Chapter 14 Environmental Economics Lecture Slides Economics for Today Irvin B. Tucker © 2011 South-Western, a part of Cengage Learning

What will I learn in this chapter? Why competitive markets may fail to protect the environment How we might correct the market failure The pros and cons of government intervention © 2011 South-Western, a part of Cengage Learning

What assumption is made in this chapter? There is sufficient foreign and domestic competition to allow us to use the perfectly competitive model © 2011 South-Western, a part of Cengage Learning

When does economic efficiency exist? When marginal benefit equals marginal cost © 2011 South-Western, a part of Cengage Learning

Who is a third party? People outside the market transaction who are affected by the product © 2011 South-Western, a part of Cengage Learning

What are private benefits and costs? Benefits and costs to the decision maker, ignoring benefits and costs to third parties © 2011 South-Western, a part of Cengage Learning

What are externalities? Benefits or costs that are not considered by market buyers and sellers © 2011 South-Western, a part of Cengage Learning

What is an example of a negative externality? Pollution from cars © 2011 South-Western, a part of Cengage Learning

What is an example of a positive externality? The enjoyment you derive from your neighbor’s well-kept yard © 2011 South-Western, a part of Cengage Learning

What happens when externalities are present? Competitive markets are not likely to achieve economic efficiency © 2011 South-Western, a part of Cengage Learning

What are social benefits? The sum of benefits to everyone, including both private benefits and external benefits © 2011 South-Western, a part of Cengage Learning

What are private costs? Production costs of capital, labor, land, and entrepreneurship © 2011 South-Western, a part of Cengage Learning

What are social costs? The sum of costs to everyone, including both private costs and external costs © 2011 South-Western, a part of Cengage Learning

When is social welfare maximized? When marginal social benefit equals marginal social cost © 2011 South-Western, a part of Cengage Learning

Why can’t businesses solve pollution? The added costs of cleaning up the environment will make them less competitive in the market place © 2011 South-Western, a part of Cengage Learning

The following graphs show the short-run marginal cost curves and the long-run average cost curves for two firms. One pays private costs (typical) and the other pays both private and external costs (green firm). © 2011 South-Western, a part of Cengage Learning

Exhibit 1(a) Short-run Marginal Cost MSC (green) MPC (typical) Price per unit MPC (typical) PSR=SRMPC QS QP Quantity of Output (units per time period) 17 © 2011 South-Western, a part of Cengage Learning

Exhibit 1(b) Long-run Average Cost ASC (green) Price per unit PLR=LRASC PLR=LRAPC APC (typical) QLR Quantity of Output (units per time period) 18 © 2011 South-Western, a part of Cengage Learning

Why should a firm minimize costs? Only firms that choose the lowest cost method of production will survive the market © 2011 South-Western, a part of Cengage Learning

What happens when external costs are ignored? Competitive firms produce “too much,” and the market equilibrium price is “too low,” compared to a socially efficient industry © 2011 South-Western, a part of Cengage Learning

What happens when there is no government intervention? If left to the competitive market, profit-maximizing firms would have no reason to reduce emissions © 2011 South-Western, a part of Cengage Learning

Quantity of Output (units per time period) Exhibit 2 A Comparison of Equilibriums for Typical Competitive and “Green” Industries SS =  MSC (green) SP =  MPC (typical) PS Price per unit PC D QS QC Quantity of Output (units per time period) © 2011 South-Western, a part of Cengage Learning

Who is a free rider? A person who gets the same benefit from purchasing a good whether she or he pays for anti-pollution devices or not © 2011 South-Western, a part of Cengage Learning

Do markets fail when externalities are present? Externalities illustrate that private markets fail to produce society’s preferred outcome © 2011 South-Western, a part of Cengage Learning

How can society achieve efficiency when markets fail? Government has a potential role when there is market failure © 2011 South-Western, a part of Cengage Learning

What is an example of government failure? Government can fail to correct market failure by doing too little or too much about pollution © 2011 South-Western, a part of Cengage Learning

What are government approaches to achieving environment efficiency? Command-and-control regulations Incentive-based regulations © 2011 South-Western, a part of Cengage Learning

What is a command-and-control regulation? Government regulations that set an environmental goal and dictate how the goal will be achieved © 2011 South-Western, a part of Cengage Learning

What is an example of a command-and-control regulation? Mandatory installation of catalytic converters on automobiles © 2011 South-Western, a part of Cengage Learning

What is an incentive-based regulation? Government regulations that set an environmental goal, but are flexible in how buyers and sellers achieve the goal © 2011 South-Western, a part of Cengage Learning

What is an effluent tax? A tax on the pollutant © 2011 South-Western, a part of Cengage Learning

Social efficiency Decrease quantity Increase price Effluent tax © 2011 South-Western, a part of Cengage Learning

D PS PC QS QC t Price per unit Exhibit 3 Using an Effluent Tax to Achieve Environmental Efficiency SS =  MSC (green) SP =  MPC (typical) PS Price per unit PC t D QS QC Quantity of Output (units per time period) 33 © 2011 South-Western, a part of Cengage Learning

What is emissions trading? Trading that allows firms to buy and sell the right to pollute © 2011 South-Western, a part of Cengage Learning

What is new-source bias? Bias that occurs when there is an incentive to keep assets past the efficient point as a result of regulation © 2011 South-Western, a part of Cengage Learning

Is the efficient amount of pollution typically zero? No, the marginal social cost of achieving one more unit of clean air may be greater than the marginal social benefit © 2011 South-Western, a part of Cengage Learning

What conclusion can be made? Economists generally believe that incentive based regulations are more efficient than command-and-control regulations © 2011 South-Western, a part of Cengage Learning

Allowance Price (dollars) Exhibit 4 Monthly Average Price of Sulfur Dioxide Allowances under the Acid Rain Program 1,800 1,600 1,400 1,200 1,000 Allowance Price (dollars) 800 600 400 200 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ‘11 Year © 2011 South-Western, a part of Cengage Learning

What is the Coase Theorem? The proposition that private market negotiations can achieve social efficiency, regardless of the initial definition of property rights © 2011 South-Western, a part of Cengage Learning

How comprehensive is the Coase Theorem? Only a small number of environmental problems qualify for Coase Theorem solutions © 2011 South-Western, a part of Cengage Learning

Exhibit 5 Choosing the Efficient Amounts of Spark Trains and Farm Crops © 2011 South-Western, a part of Cengage Learning

Which cases qualify for the Coase Theorem? no transactions costs no income effects only two parties in the negotiation © 2011 South-Western, a part of Cengage Learning

What is a transaction cost? The costs of negotiating and enforcing a contract © 2011 South-Western, a part of Cengage Learning

What is the free-rider problem? If some people benefit while others pay, few will be willing to pay for improvement of the environment or other public goods © 2011 South-Western, a part of Cengage Learning

What is the result of the free-rider problem? Goods affected are underproduced © 2011 South-Western, a part of Cengage Learning

What is Tragedy of the Commons? Individuals will use an open access resource to the point of exhaustion, basing their use on private benefits while disregarding external costs to others. © 2011 South-Western, a part of Cengage Learning

What is the conclusion to this chapter? Neither government nor the markets can be asserted to be the best solution to environmental problems, although government is our best option © 2011 South-Western, a part of Cengage Learning

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