1. Part I. Principles Markets Market failure Discounting & PV Markets 2
Dynamic efficiency
Pollution solutions

2. F. Pollution Solutions
Chapter 3

3. Introduction
Should society intervene to correct market failures associated with environmental externalities?
If so, how?

4. Pigou Use taxes to correct divergence between MPC and MSC
Set Pigouvian tax = divergence (measured at Q*) – this raises firm’s private costs, forcing MPC=MSC
“Internalizing the externality”

5. Figure 3.1 – An Externality Tax on Output

6. Coase Theorem
Ronald Coase (1960) argued that not only is a tax unnecessary, it is often undesirable.
Coase argued:
The market will automatically generate the optimal level of the externality.
This optimal level of the externality will be generated regardless of the initial allocation of property rights.

7. Rancher & farmer
Cattle occasionally leave pasture for farmer’s property, damaging his crops
Numerical example: if rancher ↑ herd by 1 unit, receives profits of $3 ,but farmer suffers loss $10
Will rancher pursue private benefit and add the cow?

8. Rancher & farmer cont.
No! The rancher and the farmer will negotiate, because an agreement will make them both better off
Farmer WTP rancher < 10 to forgo adding cow
Rancher WTA > 3 to forgo adding cow
Clearly, room for agreement

9. Problems applying Coase to environmental problems
Assumes zero or insignificant transactions costs
Property rights matter – affects number of potential participants in market (if rancher rights, more ranchers than if farmer rights)
Income effects – differences in victim’s WTP to reduce externality and WTA compensation for increases in externality

10. Types of Government Intervention
Moral suasion “give a hoot, don’t pollute”
Direct production of environmental quality (reforestation, stocking fish, cleaning toxic sites, etc.)
Pollution prevention (to address imperfect info)
Command and control regulations
Economic incentives

11. Command & Control Regulation
Place constraints on the behavior of households and firms
Generally in form of limits on inputs or outputs to consumption/production process
Inputs: scrubbers on smokestacks, banning use of leaded gasoline
Outputs: auto exhaust limits, no littering

12. Economic Incentives
Goal: to make self-interest coincide with the social interest
Pollution taxes/subsidies
Marketable pollution permits
Performance bonds
Liability systems

13. The correct level of environmental quality
Whether employ C & C or economic incentives – first need to determine the optimal level of environmental degradation
What is the desirable level? Is this illogical? Isn’t all pollution bad?

14. The correct level of environmental quality
Zero level pollution impossible by physics – law of mass balance
An activity cannot destroy matter in the reaction (can only change form)
Mass outputs = mass inputs
Burn 10 lbs. wood → 10 lbs not destroyed (just changed form: smoke, ash, etc.)

15. The correct level of environmental quality cont.
Therefore, eliminating all air pollution → eliminating all production and consumption activities
Some pollution inevitable, zero pollution neither desirable nor achievable
Correct level? Depends on MAC and MDC

16. The Marginal Damage Function
Damage pollution creates by degrading the physical, natural, and social environment.
Include effects on ecosystems, human health, inhibition of economic activity, damage to human made structures, aesthetic effects

17. Figure 3.3 Marginal Damage Function

18. MDF
The marginal damage function in Figure 3.3 specifies the damages associated with an additional unit of pollution.
The total damages generated by a particular level of pollution is represented by the area under the marginal damage function.

19. MDF
An upward sloping marginal damage function indicates that as the level of pollution becomes larger, the damages associated with the marginal unit of pollution become larger.
Increasing at increasing rate – rate of increase increasing

20. Marginal Abatement Cost Function
Represents the costs of reducing pollution by one more unit.
Abatement costs include:
Labor
Capital
Energy needed to lessen emissions
Opportunity costs from reducing levels of production or consumption.

21. Marginal Abatement Cost Function

22. MAC
In the figure, Eu represents the level of pollution that would be generated in absence of any government intervention (MAC = 0)
Reading from R to L, as pollution is reduced below Eu, the marginal abatement cost increases.

23. MAC
MAC rises as cheaper options for reducing pollution are exhausted and more expensive steps must be taken.
Slope decreasing rate– costs of reducing pollution increases at an increasing rate.
High vertical intercept – cost of eliminating the last few units of pollutants would be extremely high.

24. The Optimal Level of Pollution
Optimal level of pollution minimizes the total social costs of pollution (the sum of total abatement costs and total damages).
This level occurs at the point where
MAC = MDF
Why?

25. The Optimal Level of Pollution

26. The Optimal Level of Pollution
If E < E1, then MAC > MDF that the unit of pollution would have caused.
Doesn’t make sense to reduce pollution.
If E > E1, then MDF > MAC associated with reducing pollution by one unit.
Better off eliminating unit of pollution.

27. Social Costs When Pollution Level is Greater than Optimal

28. Social Costs When Pollution Level is Greater than Optimal
The optimal level of pollution is E1.
The actual level of pollution is E2.
Total costs associated with pollution have been increased by the area of triangle abc.
This represents marginal damages greater than marginal abatement costs for the range of pollution emissions between E1 and E2.

29. Social Costs When Pollution Level is Less than Optimal

30. Social Costs When Pollution Level is Less than Optimal
The optimal level of pollution is E1.
The actual level of pollution is E3.
Total costs associated with pollution have been increased by the area of triangle ade.
This represents marginal abatement costs greater than marginal damage for the range of pollution emissions between E1 and E3.