Chapter 2 Externalities and the Environment McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Introduction The economist’s approach to pollution Economic analysis of a pollution tax and tradable permits Applications: Acid rain and global warming

Externalities and the Environment Negative externality Exists whenever a producer or consumer does not have to pay for a cost he generates. Examples: air pollution, water pollution, or noise pollution Positive externality Exists whenever a producer or consumer does not receive a payment for a benefit he generates. Examples: immunizations or improving your home.

The Economist’s Approach to Pollution Pollution is an example of a market failure. An allocation of resources that is not socially optimal. When externalities exist, there is a failure of property rights. Establish property rights and charge a price for its use. Solution? government private firms individuals Who can have property rights?

The Economist’s Approach to Pollution If the government has property rights, how do they charge a price? TAXES PERMITS Charging polluters a price forces them to internalize the externality. A private solution (Coase’s prescription) is possible if: Property rights exist A small number of citizens are harmed There are low transaction costs

Trade-off between Environmental Quality and Output c d e f Figure 2.1 Maximum environmental quality Increase in environmental quality and a decrease in output Maximum output with zero environmental quality

Trade-off between Environmental Quality and Output The Virtues of Pollution Prices Allocation problem Command and control method Tax method Polluters with different technological options Permit method Objections to pollution prices and economist’s responses Pollution price is a “license to pollute” Pollution prices will raise product prices Pollution taxes will raise the tax burden on the population

Charging a Price vs. Mandating or Subsidizing Clean Technologies Economists recommend using pollution prices and oppose mandating or subsidizing clean technologies. WHY? Pollution prices stimulate clean technologies Mandates lead to high costs for consumers - CAFE standards Subsidies lead to a distorted playing field among potential alternatives Political lobbying for subsidies cause distortion Clean alternatives is not always the socially optimal response Subsidies require raising taxes

A Pollution Tax The right tax generates the right quantity of a polluting good Figure 2.2 80 100 Gasoline P $2.50 S (MPC) D (MB) H J I K MSC MSC = MPC + MD MD

Social optimum quantity is where MSC = MB at 80 units of gasoline A Pollution Tax Levy a corrective tax (Pigouvian tax) equal to the MD Figure 2.3 P $2.50 Social optimum quantity is where MSC = MB at 80 units of gasoline S` (MSC`) H J I K T S (MPC) D (MB) 80 100 Gasoline

A Pollution Tax An optimal tax confers a net benefit to society Figure 2.4 P $2.50 MSC Gain in environmental benefit = HIJK J S (MPC) I Loss of output = HIK K Net gain to society = HIJK – HIK = IJK H D (MB) 80 100 Gasoline

A Pollution Tax Use pollution tax revenue to cut other taxes Pollution taxes as revenue replacers Different ways of returning the tax revenue to the private sector will have different effects Tax emissions, not the polluting good Whenever feasible, levy the tax per unit of pollution – per emission – not per unit of polluting good

A Pollution Tax $60 $100 $20 $25 $40 $50 $200 10 25 30 35 40 45 50 Emissions MACH MACL Figure 2.5 To minimize cost, levy the same tax on all firms emitting pollutant X 2 firms with different MACs Without government policy, each firm pollutes 50 units.

After tax, total emission is 50 units A Pollution Tax $60 $100 $20 $25 $40 $50 $200 10 25 30 35 40 45 50 Emissions MACH Figure 2.5 To minimize cost, levy the same tax on all firms emitting pollutant X MD = T Marginal damage and tax rate is constant at $40 Firms will abate until MAC = T Equi-marginal principle After the tax is levied, MACH will abate 10 units and MACL will abate 40 units MACL After tax, total emission is 50 units

Tradable Permits CAP and TRADE Cap – supply of emissions permits is fixed Trade – permits can be bought and sold in the market throughout the year How do firms get the permits? 1. Government sells permits 2. Government gives the permits away

Tradable Permits – Government sells permits DH Each firm’s permit demand curve is its MAC curve = MACH = MACL $200 = market demand S The government decided to supply 50 pollution permits $100 $60 DL $50 $40 D $25 $20 10 25 30 35 40 45 50 75 Permits

Tradable Permits – Government sells permits $60 $100 $20 $25 $40 $50 $200 10 25 30 35 40 45 50 75 Permits DH D DL S What is the optimal permit price? Price where S = D Tentative prices P = $50 is too high P=$50 P = $20 is too low P=$20 P = $40 results in the desired outcome P=$40 Tax vs. permit A hybrid policy

Government gives the permits away Tradable Permits – Government gives the permits away Just like selling permits or levying a tax, giving permits to polluting firms will reduce pollution. The supply curve for each polluting good will shift to the left The price of polluting goods will increase But, giving the permits away can lead to higher output and emissions than is socially optimal in the long run. Which is best? Firms want the government to give permits Taxpayers want the government to sell permits

Application: Tradable Permits for Sulfur Dioxide to Reduce Acid Rain Sulfur dioxide causes acid rain Old policy – a maximum sulfur dioxide emission rate for new coal-burning electricity generating firms. New policy – tradable permits are given to electric power plants Clean Air Act Amendments of 1990 Plants can then buy and sell permits an needed Total emissions have fallen with the new policy Two issues: long run issue, and tax revenue issue

Application: A Carbon Tax or Tradable Permits to Reduce Global Warming Carbon emissions cause global warming A carbon tax treaty A carbon tradable permits treaty A hybrid carbon treaty: a permit system with a safety valve The political challenge Policy decision – carbon tax or carbon permits? Policy decision – how can low-income countries be induced to participate?

Summary The Economist’s approach to pollution Applications: Acid rain and global warming Economic analysis of a pollution tax and tradable permits The Economist’s approach to pollution

Preview of Chapter 3: Public Goods and Political Economy The concept of a public good Political economy The behavior of the government