1. Chapter 4 Pollution Problems: Must We Foul Our Own Nests?
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Key Concepts Cost-benefit analysis
Supply and demand as marginal costs and benefits
Externalities and opportunity costs
Marginal social costs
Marginal social benefits
Externalities in consumption
Externalities in production
Market failures
Pollution rights markets

3. Environment and Its Services
Air
Water
Land
Environment services
Are used during the production process
Consequences of using the environment
Depletion of exhaustible resources
Irresponsible usage of replaceable resources
Waste disposal

4. What Is Pollution? The Environment and Its Services
Exhaustible resources
Replaceable resources
Waste disposal
Recycling Wastes and the Concept of Pollution
Pollution occurs when recycling processes fail to prevent wastes from accumulating in the environment

5. Common Forms of Pollution
Air Pollution
Carbon monoxide
Sulfur dioxides
Nitrogen oxides
Hydrocarbons
Particulates
Water pollution
Level of dissolved oxygen
Materials and matter
Land pollution
Dumping of wastes
Tearing up Earth’s surface

6. Markets and Resource Allocation
Supply and demand schedule intersection determines market equilibrium
Market-determined equilibrium reflects the socially optimal allocation of resources
Maximum social well-being is achieved whenever marginal social benefit equals marginal social cost
We now fit cost-benefit thinking into the supply and demand model

7. Market: the Demand Side
Demand curve
Shows the maximum quantity of a good or service that can be bought at any given price
Shows the maximum price consumers will be willing to pay for each successive unit of a good or service
Demand curve is downward sloping:
Suppose the first pizza is sold at $10the marginal benefit of the first pizza is at least $10
The second pizza is worth less, say, $8 reflecting the declining marginal willingness to pay
Market demand curve is reflecting the marginal private benefit of consumption
Marginal private benefit is the benefit that accrues to the direct consumers of a good or service resulting from a one-unit increase in consumption

8. Marginal Social Benefit
Normally consuming goods or services does not affect anybody except the direct consumer
However: consider vaccination for a contagious disease
There is a spillover of benefits from the vaccine to third parties (that is, to the society, not only the direct consumer), or externalities in consumption
Externality in consumption is a change in satisfaction, which can be either positive or negative, for someone other than the direct consumer of an item
When externalities are present, the marginal private benefit does not equal marginal social benefit:
Marginal social benefit = Marginal private benefit +/- Externality

9. Demand and Marginal Private Benefit$
The demand curve is a marginal private benefit curve 14 12 10 8 6
Click 1: Callout flies in from right waits at top left of demand curve for 3 seconds and then slowly traces the demand curve down to the lower right
Click 2: Callout flies out to bottom
Click 3: Grid lines for 12 and 1
Click 4: Grid lines for 10 and 2
Click 5: Grid lines for 8 and 3
Click 6: Grid lines for 6 and 4
Click 7: Grid lines for 4 and 5
Click 8: Grid lines for 2 and 6 4
D = MPB 2 1 2 3 4 5 6
Quantity of pizza

10. Externality in Consumption$
MSB = MPB ± Externality
MSB 14 12 10 8 6
Click 1: MSB = MPB +/- Externality
Click 2: MPB curve
Click 3: All orange grid lines 4 2
MPB 1 2 3 4 5 6
HIV vaccine

11. Marginal Private Cost
A supply curve shows the maximum quantity of a good or service that sellers are willing to offer given the price
A supply curve shows the minimum price sellers are willing to accept for an additional unit of a good or service
The supply curve is the producer’s marginal private cost curve
Marginal private cost is the increase in total cost that producers incur when output is increased by one unit

12. Increasing Slope of Supply Curve
Supply curve is upward sloping reflecting the fact that the marginal private costs increase as the volume of production increases
Increasing opportunity costs reflect the fact that as producers produce more they have to attract resources that are increasingly valuable
Example: hiring workers in a student town

13. Externality in Production
In most production processes, the actual producer of a product bears all costs associated with this production so that the marginal private product and the marginal social product coincide
Externalities in production occur whenever production of a good or service leads to cost changes (negative or positive) in the production of the other items
Examples
Smoking
Landscaping
Marginal social cost = Marginal private cost +/- Externality

14. Supply and Marginal Private Cost$ 11
S = MPC 10 9 8 7
Click 1: S=MPC curve
Click 2: grids for 5,1
Click 3: grids for 6,2
Click 4: grids for 7,3
Click 5: grids for 8,4
Click 6: grids for 9,5
Click 7: grids for 10, 6 6 5 1 2 3 4 5 6
Quantity of pizza

15. Externality in Production
MSC
MSC = MPC ± Externality $ 11 10
S = MPC 9 8 7
Click 1: MSC = MPC +/- Externality
Click 2: MSC curve
Click 3: orange grids 6 5 1 2 3 4 5 6
Steel

16. Market Failure
The market leads to the outcome where the marginal private benefit to consumers is equal to the marginal private cost of producers
When externalities exist and are of significant size, the market equilibrium outcome is not a socially optimal one
Market failure occurs when markets, operating on their own, do not lead to a socially optimal allocation of resources

17. Explicit and Implicit Costs
Explicit costs of production are the ones incurred by the producer to buy or hire the resources required to produce
Actual cost outlays
Implicit costs of production are the ones incurred by the producer for the use of self-owned, self-employed resources required to produce
Household members’ labor

18. Marginal Social vs Marginal Private Cost
A firm dumping its waste into the river produces negative externalities by increasing the social cost of production
The market outcome in this case is not socially optimal since the private supply curve is not the social supply curve
In case of negative externalities, too much production occurs

19. Market Equilibrium without Externalities$ 14 12
S = MPC 10 8 7 6 4
D = MPB 2 1 2 3
3.5 4 5 6
Steel

20. Marginal Private Cost vs Marginal Social Cost
The true cost of producing electric power is the cost that would exist were the river not polluted by the paper producers
However, the power producer has to clean the water so from their perspective the cost of producing power has to include the cost of cleaning water
The market gets it wrong again since it overestimates the true costs of power production by internalizing the negative externality produced by the paper mill so that too little power is produced

21. Why Polluters Pollute
Property rights in the environment either nonexistent or not enforced
Much of environment’s services shared by entire population

22. Consumer Surplus and the Demand Curve
A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good.
Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyer’s willingness to pay and the price paid.

23. The Demand Curve for Used Textbooks
Price of book
Aleisha
$59
Potential buyers
Willingness to pay
Aleisha
$59 45
Brad
Brad 45
Claudia 35 35
Claudia
Darren 25
Edwina 10 25
Darren
A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good. 10
Edwina D 1 2 3 4 5
Quantity of books

24. Willingness to Pay and Consumer Surplus
Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good.
The term consumer surplus is often used to refer to both individual and total consumer surplus.

25. Consumer Surplus in the Used Textbook Market5 4 3 2 1
Aleisha
Brad
Claudia
Darren D
Edwina
$59 45 35 30 10 25
Price of book
Quantity of books
Aleisha’s consumer surplus:
$59-$30=$29
Brad’s consumer surplus:
$45-$30=$15
The total consumer surplus is given by the entire shaded area - the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia - equal to $29 + $15 + $5 = $49.
Claudia’s consumer surplus: $35-$30=$5
Price = $30

26. Consumer Surplus in the Used Textbook Market

27. Consumer Surplus
The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price.
1 million
$1,500
Price of computers
Quantity of computers D
Consumer surplus
Price = $1,500

28. How Changing Prices Affect Consumer Surplus
A fall in the price of a good increases consumer surplus through two channels:
A gain to consumers who would have bought at the original price and
A gain to consumers who are persuaded to buy by the lower price.

29. Consumer Surplus and a Fall in the Price of Used Textbooks5 4 3 2 1 D
$59 45 35 30 10 25 20
Aleisha
Brad
Claudia
Darren
Edwina
Price of book
Quantity of books
Increase in Aleisha’s consumer surplus
Increase in Brad’s consumer surplus
Increase in Claude’s consumer surplus
Original price = $30
Darren’s consumer surplus
New price = $20

30. A Fall in the Market Price Increases Consumer Surplus
1 million
200,000
1,500
$5,000
Price of computers
Quantity of computers D
Increase in consumer surplus to original buyers
Consumer surplus gained by new buyers

31. Producer Surplus and the Supply Curve
A potential seller’s cost is the lowest price at which he or she is willing to sell a good.
Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the seller’s cost.
Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good.

32. The Supply Curve for Used Textbooks
Price of book
Potential sellers S
Cost
Andrew $5
$45
Engelbert
Donna 15 25
Carlos 35
Donna
Betty 35
Engelbert 45 25
Carlos 15
Betty 5
Andrew 1 2 3 4 5
Quantity of books

33. Producer Surplus in the Used Textbook Market5 4 3 2 1 S
$45 35 30 25 15
Price of book
Quantity of books
Engelbert
Donna
Carlos
Betty
Andrew
Price = $30
Andrew’s producer surplus
Betty’s producer surplus
Carlos’s producer surplus

34. Price of wheat (per bushel) Quantity of wheat (bushels)
Producer Surplus
The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. $5
1 million
Price of wheat (per bushel)
Quantity of wheat (bushels) S
Price = $5
Producer surplus

35. Price of wheat (per bushel) Quantity of wheat (bushels)
A Rise in the Price Increases Producer Surplus
1.5 million $7 5
1 million
Price of wheat (per bushel)
Quantity of wheat (bushels)
Increase in producer surplus to original sellers
Producer surplus gained by new sellers S

36. Putting It Together: Total Surplus
The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus.
The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity.

37. Total Surplus Price of book S Consumer surplus E Equilibrium price $30
Quantity of books
1,000
$30 S D
Producer surplus
Consumer surplus
Equilibrium quantity
Equilibrium price E

38. Pollution and Resource Allocation
Price $
MSC
Loss of well-being to society B
S = MPC 11 C 10 A 9
Click 1: MSC curve
Click 2: grids at r0 and 10
Click 3: grids at r1 and 11
Click 4: triangle
Click 5: Callout flies in from top right, waits 2 seconds and circles triangle
Click 6: Callout flies out to bottom right
D = MPB = MSB r0 r1
Reams per day

39. Pollution and Resource Allocation
Price $
S = MPC
MSC A 12 10 C B
D = MPB = MSB r0 r1
Kilowatt-hours per day

40. Externalities and the Market Outcome
When a negative externality in production exists, the outcome in the markets do not reflect an allocation of resources that maximizes social well-being
Market incentives in case there are externalities lead to suboptimal production levels
For the polluter, production costs are artificially reduced so they overproduce
For the power producers, production costs are artificially increased so they underproduce

41. How Much Pollution Control is Appropriate?
We need to apply cost and benefit analysis to answer this question
Measurement of both costs and benefits of pollution control measures is difficult
As pollution control increases, marginal costs of it increase while the marginal benefits of it decline
The level of pollution control that yields the maximum net social benefit is the one at which the marginal social benefit equals marginal social cost

42. Why Polluters Pollute
Property rights in the environment either nonexistent or not enforced
Much of environment’s services shared by entire population

43. The Appropriate Level of Pollution Control
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Pollution Control or Eliminated Stench
Total Social Cost of Control ($000)
Marginal Social Cost of Control ($000)
Per-Person Marginal Benefit of Control
Marginal Social Benefit of Control ($000)
Total Social Benefit of Control ($000)
Net Social Benefit of Control ($000)
1st 10% 10
10.00
100 90
2nd 10% 20
8.00 80
180
160
3rd 10% 30
6.00 60
240
210
4th 10% 40
4.00
280
5th 10% 50
2.00
300
250
6th 10%
1.60 16
316
256
7th 10% 70
1.20 12
328
258
8th 10%
.80 8
336
9th 10%
.40 4
340
10th 10%
.20 2
342
242
4-43

44. Direct Controls Assumes regulatory bodies know what social optimum is
Assumes regulatory bodies can allocate pollution reducing costs efficiently
Fail to provide polluters with economic incentives not to pollute so enforcement can be a problem

45. Indirect Controls Economic incentives are there
Incentives to overproduce are reduced for the polluter
Determining the benefits of cleaning the waste is difficult
Enforcement is not easy
Taxes are a political matter

46. Pollution Rights Markets
A market that exists when firms are allowed to buy and sell government-issued licenses granting the holder the right to create a certain amount of pollution
Economic incentives are there
Any desired level of pollution can be achieved by the market rather than administrative means

47. What Can Be Done About Pollution? Creation of Pollution Rights Markets
Pollution rights license
Pollution rights market
Clean Air Act of 1990