1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 17 The Economics of Environmental Protection

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-2 In this chapter you will learn to 1. Describe how an externality can be internalized, and how this can lead to allocative efficiency. 4. Describe and evaluate some of the most common arguments against market-based environmental policies. 3. Explain why market-based policies such as emissions taxes and tradable pollution permits can improve economic efficiency. 2. Explain why direct pollution controls are often inefficient.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-3 Pollution as an Externality The production of most goods generates some pollution that imposes costs on other members of society. The Economic Rationale for Regulating Pollution The socially optimal level of output is at the quantity where all marginal costs, private plus external, equal the marginal benefit to society.

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-4 One solution is to internalize the externality – a process that results in a producer of consumer taking the account of a previously external effect. Pollution is a negative externality. - the social marginal cost of production exceeds the private marginal cost of production. Negative Externality

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-5 Figure 17.1 A Pollution Externality in a Competitive Market With a negative externality, MC s exceeds MC p... … with the result that too much gets produced.

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-6 How can this be achieved? If the externality can be internalized (by making the producers bear the full external cost), allocative efficiency can be achieved. The socially optimal level of output is where the social marginal costs -- private plus external -- equal the marginal benefit to society. Internalizing Externality

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-7 Figure 17.2 The Optimal Amount of Pollution Abatement

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-8 Direct control is a form of environmental regulation that either: stipulates the use of specific technology, or prohibits certain polluting behaviour altogether. Pollution-Control Policies Direct Controls

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-9 The use of direct controls is usually economically inefficient: - because the MC of abatement is not equated across different firms Problems with Direct Control Direct pollution controls are inefficient because they do not minimize the cost of a given amount of pollution abatement

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-10 Figure 17.3 The Inefficiency of Direct Pollution Controls Direct pollution controls usually do not minimize the cost of a given amount of pollution abatement.

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-11 Figure 17.4 The Efficiency of Emissions Taxes With a tax of $t per unit of pollution emitted, the tax becomes the firm’s marginal benefit of pollution abatement.

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-12 Set the emissions tax equal to the size of the marginal external cost - this fully internalizes the externality APPLYING ECONOMIC CONCEPTS 17.1 Garbage Collection and “Pay-As-You-Throw” But the information required to know the optimal tax rate is often unavailable. Efficient amount of pollution

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-13 The government could issue (or auction) a given number of tradable emissions permits. The price of the permit is the MB of abatement. Firms will abate pollution until the MB equals the MC. Pollution is abated at minimum cost. Tradable Emissions Permits This kind of problem is also called “cap and trade.”

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-14 Figure 17.5 The Efficiency of Tradable Emissions Permits

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-15 With an emissions tax, government must determine the optimal tax rate. With pollution permits, the market for permits determines the equilibrium permit price, but government needs to set the total amount of permits. So how does the government set the optimal quantity that leads to the optimal equilibrium price -- the one that fully internalizes the externality? Pollution Permits

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-16 Figure 17.6 The Market for Tradable Emissions Permits

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-17 Technological Change Government regulation tends to respond only slowly to changes in technology or market conditions. Improvements in abatement technology will lead to a reduction in the demand for emissions permits and thus a reduction in their equilibrium price. The total cost of a given amount of pollution abatement will still be minimized.

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-18 The U.S. Experience with Tradable Emission Permits The cap and trade approach has been implemented in: – California’s 2006 greenhouse gas reduction program – Kyoto Protocol’s strategy for greenhouse gas reduction Problems with Tradable Emissions Permits Technical difficulties in measuring pollution and in designing mechanisms to ensure that firms and households comply with regulations. Tradable Emission Permits

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-19 The Politics of Pollution Control Several groups argue against the use of market-based environmental policies - especially tradable pollution permits But the growing concern about global warming and the debate over the Kyoto Protocol have led to more discussion and growing acceptance of the basic principles.

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-20 Producers Emissions taxes or permits are costly, and firms naturally complain. These policies, if implemented, signal the end of a free ride that firms have been taking at society’s expense. Firms also argue that such policies reduce overall welfare because of reduced output and employment: - but reduced output of the polluting products is part of the solution that increases welfare!

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-21 The General Public But the relevant question is: How can society best reduce pollution? Emissions taxes and tradable emissions permits lead to pollution reduction with the least cost. There is also opposition to having some firms reduce pollution less than others. Shouldn’t they reduce by equal amounts? Some people have a moral opposition to giving anyone the “right” to pollute.

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-22 Environmentalists They often don’t see how private firms could ever be induced to do what is desirable for society. As a result, they tend to prefer the use of direct controls. Some argue that clean air and water are above monetary evaluation and should be treated in special ways. Economists can emphasize that market-based schemes are often more efficient than other policies -- which means more pollution abatement with a given amount of resources.

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-23 Summary The efficient solution to pollution involves internalizing the externality. If properly designed, such market-based environmental policies can reverse the effects of the pollution externality. However, there is considerable opposition among some environmentalists and some of the general public to market- based environmental policies. Tradable emission permits also generate skepticism due to the failure to appreciate how markets work to allocate resource efficiently.