1. Environmental and Natural Resource Economics 3rd ed. Jonathan M
Environmental and Natural Resource Economics 3rd ed. Jonathan M. Harris and Brian Roach Chapter 3 – The Theory of Environmental Externalities
Copyright © 2013 Jonathan M. Harris

2. Figure 3.1: The Market for Automobiles
Demand
(Marginal Benefits)
Price
Quantity of Automobiles PM
Supply (Private Marginal Costs) QM
Market Equilibrium •
The standard supply and demand graph reflects private benefits and costs, but does not include social costs and benefits such as environmental externalities.
Note: Private marginal costs are the costs of production to private producers.

3. Total ($billion/year)
Table 3.1: External Costs of Automobile Use in the United States
Cost Category
Dollars/gallon
Total ($billion/year)
Climate change
0.06 10
Oil dependency
0.12 20
Local pollution
0.42 71
Congestion
1.05
177
Accidents
0.63
106
Total externality costs
2.28
384
Empirical research shows that external costs of automobile use are significant. In this study, a relatively low estimate of the costs of climate has been used. A higher estimate (such as those discussed later in the text in Chapter 18) could raise the overall external costs to equal or exceed the current cost of gasoline.
Sources: Delucchi, 1997; Parry et al., 2007.
Note: Total externality cost estimated by multiplying Parry et al.’s per-gallon damages by annual highway fuel consumption of 168 billion gallons, based on data from the 2012 Statistical Abstract of the United States (table 929).

4. Figure 3.2: The Market for Automobiles with Negative Externalities
Demand (Marginal Benefits)
Price
Quantity of Automobiles PM
Supply (Private Marginal Costs) QM
Market Equilibrium •
Social Marginal Costs (Private + External)
Social Optimum Q* P*
External Costs
Economic theory implies that external costs should be included in a complete analysis of supply and demand. The inclusion of externalities indicates that the market equilibrium is no longer optimal, and the true social optimum lies at a higher price and lower quantity produced.

5. Figure 3.3: Automobile Market with Pigovian Tax
Demand (Marginal Benefits)
Price
Quantity of Automobiles PM
Supply (Private Marginal Costs) QM •
Supply with Tax Q* P*
External Costs P0
Equilibrium with Tax
A Pigovian tax can be used to internalize externalities. This will achieve the result that price rises and equilibrium quantity demanded falls, achieving the socially optimal equilibrium if the tax accurately reflects the cost of the externality. The price does not rise by the full amount of the tax, indicating that the burden of the tax is shared between consumers and producers.

6. Figure 3.4: The Market for Solar Energy with Positive Externalities
Demand (Private Marginal Benefits)
Price
Solar Energy PM
Supply (Private Marginal Costs) QM •
External Benefits
Social Marginal Benefits Q*
A positive externality such as pollution reduction can be shown on the demand side as an increase in social marginal benefits, above the private benefits shown by the market demand curve.

7. Figure 3.5: The Market for Solar Energy with a Subsidy
Demand (Private Marginal Benefits)
Price
Solar Energy PM
Supply (Private Marginal Costs) QM •
External Benefits
Social Marginal Benefits Q*
Supply with Subsidy P*
Internalization of a positive externality is usually achieved by a subsidy, which shifts costs of supply downward. The effect is to increase quantity while lowering price.

8. Figure 3.6: Welfare Analysis of the Automobile Market
Demand (Marginal Benefits)
Price
Quantity of Automobiles PM
Supply (Private Marginal Costs) QM
Market Equilibrium • A B
A basic market analysis shows benefits to consumers (consumer surplus = A) and benefits to producers (producer surplus = B) as areas between the demand and supply curves to the left of equilibrium.

9. Figure 3.7: Welfare Analysis of the Automobile Market with Externalities
Demand (Marginal Benefits)
Price
Quantity of Automobiles PM
Supply (Private Marginal Costs) QM
Social Marginal Costs Q* A’ B’ C •
Adding externalities complicates the welfare analysis, showing that in addition to consumer and producer surplus, there is an area (shown in dark blue) of pollution costs, making the market equilibrium non-optimal. Net social benefit at the market equilibrium are A’ + B’ – C where C is the triangle of net loss between the “optimal” and market equilibria.

10. Figure 3.8: The Welfare-Improving Effect of a Pigovian Tax
Demand (Marginal Benefits)
Price
Quantity of Automobiles P*
Supply Without Tax QM
Supply With Tax Q*
A’’
B’’ D •
Per-Unit Tax
Equilibrium With Tax
If a tax is imposed to internalize the externality, the areas of consumer and producer surplus shrink due to a reduction in quantity produced and consumed. There is a remaining total cost of pollution equal to area D, but the maximum net social benefit of A’’ + B” is achieved.

11. Figure 3.8: Application of the Coase TheoremD C B
Marginal Benefits to Company
Marginal Costs to Community
Since emission of effluent generates both net benefits to the company and net costs to the community, the level of net social benefit will vary depending on the level of effluent emission. If that level was zero, there would be no costs to the community, but also no net benefits. At a level of 80, the company gains benefits equal to A+B+C+D, but the community loses C+D+E+F, for a net social effect of A+B – (E+F). The best solution is an effluent level of 50, leading to company befits of (A+B+C) and community costs of C, with a net social benefit of A+B.

12. Table 3.2: Gains and Losses from Negotiation with Different Property Rights
If community holds rights
If company holds rights
Net gain/loss to community
+ $7,500 payment
– $3,750 environmental costs
+ $3,750
– $4,500 payment
– $8,250
Net gain/loss to company
+ $13,750 total benefits
– $7,500 payment
+ $6,250
+ $4,500 payment
+ $18,250
Net social gain
+$10,000
The socially optimal equilibrium can be achieved by negotiation, regardless of which party holds the property right to emit effluent, or to prohibit its emission. The distribution of benefits is different depending on which party holds the rights, but in either case the optimum result can be achieved through negotiation, and the net social benefit is the same.

13. Figure A3.1: Demand Curve for Gasoline
Price ($/gallon)
Quantity Demanded (thousand gallons/week)

14. Figure A3.2: A Change in Demand
Quantity Demanded (thousand gallons/week)
Price ($/gallon)

15. Figure A3.3: Supply Curve For Gasoline
Quantity Supplied (thousand gallons/week)
Price ($/gallon)

16. Figure A3.4: A Change in Supply
Quantity Supplied (thousand gallons/week)
Price ($/gallon)
Figure A3.4

17. Figure A3.5: Equilibrium in the Market for Gasoline
Quantity (thousand gallons/week)
Price ($/gallon)
Supply
Demand
Figure A3.5

18. Figure A3.6: A New Equilibrium with a Change in Demand for Gasoline
Quantity (thousand gallons/week)
Price ($/gallon)
Supply D0 D1
Figure A3.6

19. Figure A3.7: Consumer and Producer Surplus
Quantity (thousand gallons/week)
Price ($/gallon)
Supply
Demand
Consumer Surplus
Producer Surplus

20. Figure A3.8: Welfare Analysis of Automobile Market with Externalities
Demand (Marginal Benefits)
Price
Quantity of Automobiles PM
Supply (Private Marginal Costs) QM •
Social Marginal Costs Q* P* A B C D E F G H I
Figure A3.8

21. Figure A3.9: Welfare Analysis of Automobile Market with Pigovian Tax
Demand (Marginal Benefits)
Price
Quantity of Automobiles PM
Supply (Private Marginal Costs) QM •
Supply With Tax Q* P* A B C D E F G H I J P0
Figure A3.9

22. Figure A3.10: Automobile Market Example
Demand
Supply
Consumer Surplus
Producer Surplus
Figure A3.10

23. Figure A3.11: Automobile Market Example with Externality Tax
Demand
Supply (Private)
Supply with Tax
Tax Revenue

24. Figure A3.12: Welfare Analysis of a Positive Externality
Demand (Private Marginal Benefits)
Price
Solar Energy PM
Supply (Private Marginal Costs) QM • A B C D E F
Social Marginal Benefits Q*

25. Figure A3.13: The Market for Solar Energy with a Subsidy
Demand (Private Marginal Benefits)
Price
Solar Energy PM
Supply (Private Marginal Costs) QM • A B C D E F
Social Marginal Benefits Q* G H I J K L M
Supply with Subsidy P0 P*