Environmental and Natural Resource Economics 3rd ed. Jonathan M Environmental and Natural Resource Economics 3rd ed. Jonathan M. Harris and Brian Roach Chapter 3 – The Theory of Environmental Externalities Copyright © 2013 Jonathan M. Harris

Figure 3.1: The Market for Automobiles Demand (Marginal Benefits) Price Quantity of Automobiles PM Supply (Private Marginal Costs) QM Market Equilibrium • The standard supply and demand graph reflects private benefits and costs, but does not include social costs and benefits such as environmental externalities. Note: Private marginal costs are the costs of production to private producers.

Total ($billion/year) Table 3.1: External Costs of Automobile Use in the United States Cost Category Dollars/gallon Total ($billion/year) Climate change 0.06 10 Oil dependency 0.12 20 Local pollution 0.42 71 Congestion 1.05 177 Accidents 0.63 106 Total externality costs 2.28 384 Empirical research shows that external costs of automobile use are significant. In this study, a relatively low estimate of the costs of climate has been used. A higher estimate (such as those discussed later in the text in Chapter 18) could raise the overall external costs to equal or exceed the current cost of gasoline. Sources: Delucchi, 1997; Parry et al., 2007. Note: Total externality cost estimated by multiplying Parry et al.’s per-gallon damages by annual highway fuel consumption of 168 billion gallons, based on data from the 2012 Statistical Abstract of the United States (table 929).

Figure 3.2: The Market for Automobiles with Negative Externalities Demand (Marginal Benefits) Price Quantity of Automobiles PM Supply (Private Marginal Costs) QM Market Equilibrium • Social Marginal Costs (Private + External) Social Optimum Q* P* External Costs Economic theory implies that external costs should be included in a complete analysis of supply and demand. The inclusion of externalities indicates that the market equilibrium is no longer optimal, and the true social optimum lies at a higher price and lower quantity produced.

Figure 3.3: Automobile Market with Pigovian Tax Demand (Marginal Benefits) Price Quantity of Automobiles PM Supply (Private Marginal Costs) QM • Supply with Tax Q* P* External Costs P0 Equilibrium with Tax A Pigovian tax can be used to internalize externalities. This will achieve the result that price rises and equilibrium quantity demanded falls, achieving the socially optimal equilibrium if the tax accurately reflects the cost of the externality. The price does not rise by the full amount of the tax, indicating that the burden of the tax is shared between consumers and producers.

Figure 3.4: The Market for Solar Energy with Positive Externalities Demand (Private Marginal Benefits) Price Solar Energy PM Supply (Private Marginal Costs) QM • External Benefits Social Marginal Benefits Q* A positive externality such as pollution reduction can be shown on the demand side as an increase in social marginal benefits, above the private benefits shown by the market demand curve.

Figure 3.5: The Market for Solar Energy with a Subsidy Demand (Private Marginal Benefits) Price Solar Energy PM Supply (Private Marginal Costs) QM • External Benefits Social Marginal Benefits Q* Supply with Subsidy P* Internalization of a positive externality is usually achieved by a subsidy, which shifts costs of supply downward. The effect is to increase quantity while lowering price.

Figure 3.6: Welfare Analysis of the Automobile Market Demand (Marginal Benefits) Price Quantity of Automobiles PM Supply (Private Marginal Costs) QM Market Equilibrium • A B A basic market analysis shows benefits to consumers (consumer surplus = A) and benefits to producers (producer surplus = B) as areas between the demand and supply curves to the left of equilibrium.

Figure 3.7: Welfare Analysis of the Automobile Market with Externalities Demand (Marginal Benefits) Price Quantity of Automobiles PM Supply (Private Marginal Costs) QM Social Marginal Costs Q* A’ B’ C • Adding externalities complicates the welfare analysis, showing that in addition to consumer and producer surplus, there is an area (shown in dark blue) of pollution costs, making the market equilibrium non-optimal. Net social benefit at the market equilibrium are A’ + B’ – C where C is the triangle of net loss between the “optimal” and market equilibria.

Figure 3.8: The Welfare-Improving Effect of a Pigovian Tax Demand (Marginal Benefits) Price Quantity of Automobiles P* Supply Without Tax QM Supply With Tax Q* A’’ B’’ D • Per-Unit Tax Equilibrium With Tax If a tax is imposed to internalize the externality, the areas of consumer and producer surplus shrink due to a reduction in quantity produced and consumed. There is a remaining total cost of pollution equal to area D, but the maximum net social benefit of A’’ + B” is achieved.

Figure 3.8: Application of the Coase Theorem D C B Marginal Benefits to Company Marginal Costs to Community Since emission of effluent generates both net benefits to the company and net costs to the community, the level of net social benefit will vary depending on the level of effluent emission. If that level was zero, there would be no costs to the community, but also no net benefits. At a level of 80, the company gains benefits equal to A+B+C+D, but the community loses C+D+E+F, for a net social effect of A+B – (E+F). The best solution is an effluent level of 50, leading to company befits of (A+B+C) and community costs of C, with a net social benefit of A+B.

Table 3.2: Gains and Losses from Negotiation with Different Property Rights If community holds rights If company holds rights Net gain/loss to community + $7,500 payment – $3,750 environmental costs + $3,750 – $4,500 payment – $8,250 Net gain/loss to company + $13,750 total benefits – $7,500 payment + $6,250 + $4,500 payment + $18,250 Net social gain +$10,000 The socially optimal equilibrium can be achieved by negotiation, regardless of which party holds the property right to emit effluent, or to prohibit its emission. The distribution of benefits is different depending on which party holds the rights, but in either case the optimum result can be achieved through negotiation, and the net social benefit is the same.

Figure A3.1: Demand Curve for Gasoline Price ($/gallon) Quantity Demanded (thousand gallons/week)

Figure A3.2: A Change in Demand Quantity Demanded (thousand gallons/week) Price ($/gallon)

Figure A3.3: Supply Curve For Gasoline Quantity Supplied (thousand gallons/week) Price ($/gallon)

Figure A3.4: A Change in Supply Quantity Supplied (thousand gallons/week) Price ($/gallon) Figure A3.4

Figure A3.5: Equilibrium in the Market for Gasoline Quantity (thousand gallons/week) Price ($/gallon) Supply Demand Figure A3.5

Figure A3.6: A New Equilibrium with a Change in Demand for Gasoline Quantity (thousand gallons/week) Price ($/gallon) Supply D0 D1 Figure A3.6

Figure A3.7: Consumer and Producer Surplus Quantity (thousand gallons/week) Price ($/gallon) Supply Demand Consumer Surplus Producer Surplus

Figure A3.8: Welfare Analysis of Automobile Market with Externalities Demand (Marginal Benefits) Price Quantity of Automobiles PM Supply (Private Marginal Costs) QM • Social Marginal Costs Q* P* A B C D E F G H I Figure A3.8

Figure A3.9: Welfare Analysis of Automobile Market with Pigovian Tax Demand (Marginal Benefits) Price Quantity of Automobiles PM Supply (Private Marginal Costs) QM • Supply With Tax Q* P* A B C D E F G H I J P0 Figure A3.9

Figure A3.10: Automobile Market Example Demand Supply Consumer Surplus Producer Surplus Figure A3.10

Figure A3.11: Automobile Market Example with Externality Tax Demand Supply (Private) Supply with Tax Tax Revenue

Figure A3.12: Welfare Analysis of a Positive Externality Demand (Private Marginal Benefits) Price Solar Energy PM Supply (Private Marginal Costs) QM • A B C D E F Social Marginal Benefits Q*

Figure A3.13: The Market for Solar Energy with a Subsidy Demand (Private Marginal Benefits) Price Solar Energy PM Supply (Private Marginal Costs) QM • A B C D E F Social Marginal Benefits Q* G H I J K L M Supply with Subsidy P0 P*