1. Copyright © 2002 by Thomson Learning, Inc. A Lecture Presentation in PowerPoint to accompany Exploring Economics Second Edition by Robert L. Sexton Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0030342333

2. Copyright © 2002 by Thomson Learning, Inc. Chapter 16 The Environment

3. Copyright © 2002 by Thomson Learning, Inc. 16.1 Negative Externalities Whenever an economic activity has benefits or costs that are shared by persons other than the demanders or suppliers of a good or service, an externality is involved. Negative externalities exist anytime the social costs of producing a good or service exceed the private costs.

4. Copyright © 2002 by Thomson Learning, Inc. 16.1 Negative Externalities The classic example of a negative externality is pollution. Soot and other forms of "crud" in the air are a byproduct of making steel Costs are imposed on others not buying or selling steel from the steel mill. Steel maker is governed by demand and supply. Producers do not worry about the external costs they do not have to pay.

5. Copyright © 2002 by Thomson Learning, Inc. 16.1 Negative Externalities When a negative externality is involved, the marginal social costs of production are higher than the firm's private costs by the costs that spillover to other members of society from the pollution produced. The firm does not pay all of the social costs, and therefore creates too much output and too much pollution.

6. Copyright © 2002 by Thomson Learning, Inc. The Effect of a Negative Externality P Social Q Social Q Private Price of Steel Quantity of Steel 0 P Private D S = MPC MPC (MPC + External costs)

7. Copyright © 2002 by Thomson Learning, Inc. 16.1 Negative Externalities When negative externalities are internalized, People who incur the costs of pollution are compensated; Firms produce less output and charge higher prices. The optimal output occurs where the marginal social costs are equal to the marginal social benefits.

8. Copyright © 2002 by Thomson Learning, Inc. 16.1 Negative Externalities It is generally accepted that in the absence of intervention, the market mechanism will underproduce goods and services with positive externalities; overproduce those with negative externalities.

9. Copyright © 2002 by Thomson Learning, Inc. 16.1 Negative Externalities But the exact extent of these market misallocations is quite difficult to establish in the real world because the divergence between social and private costs and benefits is often difficult to measure. No one really knows because no market fully measures those costs. Indeed, the costs are partly nonpecuniary, meaning that no outlay of money occurs.

10. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment While measuring externalities, both negative and positive, is often nearly impossible, that does not necessarily mean that it is better to ignore the externality and allow the market solution to operate. The market solution will almost certainly result in excessive output by polluters unless some intervention occurs.

11. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment One approach to dealing with externalities is to require private enterprise to produce their output in a manner that would reduce the negative externality below the amount that would persist in the absence of regulation.

12. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Compliance standards approach Regulatory agency such as the EPA identifies and then enforces a standard equal to the maximum amount of pollution that firms can produce per unit of output per year. The standards force companies to find less pollution ‑ intensive ways of producing. Compliance standards approach has led to some reduction in pollution levels from what would otherwise be the case.

13. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment In many respects, a clean environment is no different from any other desirable good. In a world of scarcity, we can increase our consumption of clean environment only by giving up something else. Only by considering the additional cost as well as the additional benefit of increased consumption of clean air and water, can decisions on the desirable combination of goods to consume be properly made.

14. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Pollution elimination, like nearly everything else, is subject to diminishing returns. A large amount can be initially eliminated inexpensively, but getting rid of more may prove more costly. The benefits from eliminating pollution might decline as more is eliminated.

15. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Optimum pollution control occurs when the marginal benefits from the reduction of pollution equal the marginal costs, both pecuniary and nonpecuniary, of the pollution control. Because of measurement problems, however, it is difficult to state whether we are generally below, at, or above the optimal pollution level.

16. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Q*Q*Q2Q2 Q1Q1 Marginal Social Benefits Marginal Social Costs Amount of Pollutants Eliminated Marginal Social Benefits and Marginal Social Costs MSB < MSC MSB > MSC

17. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment People with different preferences and situations are simply going to have different ideas about the costs and benefits of pollution abatement. It is practically impossible to get widespread agreement on what the appropriate level of pollution should be.

18. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Conflicts are inevitable because different people have different preferences and face different costs. Those most eager to clean up the environment are often those who will reap many of the benefits and pay few of the costs.

19. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment If everyone could pay for and consume a preferred level of environmental quality, independent of the level paid for and consumed by others, controversy over environmental protection would largely disappear. But there is no way to completely avoid this type of controversy.

20. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment However, one way people often moderate controversies of this type is by sorting themselves out in relatively homogeneous groupings, making them more likely to avoid socially divisive controversies than are communities containing more diverse populations.

21. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Another means of solving the misallocation problem posed by the existence of externalities is for the government to create incentives for firms to internalize the external costs or benefits resulting from their activities.

22. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment If the government levied a pollution tax equal to the external costs imposed: The firm’s costs would equal the true marginal social cost. The firm would alter its output and pricing decisions to take into account its higher marginal cost, reduce output (and pollution) and raise prices, seek new, less pollution ‑ intensive methods of production.

23. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Using taxes to internalize external costs is very appealing because it allows the relatively efficient private sector to operate according to market forces in a manner that takes socially important spillover costs into account.

24. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment A major objection is that it is very difficult or even impossible to measure externalities with any precision. Choosing a tax rate involves some guesswork, and poor guessing might lead to a solution that is far from optimal. But it is likely to be better than ignoring the problem.

25. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Economists would like to see greater effort made to force internalization of externalities through taxes because firms will seek out the least-expensive approaches to clean up, since they want more profits.

26. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Economists see an opportunity to control pollution through a government- enforced system of property rights. In this system, the government issues transferable pollution rights that give the holder the right to discharge a specified amount of pollution into the air.

27. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment In this plan, firms have an incentive to lower their levels of pollution because they can sell their permits if they go unused. In a system of transferable pollution rights, those firms that can lower their emissions at the lowest costs will do so and trade their pollution rights to firms that cannot reduce their pollution levels as easily.

28. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment That is, each polluter—required to reduce pollution to the level allowed by the number of rights held or buy more— will be motivated to eliminate all pollution that is cheaper than the price of pollution rights.

29. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Using transferable pollution rights, generating the least-cost pattern of abatement does not require any information about the techniques of pollution abatement on the part of the government.

30. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Faced with a positive price for pollution rights, each polluter has every motivation to discover the cheapest way to reduce pollution and to utilize it. Nor does the EPA need to know anything about the differences in abatement costs among polluters.

31. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Each polluter is motivated to reduce pollution as long as the cost of reducing one more unit is less than the price of pollution rights. The information and incentives generated by private ownership and market exchange of these pollution rights automatically leads to the desirable pattern of pollution abatement.

32. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment The pollution-rights approach also creates an incentive for polluters to develop improved pollution-abatement technologies. The absence of prices for the use of our atmosphere and waterways, however, make it privately unprofitable to worry about conserving their use.

33. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment Marketable pollution rights could remedy this neglect. Objectives of an ideal pollution control policy are reducing pollution to the efficient level, achieving pollution reduction as cheaply as possible, and motivating advances in abatement technology.

34. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment But these can never be fully realized, particularly the first objective, because without such market exchanges and prices, we have no way of knowing the value people place on clean air or water. And without this information, there is no way of determining the efficient level of air or water pollution.

35. Copyright © 2002 by Thomson Learning, Inc. 16.2 Public Policy and the Environment In the absence of market exchange, we have to rely on the political process to determine the efficient level of pollution. The existence of externalities and the efforts to deal with them in a manner that will enhance the social good can be looked at as largely being a question as to the nature of property rights.

36. Copyright © 2002 by Thomson Learning, Inc. 16.3 Property Rights If no externalities existed in the world, there would be relatively few reasons for prohibiting property owners from using their property in any manner they voluntarily chose. Sometimes, in order to deal with externalities, governments radically alter property rights arrangements.

37. Copyright © 2002 by Thomson Learning, Inc. 16.3 Property Rights Professor Ronald Coase demonstrated that where property rights are clearly defined and transactions costs are low, voluntary exchange will eliminate externalities. Voluntary exchange will not eliminate externalities when transactions cost are not low.

38. Copyright © 2002 by Thomson Learning, Inc. 16.3 Property Rights Private negotiations are limited because of ambiguity regarding the property rights involved, high transactions costs when large numbers of people are affected, and the fact that people cannot be excluded from the benefits from environmental cleanup if they don’t contribute to the costs involved.

39. Copyright © 2002 by Thomson Learning, Inc. 16.3 Property Rights Hence, in practice, private agreements are unlikely to solve many problems of market failure.