Class 7 and. 8: Externalities and Environmental Economics

An externality is a non-priced effect on the welfare of one agent in the economy resulting from the activities of another.
Negative Externalities: Activities with negative externalities lead to a level of activity that is too high from a social perspective. The socially optimal level is usually greater than zero.
Pollution Abatement: This activity provides a positive externality by reducing pollution per unit of activity.

Conditions: Requires well-defined property rights and negligible transaction costs.
Outcome: Under these conditions, Pareto efficiency can be achieved through private negotiation, regardless of how property rights are initially allocated.

Scale Effect: Policy reduces the volume of pollution-intensive economic activity.
Composition Effect: Policy shifts economic activity from pollution-intensive to less-intensive forms.
Technique Effect: Policy induces a shift to less-polluting technology.
Extensive/Intensive Margins: Intensive refers to "how much" (consumption), Extensive refers to "how many" (investment).

Efficiency: Policies are efficient if they adhere to the equi-marginal principle: the cost of abatement of the next unit of pollution equals marginal damage ( $SMC = SMB$ for abatement). Dynamic efficiency refers to innovation incentives.
Fairness: Addresses how the burden of policy is distributed (e.g., income progressive vs. regressive).
Environmental Dependability: Assesses a policy's potential to significantly reduce emissions, considering rebound effects, focus on margins, and unintended consequences.
Political Feasibility: Constraints imposed by democratic realities, influenced by urgency, invisibility, uniformity, cost (admin costs), and safety/simplicity.

Voluntary Solutions: e.g., third-party audits, ecolabels.
Command and Control: Government sets quantity controls or standards (e.g., emission standards).
Market-based Solutions: Taxes and Tradable Permits.
- Taxes: Government taxes the polluting activity (e.g., carbon tax). Taxes are set such that $Tax = Externality$ at the efficient quantity ( $Q^*$ ).
- Tradable Permits (Cap and Trade): Government sets the total quantity (cap) of emissions. Firms bid on and trade permits, determining the equilibrium price. Provides emission certainty.

Both provide incentives for pollution reduction and can achieve aggregate abatement at the lowest cost.
Tradable permits assure that aggregate pollution does not exceed a stipulated level (cap).
Taxes provide firms with more cost certainty.

Represents the economic cost of an additional tonne of carbon dioxide emissions.
Estimates are updated through various modeling efforts.

Refers to how revenues from environmental taxes (e.g., carbon tax) are used.
Can confer a "double dividend" (efficiency gains + reduced distortionary taxes).
Revenues can subsidize abatement, provide rebates to households, or protect energy-intensive sectors (EITE).

A U.S. climate bill primarily focused on abatement subsidies.
Modeling suggests it will be effective in reducing emissions and offers co-benefits, such as avoided premature deaths from air pollution.

Negative externalities lead to too much activity; positive externalities lead to too little, resulting in economic inefficiency.
The externality problem stems from incomplete property rights and transaction costs.
Environmental policy must balance efficiency, fairness, dependability, and political feasibility.