Chapter 6: Externalities In Action

1
Chapter 6 Externalities In Action

• Outline
• Addressing externalities should we focus on
  prices or on quantities?
• Understand why the answer is that it depends
• Two problems
• Some highlights from Chapter 6
• Acid rain the problems with the 1970 Clean Air
  Act
• Emissions trading
• Global warming Kyoto and beyond
• Smoking when is it a policy problem and when is
  it not?

2
A More Realistic Externality Example Acid Rain

• Sulfur dioxide (SO2) and nitrogen oxides (NOX)
  released into the atmosphere, form sulfuric and
  nitric acids.
• These acids may fall back to earth hundreds of
  miles away from their original source, known as
  acid rain.
• Majority of acid rain in North America caused by
  SO2, much coming from coal-fired power plants
  concentrated in the Ohio River Valley.
• Acid rain is a negative production externality.
  It
• Makes lakes more acidic.
• Erodes forests.
• Causes damage to property (5 billion/year).
• Reduces visibility.
• Leads to adverse health outcomes

3
History of Acid Rain Regulation

• 1970 Clean Air Act set maximum standards for
  various substances, including SO2.
• It set New Source Performance Standards (NSPS)
  for any new power plant, forcing the plant to
  either reduce emissions or install scrubbers.
• New plants, therefore, were made more expensive
  relative to older plants. Companies thus kept
  older, dirtier plants on line longer that they
  otherwise would.
• Theres an analogy to imposing regulation on new
  autos.
• Gruber calls this a consequence of partial
  policy reform.

4
History of Acid Rain Regulation

• 1990 Clean Air Act Amendments mandated a
  reduction of more than 50 of the level of SO2
  nationwide, and included all plants.
• It offered an SO2 allowance system that granted
  plants permits to emit SO2 in limited quantities,
  based on their historical fuel utilization.
• Plants were allowed to buy, sell, or save their
  allowances.
• The allowances involved very few restrictions
  trading could occur anywhere within the United
  States, with no approval or review, and the
  frequency and mechanism of trading were unlimited.

5
History of Acid Rain Regulation

• The 1990 amendments and emissions trading drew
  opposition from two very diverse groups
• Those opposed on economic grounds, like utilities
  and coal miners.
• An industry study predicted the full cost of the
  regulations to be up to 7.4 billion, with a loss
  of up to 4 million jobs.
• It was also opposed by environmentalists.
• They opposed the 1990 amendments on the grounds
  that they created a market for vice and virtue.

6
History of Acid Rain Regulation

• Estimates suggest that emissions trading
  significantly lowered the costs of the 1990
  amendments.
• Over the 1995-2007 period, costs were lowered
  from 35 billion to 15 billion.
• Thus, trading has worked to greatly improve the
  efficiency of regulation.
• Even environmentalists are now more sympathetic
  to emissions trading, because it reduces economic
  opposition.
• In less than a decade, emissions trading has
  gone from being a pariah among policymakers to
  being a star. -- Daniel Ellerman, expert on
  acid rain regulations

7
Has the Clean Air Act Been a Success?

• The overall success of the Clean Air Act is much
  harder to determine.
• The regulations were costly. In its first 15
  years, the Clean Air Act cost
• 600,000 jobs.
• 75 billion in output.
• They did result in benefits, too.
• Health improvements, such as reductions in infant
  mortality.
• Burtraw, et al. (1997) estimate that the health
  benefits alone exceed the cost of reduction by a
  factor of seven, once the lower-cost trading
  regime was implemented.

8
A Second Externality Example Global Warming

• The earth is heated by solar radiation that
  passes through our atmosphere and warms the
  earths surface.
• A large portion of the heat is trapped by certain
  gasses in the earths atmosphere, which reflect
  the heat back toward the earth again.
• This is known as the greenhouse effect.
• The concentration of greenhouse gasses like
  carbon dioxide and methane has increased due to
  human activity.
• Using fossil fuels like coal, oil, and natural
  gas produce carbon dioxide and contribute to this
  effect.

9
GLOBAL WARMING

• The surface temperatures have increased by more
  than 1 degree Fahrenheit in the past 30 years.
• Projections for the next 100 years suggest an
  unprecedented increase by as much as 6-10
  degrees.
• Carbon emissions in Boston and Bangkok have the
  same effect on the global environment.
• The stock, not the flow, of carbon dioxide cause
  the warming. Thus, it takes a long time to undo
  the damage.
• Global warming is a thus a complicated
  externality involving many nations and many
  generations of emitters.

10
The U.S. is currently responsible for nearly 25
of the planets carbon dioxide emissions.
Developing counties like China and India emit
large quantities of greenhouse gasses.
Japan contributes only 5 of annual emissions.
11
The Kyoto Treaty

• The goal of the Kyoto treaty in 1997 was to
  reduce the emissions of greenhouse gasses to 5
  below their 1990 levels.
• United States and Russia have not signed on many
  other of the 38 industrialized nations have,
  however.
• For the United States, the Kyoto treaty would
• Mean reducing emissions in 2010 by roughly 30
• With a present discounted cost of
  1,100,000,000,000 (1.1 trillion)
• The United States would bear 90 of the total
  world cost, even though it contributes only 25
  of annual greenhouse gas emissions.

12
Can Trading Make Kyoto More Cost-Effective?

• Kyoto treaty introduced international emissions
  trading.
• Under the Kyoto treaty, the industrialized
  signatories are allowed to trade emissions rights
  among themselves, as long as the total emissions
  goals are met.
• There are tremendous differences across developed
  nations in terms of meeting these goals, for two
  reasons
• Slow growth in some countries Relatively easy
  for a country like Russia to meet its goal.
  Estimates suggest that emissions trading (say,
  from Russia to United States) could lower the
  cost of the treaty by 75.
• Environmentally conscious growth Other
  countries, like Japan, tend to use more gas and
  nuclear-powered production.
• Figure 3 shows the benefits of international
  emissions trading (the readings for today give an
  update from the Montreal, the site of the most
  recent international climate change meetings).

13
Yet the treaty calls for the U.S. to reduce
emissions a lot.
It is fairly expensive for the U.S. to reduce its
emissions.
It is easier for Russia and others to reduce
their emissions.
And the requirements are lower, too.
Price of carbon reduction
SUS
The total cost to the U.S. is 440x210.
SR
ST
210
The overall cost, with emissions trading, is 32
billion.
With emissions trading, the supply curve is
summed horizontally.
The cost of worldwide emission reduction is 50
per ton with ST.
The total cost to Russia and others is 190x20.
50
The U.S. buys 400 permits (440-40).
The overall cost, with no emissions trading, is
96 billion.
20
Carbon Reduction (millions of metric tons)
0
630
440
190
590
40
14
A Third Externality Example The Economics of
Smoking

• Smoking causes more than 440,000 deaths each
  year, four times as much as AIDS, motor vehicle
  accidents, homicide, and suicide combined.
• What is the role for government intervention in
  the case of a decision like smoking? Several
  possible arguments
• Smoking is bad for you.
• Smoking is addictive.
• It generates negative externalities to the health
  system, workplace, and fire departments.
• It generates positive externalities to the Social
  Security and Medicare system.
• It creates negative externalities to other family
  members through secondhand smoke.

15
THE ECONOMICS OF SMOKING

• Smoking is bad for you.
• Smoker lives about 6 fewer years than a
  nonsmoker.
• A year of life is valued by economists at about
  200,000.
• In standard utility-maximization, any damage
  individuals do to themselves from dangerous
  activities results from a rational tradeoff of
  benefits against potential costs.
• Perhaps a rationalization can be given because
  young people make decisions to smoke when they
  are not capable of sensibly assessing the
  benefits and costs of their decisions
• Or cigarettes are so additive that people dont
  understand they cant quit (or have a very hard
  time quitting).

16
THE ECONOMICS OF SMOKING

• Smoking is addictive.
• Rational addicts understand that each cigarette
  that they smoke today increases their addiction.
• Smokers consider not only the cost of todays
  pack of cigarettes, but the cost of all
  additional future packs that will now be
  purchased because their addiction is deepened.
• Smokers also understand that smoking doesnt just
  reduce health through the current cigarette, but
  all future cigarettes that will be consumed
  because of the addiction.
• With this model, smoking remains a rational
  choice.

17
The Externalities of Smoking

• Smoking generates negative externalities due to
  higher health costs.
• Smoking-related disease increases U.S. medical
  care costs by 75 billion annually, 5 of the
  total.
• If insurance companies can make actuarial
  adjustments, they simply charge smokers higher
  rates.
• Such adjustments internalize the medical cost
  externality from smoking. In a simple model,
  there are no health externalities because smokers
  pay for the high medical costs through higher
  premiums.

18
The Externalities of Smoking

• In fact, actuarial adjustments are often not made
  with employer health insurance.
• In this case, the externality is financial, not
  physical. This is an externality because the
  social marginal benefit from an individuals
  cigarette consumption is below the private
  marginal benefitthe individuals coworkers have
  to pay higher premiums.
• In addition to higher health costs to the private
  sector, individuals who receive government
  insurance exert a negative externality onto
  taxpayers.
• The same is true of the uninsured (smokers and
  non-smokers alike)they exert negative
  externalities onto medical providers, who pass
  along the costs to consumers.

19
The Economics of Smoking

• Smoking generates negative externalities due to
  lower workplace productivity and more frequent
  absences.
• Firms may be able to adjust wages to compensate
  for this type of problem.
• If workers wages adjust to compensate for their
  lower expected productivity, then the externality
  is internalized, akin to the adjustments in
  health premiums.

20
The Economics of Smoking

• Smoking generates negative externalities due to
  fires, mostly due to falling asleep with a
  burning cigarette.
• To the extent the smoker only damages himself and
  his own property, there is not an externality.
  But if the fire spreads to other properties,
  there is an externality.
• Also costs to fire departments and insurance
  companies that may not be fully internalized.

21
The Externalities of Smoking

• Smoking generates positive externalities to
  taxpayers due to the early deaths of smokers and
  lower payouts for some social insurance programs.
• Often contribute payroll tax for Social Security
  and Medicare during working life, but smokers may
  not be alive to collect benefits when they are
  elderly.

22
The Economics of Smoking

• Smoking generates negative externalities (mostly
  to other family members) through secondhand
  smoke.
• Considerable medical uncertainty about the
  damages done from this.
• Moreover, if the smoker maximizes family utility
  rather than individual utility, he/she rationally
  trades off the benefits to himself/herself versus
  the harm to his/her family.
• Evidence suggest family utility maximization is
  incomplete, however.

23
The Economics of Smoking

• Taken together, the external costs of smoking are
  roughly 40 per pack of cigarettes in 2003
  dollars.
• Estimates of external costs of secondhand smoke
  vary widely, from 1 to 1.16 per pack.
• The average federal plus state cigarette tax is
  over 1 per pack.

24
Should We Care Only About Externalities, or Do
Internalities Matter Also?

• Traditional economics approach cares only about
  externalities that smokers impose on others.
• Model ignores some key features of the smoking
  decision that may motivate government
  intervention.
• Youth smoking decisions
• Inability of adults to quit
• Maybe policymakers should decide that people are
  unable to do what is best for them, and
  consequently policy should try to influence
  choices. This, of course, is a slippery slope.
• Information/outreach campaignsthese have reduced
  the smoking rate a lot over the last 30 years.
• Reducing access to cigarettes for teenagers.
• Taxationelasticity of demand for cigarettes is
  around -0.5, and higher for youth smokers.