19 Externalities The market tends to overproduce. Spillover CostsSpillover Benefits The market tends to underproduce.

Pollution (tons) Clean-up cost (000$) The Economics of Pollution  Company A produces 40,000 units and emits 600 tons of pollution. Clean-up is costly , ,000 0 Pollution (tons) Clean-up cost MC per ton $90,000 $40,000 $10, $0600

Pollution (tons) Marginal benefit ($)  The marginal “benefit” of pollution is the cost of cleaning-up an extra ton. Marginal “Benefit” of Pollution MB: Company A MB: Company B  Company B has higher clean-up costs.

20,00040,00060, Pollution (tons) MC and MB ($)  Costs and benefits of pollution for the economy as a whole. Costs and Benefits of Pollution MB MC  30,000 tons of pollution is optimal.  the benefit from an extra ton of pollution is offset by the cost  without regulation, companies will emit 60,000 tons

Pollution (tons) Marginal benefit ($)  A standard might require all companies to cut emissions to 300 tons. Environmental Standards MB: Company A MB: Company B  The marginal and total cost for Company B is higher. $150 $300 A Company Clean-up cost MC per ton $22,500 $45,000B

Pollution (tons) Marginal benefit ($)  Alternatively, the government could impose a tax of $200 per ton. Emission Taxes  Each firm chooses an optimal level of pollution  Total pollution is the same but at lower cost. $200 A Company Clean-up cost MC per ton $40,000 $20,000B

Clean-up cost Emissions tax Total $0 600 tons 400 tons 200 tons 0 tons $120,000 $20,000$80,000$180,000 Clean-up cost Emissions tax Total $0 600 tons 400 tons 200 tons 0 tons $120,000 $10,000$40,000$90,000 Firms Choose How Clean to Be Firm A Firm B

Marketable Pollution Permits  The government allocates permits to firms.  Firms are allowed to buy and sell permits.  Permits encourage the lowest cost clean-up to be done first.  Environmental groups can buy permits to reduce pollution.

Marginal Benefit of Transactions $20 16 Price Quantity $8 $4 $5 Marginal benefit of 2 nd unit is $16. Marginal benefit of 5 th unit is $9.

Quantity Price $2,625 $2,250 External Costs (Before a Tax) Large consumer and producer surplus if government pays for the clean-up. Consume r Surplus Producer Surplus External Cost Net benefit = $1,875

Quantity Price Marginal Benefits and Costs Marginal benefit of 100 th unit is $20. Marginal cost of 100 th unit is $7.50. Consume r Surplus Producer Surplus External Cost

Quantity Price Marginal Benefits and Costs Consume r Surplus Producer Surplus External Cost 200 = optimal quantity $10 = optimal tax Marginal benefit of 200 th unit is $10. Marginal cost of 200 th unit is $10.

Quantity MC & MB Margina l cost Margina l benefit Marginal Benefits and Costs

Quantity Price Tax on External Costs $10 With the tax, consumers and producers cover the external costs.