The Efficiency Standard

Introduction  Proponents of efficiency argue: balance the costs and benefits of pollution reduction and seek to achieve the “efficient” pollution level

Efficiency Defined  Pareto efficiency: a situation in which it is impossible to make one person better off without making anyone else worse off

The “Economic Pie”  Conditional on the existing distribution of income, efficiency makes the “economic pie” as big as possible  At the efficient point, the net monetary benefits produced by the economy are maximized

Pareto Efficiency Versus Fairness Which pie is efficient? Which pie is fair?

Efficiency and Fairness  Efficiency need not be fair  If one pie is larger than another, then the larger pie is efficient because it maximizes the benefits to society as a whole, even if the smaller pie is more fairly distributed  By enlarging the pie, it is at least possible for everyone to receive a larger slice in absolute terms

California Water Pricing and Efficiency  A lower price for agricultural water use compared to metropolitan water use in California ($10 per acre foot versus $100 per acre foot respectively) has resulted in inefficient practices  This has placed California’s GDP at as much as $5 billion lower than it could be at the efficient outcome  Simply combining the two markets into one (resulting in a single price of about $70) would reach the efficiency point (see the next slide)  This practice would be unfair to farmers (a sudden large increase in the price water) despite its social gains and so has not been enacted

California Water Pricing and Efficiency

Pareto-Improvements  In the California example, a “Pareto-improving” policy--one that makes all parties better off--does exist  Maintaining separate markets but allowing farmers to sell water allotments to the metropolitan sector could result in large profits for farmers  Farmers would abandon inefficient farming practices and become “water tycoons”  Reforms of this nature are being sought in California

Equity and Efficiency  Equity need not, in theory, be sacrificed when moving from a less to a more efficient outcome  Example: using resource rents from restricted fisheries access to compensate fishers who are locked out.  Most often, however, changes in economic policy result in winners and losers

Efficient Pollution Levels  The efficient level of pollution can be found where the marginal benefits of pollution reduction equal the marginal costs of pollution reduction  At any other level of pollution, both parties can be made better off by “trading pollution”: Proof to follow later

Marginal Analysis  A focus on reducing pollution one unit at a time: marginal analysis  The last unit of pollution reduced is called the marginal unit  The costs of reducing that unit are called the marginal costs  The benefits of reducing that unit are called the marginal benefits

The Smoking Problem

Marginal Costs and Benefits of Cleanup

Marginals and Totals Compared: Costs and Benefits of Pollution Reduction

Marginals and Totals  The area under the marginal cost curve equals the total cost  The efficient level occurs where the total benefit curve lies farthest above the total cost curve  Controlling pollution to a level at which the total benefits equal the total cost results in too much control from an efficiency perspective

More on Marginal Costs of Clean-up  The “supply curve” for pollution cleanup is the marginal cost of reduction curve; it shows the increasing cost to society of eliminating additional units of pollution  Like any supply curve, it shifts with changes in costs determined by the technology available for controlling the pollutant

More on Marginal Benefits of Cleanup  The “demand curve” for cleanup is the marginal benefits of reduction curve  Like any demand curve, its shifts with changes in tastes, income, the price of related “goods”, and population.

Marginal Costs and Benefits of Cleanup: The General Case

The Coase Theorem  If polluter and victim can bargain easily and effectively, private negotiation should arrive at the efficient outcome regardless of who has the initial right to pollute or prevent pollution  This result is known as The Coase Theorem, after Nobel prize-winning economist Ronald Coase

Proof that MB=MC Implies Efficiency  If the conditions for the Coase Theorem hold, then at any pollution level other than the efficient level, one can show that both victim and polluter can be made better off by negotiating a change in pollution levels.

Markets, Coase and Efficient Pollution  Economists do not think that free markets generate the efficient amount of pollution This would require no common property, perfect information about costs and damages,, zero transaction costs, and no free riding  In the real world, “markets for pollution” seldom develop naturally, and often the result is an inefficient one

Polluter Pays Principle  In the real world, it does matter who has the “property rights” and who pays who. Polluter pays is more efficient. Pollution clean-up is a public good; less free riding and transaction costs if polluters pay. In the long run, “victim pays” encourages firm entry into polluting markets and increases pollution relative to polluter pays.

Particulate Standards in Baltimore: Identifying the Efficient Pollution Level

Air Pollution Control in Baltimore: Calculating the Efficiency Standard  Suspended particulate emissions Small particles of ash or soot emitted as a by- product of burning fossil fuels for power or transport  Reduction in Baltimore is costly: Moving from 110 parts per million (ppm) to 109 ppm would cost about $3 million Moving from 95 ppm to 94 ppm would cost an additional $16 million

Air Pollution Control in Baltimore: Calculating the Efficiency Standard  The additional benefits of reducing particulate emissions do not decrease as the pollution level falls The estimated gain per one unit drop (say from 110 ppm to 109 ppm) is $10 million ○ To arrive at this monetary figure for benefits, the authors of the study valued each life saved at $2 million, each lost workday at $100 and each restricted activity day at $25  The efficient level of pollution is then 98 parts per million

The Ethical Basis of the Efficiency Standard  Economists sometimes call the efficient outcome “socially optimal”. All this means is that efficient outcomes balance the costs and benefits of pollution reduction at a level where net monetary benefits are maximized.  Society may ultimately prefer safety or sustainability.