Part I. Principles

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 firms private costs, forcing MPCMSC
• 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 farmers
  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 lt 10 to forgo adding cow
• Rancher WTA gt 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 victims WTP to
  reduce externality and WTA compensation for
  increases in externality

10
Types of Government Intervention

• Moral suasion give a hoot, dont 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?
  Isnt 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.)

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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.

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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 _at_ 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.

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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?

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The Optimal Level of Pollution
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The Optimal Level of Pollution

• If E lt E1, then MAC gt MDF that the unit of
  pollution would have caused.
• Doesnt make sense to reduce
  pollution.
• If E gt E1, then MDF gt MAC associated with
  reducing pollution by one unit.
• Better off eliminating unit of
  pollution.

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Social Costs When Pollution Level is Greater than
Optimal
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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.

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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.