Chapter 31 - External Costs and Environmental Policy

31.1 The Optimal Level of Pollution

• To reduce air pollution, we could eliminate trucks, but shipping goods by horse-drawn wagon would result in higher freight costs and higher prices for most products-and different sorts of pollution.

• We could reduce water pollution by shutting down all the paper mills, but reverting to parchment and slate boards would be unwieldy.

• We can use the marginal principle to determine the optimal level of pollution abatement.

• The marginal principle focuses our attention on the trade-offs from pollution-is costs and benefits.

• The benefits are you would have better health, increased enjoyment of the natural environment, and lower production costs.

• On the other hand, pollution abatement is costly because resources-labor, capital, and land are used in the abatement process.

• To illustrate, the destination of the optimum level of pollution, consider a lake shared by a steel mill and a fishing firm.

  • The mill dumps waste into the lake, and pollution degrades the fish habitat and decreases the fish harvest.
  • The firm can abate pollution, and the positively sloped curve is the marginal cost of abatement, which increases from $3 for the first unit abated (point b) to $13 for the last unit abated (point f).
  • The negatively sloped curve is the marginal benefit of abatement, equal to the increase in the fish harvest from a 1-ton decrease in pollution.
  • The marginal benefit decreases as abatement increases, from $21 for the first ton of abatement (point a) to $1 for the last ton abated (point g).

• We can apply the marginal principle to determine the socially efficient outcome.

  • The efficient outcome is shown where the marginal benefit of abatement equals the marginal cost at 300 tons of abatement and 200 tons of waste.
  • For any smaller quantity of abatement, the marginal benefit exceeds the marginal cost, so increasing abatement is more beneficial than costly.
  • The marginal benefit of abatement is less than the marginal cost.

  

• The Coase bargaining solution, named after economist Ronald Coase, applies to a situation when there is a small number of affected parties, and the transaction costs of bargaining are relatively low.

• Things would change if we assigned the property rights to the fishing firm rather than the steel mill.

  • In this case, we would start with a pristine lake, with 0 tons of pollution and thus 500 tons of abatement.
  • Going from 1 ton of pollution to 0 generates a cost to the steel firm of $13.
  • Allowing the first ton of waste would harm the fishing firm by only $1 and save the mil $13 cost savings, so there is room to bargain.

• In general, Coase bargaining requires a small number of affected parties and small transaction costs.

  • When the number of affected parties is large, the bargaining process won’t work, and the solution to a spillover problem requires a centralized policy.

31.2 Taxing Pollution

• The private cost of production is the production cost borne by a producer, which typically includes the cost of labor, capital, and materials.
• External production is a cost incurred by someone other than the producer.
• The social cost of production is the private cost plus external cost.
• The pollution tax is a tax or charge equal to the external cost per unit of pollution.
• A pollution firm will respond to a pollution tax the same way it responds to the prices of labor and materials.
  • The firm will use the marginal principle to decide how much waste to generate and how much to abate.
  • The form will increase the level of abatement as long as the marginal benefit exceeds the marginal cost and stop when the marginal benefit equals the marginal cost.
• A pollution tax changes the production process as firms switch to cleaner technology.

31.3 Traditional Regulation

• Consider an area with two electricity generators, firm L (low cost) and firm H (high cost).
  • Suppose that in the absence of pollution-abatement efforts, each firm would discharge 2 tons of pollution per hour.
  • The government sets a target abatement level of 2 tons of SO2 per hour, divided equally between the two firms.
  • Under this uniform abatement policy, the government will issue four pollution permits to each firm, forcing each firm to cut pollution from 2 tons to 1 ton.
  • The marginal abatement cost of firm L is $2,000 and the marginal abatement cost for firm H is $5,000.
  • Under the uniform-abatement policy, the total cost of abatement is $2,000 for firm L and $5,000 for firm H, for a total of $7,000.
  • A policy of uniform abatement is inefficient because it does not take advantage of the difference in abatement cost between the two firms.
  • The low-cost firm abatement costs avoid the tax, while the high-cost firm incurs tax costs to avoid costly abatement.
• One advantage of the command-and-control policy is its predictability.

31.4 Marketable Pollution Permits

• The marketable pollution permits is a system under which the government picks a target pollution level for a particular area, issues just enough pollution permits to meet. The pollution target, and allows firms to buy and sell the permits; also known as the cap-and-trade system.
• A government would run a system of marketable pollution permits by:
  • Picking a target pollution level for a particular area.
  • Issues just enough permits to meet the pollution target.
  • Allow firms to buy and sell the permits.
• The Principle of Voluntary Exchange is a voluntary exchange between two people that makes both people better off.
• Making the permits marketable exploits differences in abatement costs across firms, so we get the same level of abatement at a lower total cost.
• A model of supply and demand can be used to represent the market for pollution permits.
  • The supply curve for permits is vertical at the fixed number of permits provided by the government.
  • The demand for permits comes from firms that can use a permit to avoid paying for pollution abatement, and the willingness to pay for a permit equals the savings in abatement costs.
  • The marginal cost of abatement will be relatively low.
• A pollution permit allows a firm to avoid paying for abatement, and the higher the abatement cost that can be avoided, the larger the amount a firm is willing to pay for a permit.
  • A technological innovation that decreases abatement costs will encourage firms to use the new technology to abate pollution rather than buying permits that allow pollution.
  • As a result, the demand curve for permits shifts downward and to the left, and the equilibrium price of permits decreases.

31.5 External Costs from Automobiles

• The use of automobiles generates external costs.

  • First, a person who uses a congested highway slows down other travelers, imposing time costs on other people.
  • Second, automobiles generate air pollution, so drivers impose external costs on people sensitive to air pollutants.
  • The third is motor-vehicle accidents-collisions with other vehicles, bicycles, and pedestrians.

• Ozone pollution, also known as smog, is one of our most persistent environmental problems.

  • Because of health and other problems created by smog, the EPA has established standards for smog concentrations in urban areas.

• The automobile is by far the biggest source of smog-cause it is a pollutant.

• Burning gasoline also contributes to global warming.

• A gasoline tax would be inferior to an elastic pollution tax because the driver’s gasoline tax bill would not depend directly on pollution, so there would be less incentive to drive cleaner cars.

• Gas mileage varies across vehicles, and a person in a car with better gas mileage would pay less than the external cost of collisions.