1 Chapter 14 Environmental Economics Key Concepts Key Concepts Summary Summary Practice Quiz Internet Exercises Internet Exercises ©2002 South-Western College Publishing

2 What assumption is made in this chapter? There is sufficient foreign and domestic competition to allow us to use the perfectly competitive model

3 When does economic efficiency exist? Efficiency exists when the price to consumers, reflecting marginal benefit, equals marginal cost

4 Who is a third party? People outside the market transaction who are affected by the product

5 What are private benefits and costs? Benefits and costs to the decision maker, ignoring benefits and costs to third parties

6 What are externalities? Benefits or costs that are not considered by market buyers and sellers

7 What is an example of an externality? Air pollution is an externality that affects third parties not driving automobiles

8 What is an example of a positive externality? The enjoyment you derive from your neighbors well- kept yard

9 What happens when externalities are present? Competitive markets are not likely to achieve economic efficiency

10 What are social benefits? The sum of benefits to everyone, including both private benefits and external benefits

11 What are private costs? Production costs of capital, labor, land, and entrepreneurship

12 What are social costs? The sum of costs to everyone, including both private costs and external costs

13 When is social welfare maximized? It is achieved when marginal social benefit equals marginal social cost

14 Why can’t businesses acting on their own solve the problem of pollution? The added costs of cleaning up the environment will make them less competitive in the market place

15 What may happen to a firm that takes on the added costs of anti- pollution devices? They eventually will be driven out of business by lower cost firms

16 The following graphs show the short-run marginal cost curves and the long-run average cost curves for two firms; one pays private costs (typical) and the other pays both private and external costs (green firm)

17 PMC (typical) Short-run Marginal Cost P Q SMC (green) P SR =SRPMC QSQS QPQP

18 PAC (typical) Long-run Average Cost P Q SAC (green) P LR =LRPAC P LR =LRSAC Q LR

19 What happens when external costs are ignored? Competitive firms produce “too much,” and the market equilibrium price is “too low,” compared to a socially efficient industry

20 D Comparisons of Equilibriums for Typical Competitive and “Green Industries” P Q SS =  SMC (green) PS =  PMC (typical) QSQS QCQC PSPS PCPC

21 Do markets fail when externalities are present? Externalities illustrate that private markets fail to produce society’s preferred outcome

22 How can society achieve efficiency when markets fail? Government has a potential role when there is market failure

23 What is an example of government failure? Government can fail to correct market failure by doing too little or too much about pollution

24 What are two government approaches? Incentive-based regulations Command-and-control regulations

25 What is a command- and-control regulation? Government regulations that set an environmental goal and dictate how the goal will be achieved

26 What is an example of a command-and- control regulation? Mandatory installation of catalytic converters on automobiles

27 What is an incentive- based regulation? Government regulations that set an environmental goal, but are flexible in how buyers and sellers achieve the goal

28 What is an effluent tax? A tax on the pollutant

29 D Using an Effluent Tax to Achieve Environmental Efficiency P Q SS =  (MC, t) (green) PS =  MC =  PMC (typical) QSQS QCQC PSPS tax PcPc

30 What is emissions trading? Trading that allows firms to buy and sell the right to pollute

31 What is new-source bias? Bias that occurs when there is an incentive to keep assets past the efficient point as a result of regulation

32 Is the efficient amount of pollution typically zero? No, the marginal social cost of achieving one more unit of clean air may be greater than the marginal social benefit

33 What is the Coase Theorem? The proposition that private market negotiations can achieve social efficiency, regardless of the initial definition of property rights

34 How comprehensive is the Coase Theorem? Only a small number of environmental problems qualify for Coase Theorem solutions

35 Which cases qualify for the Coase Theorem? no transaction costs no income effects only two parties in the negotiation

36 What is a transaction cost? The costs of negotiating and enforcing a contract

37 What is the free-rider problem? If some people benefit while others pay, few will be willing to pay for improvement of the environment or other public goods

38 What is the result of the free-rider problem? Goods affected are underproduced

39 Key Concepts

40 Key Concepts When does economic efficiency exist? Who is a third party? What are private benefits and costs? What are externalities? What are social benefits? What are private costs? What are social costs? Where is social welfare maximized? Why can’t businesses action on their own solve the problem of pollution?Why can’t businesses action on their own solve the problem of pollution?

41 Key Concepts cont. How can society achieve efficiency when markets fail?How can society achieve efficiency when markets fail? What is a command-and-control regulation?What is a command-and-control regulation? What is an incentive-based regulation? What is an effluent tax? What is emissions trading? What is new-source bias? What is the coase theorem?

42 Summary

43 Externalities are benefits or costs that fall on third parties who are neither buyers nor sellers. Pollution is a negative externality or external cost that is a byproduct of many industrial production processes.

44 Market failure is present when the market produces a socially inefficient outcome. One instance is when there are externalities All firms, including competitive firms, consider private costs, but disregard external costs, in making decisions

45 Government failure occurs when public-sector actions move us away from desired outcomes, such as efficiency. Government officials seeking campaign contributions and votes may choose environmental measures that favor wealthy contributors over society’s best interests.

46 Command-and-control regulations occur when the government dictates the approach to achieving an environmental goal.

47 Command-and-control (CAC) regulations are generally inefficient on three grounds: They do not distinguish between high and low pollution areas, they do not allow firms to choose lower cost technologies that could achieve the environmental standard, and they do not encourage improved technology to lower future emissions.

48 Incentive-based regulations build on markets to achieve environmental efficiency. Effluent taxes are taxes that reflect external costs. Emissions-trading allows firms to buy and sell the “right to pollute.”

49 The Coase Theorem maintains that markets can be efficient in the presence of externalities with minimal government intervention. Even in the presence of externalities, markets may produce efficient outcomes so long as property rights are clearly established.

50 Transactions costs, income effects, and free-rider problems are obstacles to achieving environmental efficiency through markets.

51 Transactions costs are the costs of negotiating an agreement

52 Income effects are present when limited income prevents one party from being able to afford the efficient solution

53 Free-rider problems are present when participants are better off hiding than revealing their willingness to pay for an environmental improvement

54 Chapter 14 Quiz ©2002 South-Western College Publishing

55 1. New Orleans discovered chemicals in its drinking water. The source is the waste discharges of industrial plants upstream. This is an example of a. an external cost imposed on the citizens of New Orleans by the industrial plants upstream. b. a market failure where the market price of the output of these industrial plants does not fully reflect the social cost of producing these goods. c. an externality where the marginal social costs of producing these industrial goods differ from the marginal private costs. d. all of the above.

56 1. D. The upstream firm is releasing chemicals into the water, an external cost to the citizens of New Orleans. The upstream firm is not including these costs when pricing its product; hence, the market price is too low. Marginal social costs would include the marginal private cost of the industrial product (their costs of labor, capital, materials, etc.) and the external cost of the chemicals released into the water. Choices (a), (b), and (c)each are correct, so that all of the above is the correct choice.

57 2. A government policy that charges steel firms a fee per ton of steel produced (an effluent charge) where the fee is determined by the amount of pollutants discharged into the air or water will lead to a. a decrease in the market equilibrium quantity of steel produced. b. a decrease in the market price of steel. c. an increase in the market price of steel. d. the results in (a) and (b). e. the results in (a) and (c ).

58 2. E. Essentially, the government is employing an effluent tax to reduce pollution. The tax increases the cost of production. Supply decreases, leading to a higher price and smaller quantity. So choice (e), where (a) quantity decreases and (c)price increases, is the best choice.

59 3. Social costs are a. the full resource costs of an economic activity. b. usually less than private costs. c. the costs of an economic activity borne by the producer. d. all of the above.

60 3. A. Social costs include both private costs (the costs of the firm’s inputs, including labor, capital, land, etc.) and external costs (the costs to third parties, such as pollution emitted by the producer). Social costs are at least as large as private costs. Producers will not consider external costs, which are a part of social costs, unless they are forced to do so by government or court.

61 4. As a general rule, if pollution costs are external, firms will produce a. too much of a polluting good. b. too little of a polluting good. c. an optimal amount of a polluting good. d. an amount that cannot be determined without additional information.

62 4. A. Private firms will make their production decision using private costs. If there are external costs, social costs exceed private costs. If production decisions included external costs, supply would be smaller than when private costs alone are considered. So if external costs are ignored, the firm will produce too much, as compared to the social efficient level.

63 5. Many economists would argue a. the optimal amount of pollution is greater than zero. b. all pollution should be eliminated. c. the market mechanism can handle pollution without any government intervention. d. central planning is the most efficient way to eliminate pollution.

64 5. A. The optimal amount of pollution is where marginal social cost equals marginal social benefit. This amount typically exceeds zero. The marginal cost of eliminating all pollution would likely be very high. For example, we would have to eliminate all cars. However, firms tend to ignore external costs such as pollution, in an unfettered market. While government is likely to be needed, pollution has actually been worse in centrally planned economies.

65 6. Which of the following used marketable pollution permits as an incentive for reducing pollution? a. The 1970 Clean Air Act. b. The Comprehensive Environmental Response, Compensation, and Liability Act of c. The 1990 Clean Air Act amendments. d. The Water Quality and Improvement Act of 1970.

66 6. C. The 1990 Clean Air Act was the first piece of federal legislation to introduce emissions trading. It introduced this approach for sulfur emissions, thought to contribute to acid rain.

67 7. The disposable diaper industry is perfectly competitive. Which of the following is true? a. Since the industry is perfectly competitive, price and quantity are at the socially efficient levels. b. Competitive price is higher and competitive quantity lower than the socially efficient point. c. Competitive price is higher and competitive quantity higher than the socially efficient point. d. Competitive price is lower and competitive quantity higher than the socially efficient point.

68 7.D. Disposable diapers have an external cost, to the extent that they are not biodegradable and sit in landfills. Producers in a competitive market consider only private costs, ignoring disposal issues. Similarly, consumers just want to prevent leaks that affect them, but ignore leaks that affect landfills. So producers and consumers use private costs and benefits. Social costs are higher, so that social supply is smaller. The competitive price, based on private costs and benefits, is lower than the social cost. Competitive quantity is larger, given the larger supply, than the socially efficient quantity.

69 8. An example of the command-and- control approach to environmental policy is a. placing a tax on high-sulfur coal to reduce its use and the corresponding sulfur emissions (which contribute to acid rain). b. requiring electric utilities to install scrubbers to reduce sulfur dioxide emissions (which contribute to acid rain). c. allowing coal producers to buy and sell permits to allow sulfur emissions. d. allowing individuals to sue coal producers if sulfur emissions exceed government-set standard.

70 8. B. Command-and-control is a regulation whereby the government establishes a pollution target and dictates the method to achieve the target. An example is requiring scrubbers to reduce sulfur emissions. Sulfur emission permits and effluent taxes are example of incentive-based approaches. With taxes, for example, the firm can choose low-sulfur coal to avoid the tax.

71 Private ATC EXHIBIT 6 Private MC Demand Q2Q2 Q4Q4 Social ATC Social MC Q3Q3 Q1Q1 A E HG L P1P1 C K J F B P Q

72 9. The profit-maximizing firm in Exhibit 6 creates water and air pollution as a consequence of producing its output of beef cattle. If pollution costs are borne by third parties, the firm will maximize economic profit by choosing toExhibit 6 a. voluntarily incur costs to reduce its pollution. b. produce at output rate Q 3 c. produce at output rate Q 2 d. produce at output rate Q 4 D. The firm will produce at Q 4 where demand (MR) intersects Private MC.

Use Exhibit 6 to complete the following: To maximize social welfare, the firm should produce at output rateExhibit 6 a. Q 1 b. Q 2 c. Q 3 d. Q 4 B. The firm will produce at Q 2, where demand (MR) intersects Social MC.

74 Exhibit 7 Impact of Flights on House Value Number of Flights $10,000 18,000 24,000 28,000 30,000 Total Profits Marginal Profits Value of Wilbur’s House $10,000 8,000 6,000 4,000 2,000 $100,000 95,000 90,000 85,000 80,000

As shown in Exhibit 7, if Orville has the property right to fly over Wilbur’s house, but Wilbur is allowed to negotiate with Orville on the number of flights, what will be the number of flights?Exhibit 7 a. 2. b. 3 c. 4 d. 5 B. At 3 flights, marginal profits for Orville is $6,000 and the value of Wilbur’s property goes down by $5,000.

As shown in Exhibit 7, Wilbur has the property right to have no planes flying over his house, but Orville is allowed to negotiate with Wilbur, what will be the number of flights?Exhibit 7 a. 2. b. 3 c. 4 d. 5 B. At 3 flights, marginal profits for Orville is $6,000 and the value of Wilbur’s property goes down by $5,000.

As shown in Exhibit 7, at the socially efficient number of flights, what will be the market value of Orville’s house?Exhibit 7 a. $100,000 b. $95,000 c. $90,000 d. $85,000 C. At 3 flights, this is the last number of flights that the marginal profits are greater than the marginal costs (ie. the amount that Orville’s house declines in value)

78 END