The market tends to overproduce.

1
Spillover Costs
Spillover Benefits
The market tends to overproduce.
The market tends to underproduce.
2
The Economics of Pollution

• Company A produces 40,000 units and emits 600
  tons of pollution. Clean-up is costly.

3
Marginal Benefit of Pollution

• The marginal benefit of pollution is the cost
  of cleaning-up an extra ton.

MB Company B

• Company B has higher clean-up costs.

MB Company A
4
Costs and Benefits of Pollution

• Costs and benefits of pollution for the economy
  as a whole.

• 30,000 tons of pollution is optimal.
• the benefit from an extra ton of pollution is
  offset by the cost
• without regulation, companies will emit 60,000
  tons

MC
MB
5
Environmental Standards

• A standard might require all companies to cut
  emissions to 300 tons.

• The marginal and total cost for Company B is
  higher.

MB Company B
MB Company A
6
Emission Taxes

• Alternatively, the government could impose a tax
  of 200 per ton.

• Each firm chooses an optimal level of pollution
• Total pollution is the same but at lower cost.

7
Firms Choose How Clean to Be
Firm A
10,000
40,000
90,000
120,000
120,000
Firm B
20,000
80,000
180,000
120,000
120,000
8
Marketable Pollution Permits

• The government allocates permits to firms.
• Firms are allowed to buy and sell permits.
• Permits encourage the lowest cost clean-up to be
  done first.
• Environmental groups can buy permits to reduce
  pollution.

9
Marginal Benefit of Transactions
Marginal benefit of 2nd unit is 16.
Marginal benefit of 5th unit is 9.
8
4
8
5
10
External Costs (Before a Tax)
Large consumer and producer surplus if government
pays for the clean-up.
Consumer Surplus
2,250
2,250
Net benefit 1,875
Producer Surplus
External Cost
11
Marginal Benefits and Costs
Marginal benefit of 100th unit is 20.
Consumer Surplus
Producer Surplus
Marginal cost of 100th unit is 7.50.
External Cost
12
Marginal Benefits and Costs
Consumer Surplus
Marginal benefit of 200th unit is 10.
Marginal cost of 200th unit is 10.
Producer Surplus
200 optimal quantity 10 optimal tax
External Cost
13
Marginal Benefits and Costs
Marginal benefit
Marginal cost
14
Tax on External Costs
10
With the tax, consumers and producers cover the
external costs.