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Chapter 2: Externalities and the Environment
2 - 1
Chapter 2
Externalities and the Environment
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter 2: Externalities and the Environment
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Introduction
Applications: Acid rain and global warming
Economic analysis of a pollution tax and tradable permits
The economist’s approach to pollution
Chapter 2: Externalities and the Environment
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Externalities and the Environment
Positive externality
Negative externality Exists whenever a producer or consumer does not have to pay for a cost he generates.
Exists whenever a producer or consumer does not receive a payment for a benefit he generates.
• Examples: air pollution, water pollution, or noise pollution
• Examples: immunizations or improving your home.
Chapter 2: Externalities and the Environment
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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.
Solution? Establish property rights and charge a price for its use.
Who can have property rights?• government • private firms • individuals
Chapter 2: Externalities and the Environment
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The Economist’s Approach to PollutionIf 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:1. Property rights exist2. A small number of citizens are harmed3. There are low transaction costs
Chapter 2: Externalities and the Environment
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Trade-off between Environmental Quality and Output
Environmental Quality
Output
a
b
c
d
e
f
Figure 2.1
Maximum environmental quality
Maximum output with zero environmental quality
Increase in environmental quality and a decrease in output
Chapter 2: Externalities and the Environment
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Trade-off between Environmental Quality and Output
Objections to pollution prices and economist’s responses
Allocation problem
• Tax method• Command and control method
• Polluters with different technological options• Permit method
The Virtues of Pollution Prices
• Pollution price is a “license to pollute”• Pollution prices will raise product prices• Pollution taxes will raise the tax burden on the population
Chapter 2: Externalities and the Environment
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Charging a Price vs. Mandating or Subsidizing Clean Technologies
Economists recommend using pollution prices and oppose mandating or subsidizing clean technologies.
• 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
WHY?
Chapter 2: Externalities and the Environment
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A Pollution Tax
MD
Figure 2.2
80 100 Gasoline
P
$2.50
S (MPC)
D (MB)
The right tax generates the right quantity of a polluting good
H
J
I
K
MSC
MSC = MPC + MD
Chapter 2: Externalities and the Environment
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A Pollution Tax
Levy a corrective tax (Pigouvian tax) equal to the MD
Figure 2.3
T Social optimum quantity is where MSC = MB at 80 units of gasoline
S` (MSC`)
H
J
I
K
80 100 Gasoline
P
$2.50
S (MPC)
D (MB)
Chapter 2: Externalities and the Environment
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A Pollution Tax
An optimal tax confers a net benefit to society
Net gain to society = HIJK – HIK = IJK
Gain in environmental benefit = HIJK
Loss of output = HIK
MSC
H
J
I
K
Figure 2.4
80 100 Gasoline
P
$2.50
S (MPC)
D (MB)
Chapter 2: Externalities and the Environment
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A Pollution Tax
Use pollution tax revenue to cut other taxes
Tax emissions, not the polluting good
• Pollution taxes as revenue replacers
• Whenever feasible, levy the tax per unit of pollution – per emission – not per unit of polluting good
• Different ways of returning the tax revenue to the private sector will have different effects
Chapter 2: Externalities and the Environment
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A Pollution Tax
• To minimize cost, levy the same tax on all firms emitting pollutant X
$60
$100
$20$25
$40$50
$200
10 25 30 35 40 45 50
Emissions
MACH
MACL
2 firms with different MACs
Without government policy, each firm pollutes 50 units.
Figure 2.5
Chapter 2: Externalities and the Environment
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A Pollution Tax• To minimize cost, levy the same
tax on all firms emitting pollutant X
MACL
MD = T
• Marginal damage and tax rate is constant at $40
$60
$100
$20$25
$40$50
$200
10 25 30 35 40 45 50
Emissions
MACH Figure 2.5
• After the tax is levied, MACH will abate 10 units and MACL will abate 40 units
• After tax, total emission is
50 units
• Firms will abate until MAC = T• Equi-marginal principle
Chapter 2: Externalities and the Environment
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1. Government sells permits2. Government gives the permits away
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?
Tradable Permits
Chapter 2: Externalities and the Environment
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$60
$100
$20$25
$40$50
$200
10 25 30 35 40 45 50 75 Permits
DH
D
DL
Tradable Permits – Government sells permits
S
• The government decided to supply 50 pollution permits
• Each firm’s permit demand curve is its MAC curve
= MACH
= MACL
= market demand
Chapter 2: Externalities and the Environment
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• Price where S = D
• Tax vs. permit• A hybrid policy
Tradable Permits – Government sells permits
What is the optimal permit price?
$60
$100
$20$25
$40$50
$200
10 25 30 35 40 45 50 75 Permits
DH
D
DL
S
• P = $50 is too high
P=$50
• P = $20 is too low
P=$20
• P = $40 results in the desired outcome
P=$40
Tentative prices
Chapter 2: Externalities and the Environment
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giving permits to polluting firms will reduce pollution.
Tradable Permits – Government gives the permits away
• The supply curve for each polluting good will shift to the left
• The price of polluting goods will increase
Just like selling permits or levying a tax,
• Taxpayers want the government to sell permits
Which is best?• Firms want the government to give permits
But, giving the permits away can lead to higher output and emissions than is socially optimal in the long run.
Chapter 2: Externalities and the Environment
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Application: Tradable Permits for Sulfur Dioxide to Reduce Acid Rain
Old policy – a maximum sulfur dioxide emission rate for new coal-burning electricity generating firms.
• Clean Air Act Amendments of 1990
• Total emissions have fallen with the new policy• Two issues: long run issue, and tax revenue issue
New policy – tradable permits are given to electric power plants
• Plants can then buy and sell permits an needed
Sulfur dioxide causes acid rain
Chapter 2: Externalities and the Environment
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Application: A Carbon Tax or Tradable Permits to Reduce 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
Carbon emissions cause global warming
Policy decision – carbon tax or carbon permits?
Policy decision – how can low-income countries be induced to participate?
Chapter 2: Externalities and the Environment
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Summary
Applications: Acid rain and global warming
Economic analysis of a pollution tax and tradable permits
The Economist’s approach to pollution
Chapter 2: Externalities and the Environment
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Preview of Chapter 3:
Public Goods and Political Economy
Political economy
The concept of a public good
The behavior of the government