Chapter 4 Pollution Problems: Must We Foul Our Own Nests? McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts Cost-benefit analysis Supply and demand as marginal costs and benefits Externalities and opportunity costs Marginal social costs Marginal social benefits Externalities in consumption Externalities in production Market failures Pollution rights markets

Environment and Its Services Air Water Land Environment services Are used during the production process Consequences of using the environment Depletion of exhaustible resources Irresponsible usage of replaceable resources Waste disposal

What Is Pollution? The Environment and Its Services Exhaustible resources Replaceable resources Waste disposal Recycling Wastes and the Concept of Pollution Pollution occurs when recycling processes fail to prevent wastes from accumulating in the environment

Common Forms of Pollution Air Pollution Carbon monoxide Sulfur dioxides Nitrogen oxides Hydrocarbons Particulates Water pollution Level of dissolved oxygen Materials and matter Land pollution Dumping of wastes Tearing up Earth’s surface

Markets and Resource Allocation Supply and demand schedule intersection determines market equilibrium Market-determined equilibrium reflects the socially optimal allocation of resources Maximum social well-being is achieved whenever marginal social benefit equals marginal social cost We now fit cost-benefit thinking into the supply and demand model

Market: the Demand Side Demand curve Shows the maximum quantity of a good or service that can be bought at any given price Shows the maximum price consumers will be willing to pay for each successive unit of a good or service Demand curve is downward sloping: Suppose the first pizza is sold at $10the marginal benefit of the first pizza is at least $10 The second pizza is worth less, say, $8 reflecting the declining marginal willingness to pay Market demand curve is reflecting the marginal private benefit of consumption Marginal private benefit is the benefit that accrues to the direct consumers of a good or service resulting from a one-unit increase in consumption

Marginal Social Benefit Normally consuming goods or services does not affect anybody except the direct consumer However: consider vaccination for a contagious disease There is a spillover of benefits from the vaccine to third parties (that is, to the society, not only the direct consumer), or externalities in consumption Externality in consumption is a change in satisfaction, which can be either positive or negative, for someone other than the direct consumer of an item When externalities are present, the marginal private benefit does not equal marginal social benefit: Marginal social benefit = Marginal private benefit +/- Externality

Demand and Marginal Private Benefit $ The demand curve is a marginal private benefit curve 14 12 10 8 6 Click 1: Callout flies in from right waits at top left of demand curve for 3 seconds and then slowly traces the demand curve down to the lower right Click 2: Callout flies out to bottom Click 3: Grid lines for 12 and 1 Click 4: Grid lines for 10 and 2 Click 5: Grid lines for 8 and 3 Click 6: Grid lines for 6 and 4 Click 7: Grid lines for 4 and 5 Click 8: Grid lines for 2 and 6 4 D = MPB 2 1 2 3 4 5 6 Quantity of pizza

Externality in Consumption $ MSB = MPB ± Externality MSB 14 12 10 8 6 Click 1: MSB = MPB +/- Externality Click 2: MPB curve Click 3: All orange grid lines 4 2 MPB 1 2 3 4 5 6 HIV vaccine

Marginal Private Cost A supply curve shows the maximum quantity of a good or service that sellers are willing to offer given the price A supply curve shows the minimum price sellers are willing to accept for an additional unit of a good or service The supply curve is the producer’s marginal private cost curve Marginal private cost is the increase in total cost that producers incur when output is increased by one unit

Increasing Slope of Supply Curve Supply curve is upward sloping reflecting the fact that the marginal private costs increase as the volume of production increases Increasing opportunity costs reflect the fact that as producers produce more they have to attract resources that are increasingly valuable Example: hiring workers in a student town

Externality in Production In most production processes, the actual producer of a product bears all costs associated with this production so that the marginal private product and the marginal social product coincide Externalities in production occur whenever production of a good or service leads to cost changes (negative or positive) in the production of the other items Examples Smoking Landscaping Marginal social cost = Marginal private cost +/- Externality

Supply and Marginal Private Cost $ 11 S = MPC 10 9 8 7 Click 1: S=MPC curve Click 2: grids for 5,1 Click 3: grids for 6,2 Click 4: grids for 7,3 Click 5: grids for 8,4 Click 6: grids for 9,5 Click 7: grids for 10, 6 6 5 1 2 3 4 5 6 Quantity of pizza

Externality in Production MSC MSC = MPC ± Externality $ 11 10 S = MPC 9 8 7 Click 1: MSC = MPC +/- Externality Click 2: MSC curve Click 3: orange grids 6 5 1 2 3 4 5 6 Steel

Market Failure The market leads to the outcome where the marginal private benefit to consumers is equal to the marginal private cost of producers When externalities exist and are of significant size, the market equilibrium outcome is not a socially optimal one Market failure occurs when markets, operating on their own, do not lead to a socially optimal allocation of resources

Explicit and Implicit Costs Explicit costs of production are the ones incurred by the producer to buy or hire the resources required to produce Actual cost outlays Implicit costs of production are the ones incurred by the producer for the use of self-owned, self-employed resources required to produce Household members’ labor

Marginal Social vs Marginal Private Cost A firm dumping its waste into the river produces negative externalities by increasing the social cost of production The market outcome in this case is not socially optimal since the private supply curve is not the social supply curve In case of negative externalities, too much production occurs

Market Equilibrium without Externalities $ 14 12 S = MPC 10 8 7 6 4 D = MPB 2 1 2 3 3.5 4 5 6 Steel

Marginal Private Cost vs Marginal Social Cost The true cost of producing electric power is the cost that would exist were the river not polluted by the paper producers However, the power producer has to clean the water so from their perspective the cost of producing power has to include the cost of cleaning water The market gets it wrong again since it overestimates the true costs of power production by internalizing the negative externality produced by the paper mill so that too little power is produced

Why Polluters Pollute Property rights in the environment either nonexistent or not enforced Much of environment’s services shared by entire population

Consumer Surplus and the Demand Curve A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good. Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyer’s willingness to pay and the price paid.

The Demand Curve for Used Textbooks Price of book Aleisha $59 Potential buyers Willingness to pay Aleisha $59 45 Brad Brad 45 Claudia 35 35 Claudia Darren 25 Edwina 10 25 Darren A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good. 10 Edwina D 1 2 3 4 5 Quantity of books

Willingness to Pay and Consumer Surplus Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. The term consumer surplus is often used to refer to both individual and total consumer surplus.

Consumer Surplus in the Used Textbook Market 5 4 3 2 1 Aleisha Brad Claudia Darren D Edwina $59 45 35 30 10 25 Price of book Quantity of books Aleisha’s consumer surplus: $59-$30=$29 Brad’s consumer surplus: $45-$30=$15 The total consumer surplus is given by the entire shaded area - the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia - equal to $29 + $15 + $5 = $49. Claudia’s consumer surplus: $35-$30=$5 Price = $30

Consumer Surplus in the Used Textbook Market

Consumer Surplus The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. 1 million $1,500 Price of computers Quantity of computers D Consumer surplus Price = $1,500

How Changing Prices Affect Consumer Surplus A fall in the price of a good increases consumer surplus through two channels: A gain to consumers who would have bought at the original price and A gain to consumers who are persuaded to buy by the lower price.

Consumer Surplus and a Fall in the Price of Used Textbooks 5 4 3 2 1 D $59 45 35 30 10 25 20 Aleisha Brad Claudia Darren Edwina Price of book Quantity of books Increase in Aleisha’s consumer surplus Increase in Brad’s consumer surplus Increase in Claude’s consumer surplus Original price = $30 Darren’s consumer surplus New price = $20

A Fall in the Market Price Increases Consumer Surplus 1 million 200,000 1,500 $5,000 Price of computers Quantity of computers D Increase in consumer surplus to original buyers Consumer surplus gained by new buyers

Producer Surplus and the Supply Curve A potential seller’s cost is the lowest price at which he or she is willing to sell a good. Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the seller’s cost. Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good.

The Supply Curve for Used Textbooks Price of book Potential sellers S Cost Andrew $5 $45 Engelbert Donna 15 25 Carlos 35 Donna Betty 35 Engelbert 45 25 Carlos 15 Betty 5 Andrew 1 2 3 4 5 Quantity of books

Producer Surplus in the Used Textbook Market 5 4 3 2 1 S $45 35 30 25 15 Price of book Quantity of books Engelbert Donna Carlos Betty Andrew Price = $30 Andrew’s producer surplus Betty’s producer surplus Carlos’s producer surplus

Price of wheat (per bushel) Quantity of wheat (bushels) Producer Surplus The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. $5 1 million Price of wheat (per bushel) Quantity of wheat (bushels) S Price = $5 Producer surplus

Price of wheat (per bushel) Quantity of wheat (bushels) A Rise in the Price Increases Producer Surplus 1.5 million $7 5 1 million Price of wheat (per bushel) Quantity of wheat (bushels) Increase in producer surplus to original sellers Producer surplus gained by new sellers S

Putting It Together: Total Surplus The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.

Total Surplus Price of book S Consumer surplus E Equilibrium price $30 Quantity of books 1,000 $30 S D Producer surplus Consumer surplus Equilibrium quantity Equilibrium price E

Pollution and Resource Allocation Price $ MSC Loss of well-being to society B S = MPC 11 C 10 A 9 Click 1: MSC curve Click 2: grids at r0 and 10 Click 3: grids at r1 and 11 Click 4: triangle Click 5: Callout flies in from top right, waits 2 seconds and circles triangle Click 6: Callout flies out to bottom right D = MPB = MSB r0 r1 Reams per day

Pollution and Resource Allocation Price $ S = MPC MSC A 12 10 C B D = MPB = MSB r0 r1 Kilowatt-hours per day

Externalities and the Market Outcome When a negative externality in production exists, the outcome in the markets do not reflect an allocation of resources that maximizes social well-being Market incentives in case there are externalities lead to suboptimal production levels For the polluter, production costs are artificially reduced so they overproduce For the power producers, production costs are artificially increased so they underproduce

How Much Pollution Control is Appropriate? We need to apply cost and benefit analysis to answer this question Measurement of both costs and benefits of pollution control measures is difficult As pollution control increases, marginal costs of it increase while the marginal benefits of it decline The level of pollution control that yields the maximum net social benefit is the one at which the marginal social benefit equals marginal social cost

Why Polluters Pollute Property rights in the environment either nonexistent or not enforced Much of environment’s services shared by entire population

The Appropriate Level of Pollution Control (1) (2) (3) (4) (5) (6) (7) Pollution Control or Eliminated Stench Total Social Cost of Control ($000) Marginal Social Cost of Control ($000) Per-Person Marginal Benefit of Control Marginal Social Benefit of Control ($000) Total Social Benefit of Control ($000) Net Social Benefit of Control ($000) 1st 10% 10 10.00 100 90 2nd 10% 20 8.00 80 180 160 3rd 10% 30 6.00 60 240 210 4th 10% 40 4.00 280 5th 10% 50 2.00 300 250 6th 10% 1.60 16 316 256 7th 10% 70 1.20 12 328 258 8th 10% .80 8 336 9th 10% .40 4 340 10th 10% .20 2 342 242 4-43

Direct Controls Assumes regulatory bodies know what social optimum is Assumes regulatory bodies can allocate pollution reducing costs efficiently Fail to provide polluters with economic incentives not to pollute so enforcement can be a problem

Indirect Controls Economic incentives are there Incentives to overproduce are reduced for the polluter Determining the benefits of cleaning the waste is difficult Enforcement is not easy Taxes are a political matter

Pollution Rights Markets A market that exists when firms are allowed to buy and sell government-issued licenses granting the holder the right to create a certain amount of pollution Economic incentives are there Any desired level of pollution can be achieved by the market rather than administrative means

What Can Be Done About Pollution? Creation of Pollution Rights Markets Pollution rights license Pollution rights market Clean Air Act of 1990