1. Environmental Economics
Key Concepts
Summary
©2005 South-Western College Publishing

2. What will I learn in this chapter?
This chapter will begin by showing why competitive markets may fail to sufficiently protect the environment. Then we will see how we might correct the market failure. Finally, we will consider the pros and cons of government intervention to improve our environment.

3. What assumption is made in this chapter?
There is sufficient foreign and domestic competition to allow us to use the perfectly competitive model

4. When does economic efficiency exist?
Efficiency exists when the price to consumers, reflecting marginal benefit, equals marginal cost

5. Who is a third party?
People outside the market transaction who are affected by the product

6. What are private benefits and costs?
Benefits and costs to the decision maker, ignoring benefits and costs to third parties

7. What are externalities?
Benefits or costs that are not considered by market buyers and sellers

8. What is an example of an externality?
Air pollution is an externality that affects third parties not driving automobiles

9. What is an example of a positive externality?
The enjoyment you derive from your neighbors well-kept yard

10. What happens when externalities are present?
Competitive markets are not likely to achieve economic efficiency

11. What are social benefits?
The sum of benefits to everyone, including both private benefits and external benefits

12. What are private costs?
Production costs of capital, labor, land, and entrepreneurship

13. What are social costs?
The sum of costs to everyone, including both private costs and external costs

14. When is social welfare maximized?
It is achieved when marginal social benefit equals marginal social cost

15. Why can’t businesses acting on their own solve the problem of pollution?
The added costs of cleaning up the environment will make them less competitive in the market place

16. What may happen to a firm that takes on the added costs of anti-pollution devices?
They eventually will be driven out of business by lower cost firms

17. 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)

18. Short-run Marginal CostP
Short-run Marginal Cost
PMC (typical)
SMC (green)
PSR=SRPMC Q QS QP

19. P Q QLR Long-run Average Cost SAC (green) PLR=LRSAC PAC (typical)
PLR=LRPAC Q
QLR

20. 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

21. P Q D PS PC QS QC SS =  SMC (green) PS =  PMC (typical)
Comparisons of Equilibriums for Typical Competitive and “Green Industries”
SS =  SMC (green) PS
PS =  PMC (typical) PC D Q QS QC

22. Do markets fail when externalities are present?
Externalities illustrate that private markets fail to produce society’s preferred outcome

23. How can society achieve efficiency when markets fail?
Government has a potential role when there is market failure

24. What is an example of government failure?
Government can fail to correct market failure by doing too little or too much about pollution

25. What are two government approaches?
Incentive-based regulations
Command-and-control regulations

26. What is a command-and-control regulation?
Government regulations that set an environmental goal and dictate how the goal will be achieved

27. What is an example of a command-and-control regulation?
Mandatory installation of catalytic converters on automobiles

28. What is an incentive-based regulation?
Government regulations that set an environmental goal, but are flexible in how buyers and sellers achieve the goal

29. What is an effluent tax?
A tax on the pollutant

30. P
Using an Effluent Tax to Achieve Environmental Efficiency
SS =  (MC, t) (green)
tax PS
PS =  MC =  PMC (typical) Pc D Q QS QC

31. What is emissions trading?
Trading that allows firms to buy and sell the right to pollute

32. 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

33. 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

34. What is the Coase Theorem?
The proposition that private market negotiations can achieve social efficiency, regardless of the initial definition of property rights

35. How comprehensive is the Coase Theorem?
Only a small number of environmental problems qualify for Coase Theorem solutions

36. Which cases qualify for the Coase Theorem?
no transaction costs
no income effects
only two parties in the negotiation

37. What is a transaction cost?
The costs of negotiating and enforcing a contract

38. 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

39. What is the result of the free-rider problem?
Goods affected are underproduced

40. Key Concepts

41. When does economic efficiency exist?
Who is a third party?
What are private benefits and costs?
What are externalities?
What are social benefits?
What are private costs?
What are social costs?
Where is social welfare maximized?
Why can’t businesses action on their own solve the problem of pollution?

42. How can society achieve efficiency when markets fail?
What is a command-and-control regulation?
What is an incentive-based regulation?
What is an effluent tax?
What is emissions trading?
What is new-source bias?
What is the coase theorem?

43. Summary

44. Externalities are benefits or costs that fall on third parties who are neither buyers nor sellers. Pollution is a negative externality or external cost that is a byproduct of many industrial production processes.

45. Market failure is present when the market produces a socially inefficient outcome. One instance is when there are externalities All firms , including competitive firms, consider private costs, but disregard external costs, in making decisions

46. Government failure occurs when public-sector actions move us away from desired outcomes, such as efficiency. Government officials seeking campaign contributions and votes may choose environmental measures that favor wealthy contributors over society’s best interests.

47. Command-and-control regulations occur when the government dictates the approach to achieving an environmental goal.

48. Command-and-control (CAC) regulations are generally inefficient on three grounds: They do not distinguish between high and low pollution areas, they do not allow firms to choose lower cost technologies that could achieve the environmental standard, and they do not encourage improved technology to lower future emissions.

49. Incentive-based regulations build on markets to achieve environmental efficiency. Effluent taxes are taxes that reflect external costs. Emissions-trading allows firms to buy and sell the “right to pollute.”

50. The Coase Theorem maintains that markets can be efficient in the presence of externalities with minimal government intervention. Even in the presence of externalities, markets may produce efficient outcomes so long as property rights are clearly established.

51. Transactions costs, income effects, and free-rider problems are obstacles to achieving environmental efficiency through markets.

52. Transactions costs are the costs of negotiating an agreement

53. Income effects are present when limited income prevents one party from being able to afford the efficient solution

54. Free-rider problems are present when participants are better off hiding than revealing their willingness to pay for an environmental improvement

55. END