operate its plant in such a way as to maximize social welfare.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Externalities in Production n When social costs differ from private costs, external costs exist. n External costs are equal to the difference between the social and private costs. External costs = Social costs – Private costs

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Externalities in Production n Social costs are the full resource costs of an economic activity, including externalities. n Private costs are the costs of an economic activity directly borne by the immediate producer or consumer (excluding externalities).

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Externalities in Production n When external costs are present, the market mechanism will not allocate resources efficiently – this is a case of market failure. l Market failure – An imperfection in the market mechanism that prevents optimal outcomes

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Externalities in Production n To maximize social welfare, we need to equate social marginal cost to marginal revenue (price). n If pollution costs are external, firms will produce too much of a polluting good.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Market Failure Social MCPrivate MC Price (= MR) B A External cost Price or Cost (dollars per unit) Quantity (units per time period) 0qSqS qPqP

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Externalities in Consumption n A consumer, like a producer, tends to maximize personal welfare.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Externalities in Consumption n When people use vacant lots as open dumps, the polluter benefits by substituting external costs for private costs.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Regulatory Options n There are two general strategies for environmental protection. l Alter market incentives in such a way that they discourage pollution. l Bypass market incentives with some form of regulatory intervention.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Market-Based Options n Market incentives can be used to reduce or eliminate the divergence between private and social costs.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Emission Charges n An emission charge is a fee imposed on polluters, based on the quantity of pollution. n An emission charge increases private marginal cost and encourages lower output and cleaner technology.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Emission Charges n An emission charge might persuade firms to incur higher fixed costs. n Rather than pay emission charges, it might be more economical to install equipment that reduces the volume of pollution.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Emission Charges n Actual response depends on the relative costs and benefits. n If emission charges are high enough, firms will install new technology to avoid the charges.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Emission Fees Fee = t MC + fee Price q1q1 q0q0 0 Price or Cost (dollars per unit) Quantity (units per time period) Private MC

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Recycling Materials n A bonus that emission charges offer is an increased incentive for the recycling of materials.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Recycling Materials n A producer has no incentive to use recycled materials unless they offer superior cost efficiency and thus greater profits.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Higher User Fees n Raising the price consumers pay for scare resources encourages them to use less.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin “Green” Taxes n An efficient way to control pollution is to make those who cause it bear some of the costs through “green” taxes. n “Green” taxes run the gamut from retail taxes on gasoline to landfill charges on waste disposal.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Pollution Fines n Imposing fines or liability for cleanup costs changes the incentive structure for firms.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Tradable Pollution Permits n Rather than penalizing firms that have already polluted, tradable pollution permits let firms purchase the right to continue polluting.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Tradable Pollution Permits n The key to the success of polluting permits is that they are bought and sold among private firms.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Tradable Pollution Permits n The system starts with a government-set standard for pollution reduction.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Tradable Pollution Permits n Firms that reduce pollution by more than the standard earn pollution credits which the may sell to other firms.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Tradable Pollution Permits n The principal advantage of pollution permits is their incentive to minimize the cost of pollution control.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Tradable Pollution Permits n Entrepreneurs now have an incentive to discover cheaper methods for pollution abatement.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Tradable Pollution Permits n This has accelerated productivity and reduced the cost of environmental protection by percent.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Pricing Pollution Permits

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Command-and-Control Options n With the command-and-control option, the government commands firms to reduce pollution and then controls the process for doing so.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Command-and-Control Options n The Clean Air Acts of 1970 and 1990 are examples of command-and-control approaches.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Command-and-Control Options n Excessive process regulation may raise the costs of environmental protection and discourage cost-saving innovation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Command-and-Control Options n When process regulation raises the cost of environmental protection, we have government failure. l Government failure – Government intervention that fails to improve economic outcomes.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Central Planning n Some of the worst evidence of government failure exists in the most regulated economies. n Government-directed production isn’t more environmentally-friendly than market- directed production.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Balancing Benefits and Costs n Protecting the environment entails costs as well as benefits.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Opportunity Costs n The use of our scarce resources to clean the environment involves an opportunity cost. l Opportunity cost – The most desired goods or services that are foregone in order to obtain something else.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Opportunity Costs n The environmental expenditures contemplated by present environmental policies represent only 1-3 percent of total output.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Optimal Rate of Pollution n Optimal rate of pollution is the rate of pollution that occurs when the marginal social benefit of pollution control equals its marginal social cost.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Optimal Rate of Pollution n A totally clean environment is not economically desirable. n The costs of environmental protection are substantial and must be compared to the benefits.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost-Benefit Analysis n Marginal analysis tells us that a zero- pollution goal isn’t economically desirable. n Some studies suggest the cost/benefit ratio is extraordinarily high.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost-Benefit Analysis n Harvard Center for Risk Analysis suggests the median cost per life-year saved by EPA regulations is $7.6 million.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost-Benefit Analysis n The cost per life year saved with chloroform emission controls at pulp mills exceeds $99 billion.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Cost-Benefit Analysis n One question we must ask is how many lives would be saved if we spend $99 billion on cancer or AIDS research?

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Who Will Pay? n Depending on how much competition exists in the polluting industry and the price elasticity of demand, the cost of reducing pollution will be passed on to consumers.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Who Will Pay? n If producers can pass the cost of pollution control along to the consumer, higher prices reduce pollution in two ways: l Higher prices help to pay for pollution-control equipment. l Higher prices encourage consumers to buy less polluting goods.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The “Greenhouse” Threat n Some scientists worry about the carbon emissions we are now spreading into the atmosphere. n They warn that CO 2 is warming the earth’s atmosphere and predict the polar caps will melt, continents will flood, and weather patterns will go haywire.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Green House Effect n Scientists fear there is a build-up of carbon dioxide that might trap heat in the earth’s atmosphere, warming the planet.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin The Skeptics n Other scientists are skeptical about both the temperature change and its cause.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Global Externalities n One thing is certain, CO 2 emissions are a global externality. n Without some form of government intervention, there is little likelihood that market participants will voluntarily reduce them.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Kyoto Treaty n In December of 1997, most of the world’s industrialized nations pledged to reduce CO 2 emissions.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Kyoto Treaty n The Kyoto Treaty encourages nations to develop a global system of tradable pollution permits to encourage cost efficiency.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Environmental Protection End of Chapter 28