1. Chapter 2 Externalities and the Environment McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Introduction The economist’s approach to pollution
Economic analysis of a pollution tax and tradable permits
Applications: Acid rain and global warming

3. Externalities and the Environment
Negative externality
Exists whenever a producer or consumer does not have to pay for a cost he generates.
Examples: air pollution, water pollution, or noise pollution
Positive externality
Exists whenever a producer or consumer does not receive a payment for a benefit he generates.
Examples: immunizations or improving your home.

4. The Economist’s Approach to Pollution
Pollution is an example of a market failure.
An allocation of resources that is not socially optimal.
When externalities exist, there is a failure of property rights.
Establish property rights and charge a price for its use.
Solution?
government
private firms
individuals
Who can have property rights?

5. The Economist’s Approach to Pollution
If the government has property rights, how do they charge a price?
TAXES
PERMITS
Charging polluters a price forces them to internalize the externality.
A private solution (Coase’s prescription) is possible if:
Property rights exist
A small number of citizens are harmed
There are low transaction costs

6. Trade-off between Environmental Quality and Outputc d e f
Figure 2.1
Maximum environmental quality
Increase in environmental quality and a decrease in output
Maximum output with zero environmental quality

7. Trade-off between Environmental Quality and Output
The Virtues of Pollution Prices
Allocation problem
Command and control method
Tax method
Polluters with different technological options
Permit method
Objections to pollution prices and economist’s responses
Pollution price is a “license to pollute”
Pollution prices will raise product prices
Pollution taxes will raise the tax burden on the population

8. Charging a Price vs. Mandating or Subsidizing Clean Technologies
Economists recommend using pollution prices and oppose mandating or subsidizing clean technologies.
WHY?
Pollution prices stimulate clean technologies
Mandates lead to high costs for consumers CAFE standards
Subsidies lead to a distorted playing field among potential alternatives
Political lobbying for subsidies cause distortion
Clean alternatives is not always the socially optimal response
Subsidies require raising taxes

9. A Pollution Tax
The right tax generates the right quantity of a polluting good
Figure 2.2
Gasoline P
$2.50
S (MPC)
D (MB) H J I K
MSC
MSC = MPC + MD MD

10. Social optimum quantity is where MSC = MB at 80 units of gasoline
A Pollution Tax
Levy a corrective tax (Pigouvian tax) equal to the MD
Figure 2.3 P
$2.50
Social optimum quantity is where MSC = MB at 80 units of gasoline
S` (MSC`) H J I K T
S (MPC)
D (MB)
Gasoline

11. A Pollution Tax An optimal tax confers a net benefit to society
Figure 2.4 P
$2.50
MSC
Gain in environmental benefit = HIJK J
S (MPC) I
Loss of output = HIK K
Net gain to society = HIJK – HIK = IJK H
D (MB)
Gasoline

12. A Pollution Tax Use pollution tax revenue to cut other taxes
Pollution taxes as revenue replacers
Different ways of returning the tax revenue to the private sector will have different effects
Tax emissions, not the polluting good
Whenever feasible, levy the tax per unit of pollution – per emission – not per unit of polluting good

13. A Pollution Tax
$60
$100
$20
$25
$40
$50
$200
Emissions
MACH
MACL
Figure 2.5
To minimize cost, levy the same tax on all firms emitting pollutant X
2 firms with different MACs
Without government policy, each firm pollutes 50 units.

14. After tax, total emission is 50 units
A Pollution Tax
$60
$100
$20
$25
$40
$50
$200
Emissions
MACH
Figure 2.5
To minimize cost, levy the same tax on all firms emitting pollutant X
MD = T
Marginal damage and tax rate is constant at $40
Firms will abate until MAC = T
Equi-marginal principle
After the tax is levied, MACH will abate 10 units and MACL will abate 40 units
MACL
After tax, total emission is units

15. Tradable Permits CAP and TRADE
Cap – supply of emissions permits is fixed
Trade – permits can be bought and sold in the market throughout the year
How do firms get the permits?
1. Government sells permits
2. Government gives the permits away

16. Tradable Permits – Government sells permitsDH
Each firm’s permit demand curve is its MAC curve
= MACH
= MACL
$200
= market demand S
The government decided to supply 50 pollution permits
$100
$60 DL
$50
$40 D
$25
$20
Permits

17. Tradable Permits – Government sells permits
$60
$100
$20
$25
$40
$50
$200
Permits DH D DL S
What is the optimal permit price?
Price where S = D
Tentative prices
P = $50 is too high
P=$50
P = $20 is too low
P=$20
P = $40 results in the desired outcome
P=$40
Tax vs. permit
A hybrid policy

18. Government gives the permits away
Tradable Permits –
Government gives the permits away
Just like selling permits or levying a tax,
giving permits to polluting firms will reduce pollution.
The supply curve for each polluting good will shift to the left
The price of polluting goods will increase
But, giving the permits away can lead to higher output and emissions than is socially optimal in the long run.
Which is best?
Firms want the government to give permits
Taxpayers want the government to sell permits

19. Application: Tradable Permits for Sulfur Dioxide to Reduce Acid Rain
Sulfur dioxide causes acid rain
Old policy – a maximum sulfur dioxide emission rate for new coal-burning electricity generating firms.
New policy – tradable permits are given to electric power plants
Clean Air Act Amendments of 1990
Plants can then buy and sell permits an needed
Total emissions have fallen with the new policy
Two issues: long run issue, and tax revenue issue

20. Application: A Carbon Tax or Tradable Permits to Reduce Global Warming
Carbon emissions cause global warming
A carbon tax treaty
A carbon tradable permits treaty
A hybrid carbon treaty: a permit system with a safety valve
The political challenge
Policy decision – carbon tax or carbon permits?
Policy decision – how can low-income countries be induced to participate?

21. Summary The Economist’s approach to pollution
Applications: Acid rain and global warming
Economic analysis of a pollution tax and tradable permits
The Economist’s approach to pollution

22. Preview of Chapter 3: Public Goods and Political Economy
The concept of a public good
Political economy
The behavior of the government