Accelerated

Capitalism for Market

Externalities
An alternative approach to Marginal
Benefit equal to Marginal Cost for Taxes
and Permits
Chris Saunders, M.S.
October 25th, 2016

Introduction
In deciding what is optimal I lean on the philosopher John Stuart Mill and
Utilitarianism:
It is proper to state that I forego any advantage which could be derived
to my argument from the idea of abstract right, as a thing independent
of utility. I regard utility as the ultimate appeal on all ethical questions;
but it must be utility in the largest sense, grounded on the permanent
interests of man as a progressive being. Those interests, I contend,
authorize the subjection of individual spontaneity to external control,
only in respect to those actions of each, which concern the interest of
other people.1
Taking utility in the largest sense, grounded on the permanent interests of man as
a progressive being, we must consider sustainability:
Development that meets the needs of the present generation without
compromising the ability of future generations to meet their own needs
2

Or:

1 Mill, J. S., On Liberty, 4th Edition, Section I.II, 1859

2 Hanley, Nick, Shogren, Jason F., White, Ben, Environmental Economics in Theory
and Practice 2nd Edition, Palgrave Macmillan, Chippenham and Eastbourne, 2007

A requirement to our generation to manage the resource base such

that the average quality of life we ensure ourselves can potentially be
shared by all future generations3
Or, as Mill might put it, progressing as well.
The question then becomes what measure(s) do we impose (external control) to
achieve the most good for the people with respect to managing our capital? How
do we ensure this concept into the future? How do we define this utility, needs, or
quality of life?
One way to look at this is to ensure, to the best of our ability, the survival of the
human race at the least cost or consumption (efficiency). A free market can provide
the least cost product to the point of consumption through competition, however it
does not include the cost of externalities (pollution, poverty, etc.).
What current economic models being implemented suggest is maximizing net
benefits continuously over time by internalizing externalities 456 . I believe this
concept is central to a sustainable or Utilitarian path. What makes it work, is the
discounting of future damages from production and discounting the future benefits
3 Hanley, Nick, Shogren, Jason F., White, Ben, Environmental Economics in Theory and
Practice 2nd Edition, Palgrave Macmillan, Chippenham and Eastbourne, 2007

4 Baulmol, W., Oates, W., The Use of Standards and Prices for Protection of the
Environment, Swedish Journal of Economics, 1971
5 Weitzman, Martin, Prices vs. Quantities, The Review of Economic Studies, Vol. 41,
No. 4, 1974
6 Coase, R., The Problem of Social Cost, Journal of Law and Economics, 1960

of production (which may or may not be currently done), and maximizing the net
benefits.
The discount rate becomes very important, however maximizing the net benefits in
such a manner ensures, to the best of our ability, the progression of man. To do this
we must demand the highest return on investment (discounted) on the discounted
value of capital. Or as current models suggest maximize discounted net benefits.
In theory this seems correct, however, discounting and forecasting accurately over
the long term, at this time, is impossible. As a bare minimum I would like to suggest
what I shall call Noahs Arc. In this sense as resource depletion goes up the
associated damages goes to infinity (Return on investment goes to negative
infinity). Likewise with zero production the damages goes to infinity (Return on
investment goes to negative infinity):

+ROI

Damages, Production
Pairings
-ROI

That being said I would like to make two points regarding the models for the
externality, pollution. One, pollution, I believe, is an investment cost rather than a
social cost. For example, if we all started out as zero pollution sustainable business,
and one member preferred higher profits, he might use some toxic input to raise
output. He is thereby investing his health in his economy (profitable or not).
Looking at pollution, or damages, as an investment cost only effects the level of
optimal emissions (not maximal profits), and only slightly in the case of the United
States. It could have larger ramifications elsewhere, however. Second, I would like
to introduce a new mechanism, a Pigouvian fee and benefit, which would make the
cost of abatement a profitable investment. In this manner it would maximize net
benefits. It does this by assuming a strong economy is necessary to maximize net
benefits, and then applies a fee or benefit to each agent equal to their relative cost
or benefit to the economy, in terms of the newly termed pollution investment cost
portion of total investment cost. This should in effect accelerate the economy.
Environmental Damages can be looked at as an investment cost, in the sense that,
through legislation, we determine the marginal level of health cost we are willing to
invest to achieve desired profits, prices, wages, etc. In this sense environmental
damages can be viewed as an investment cost rather than a social cost. However,
because we are willing to accept a certain level of pollution, we can view
environmental damages as a cost necessary to keep the economy running.
In terms of growth we can invest various forms of capital. The idea is to grow them
all over time, thereby increasing the base each year. Here are a few:

NC=Natural Capital

PC=Physical Capital

HC=Human Capital

IC=Investment Capital

By maximizing growth, return on investments, continuously over time we maximize

the base for the future.
Let,

C=Investment Capital

C=NC + PC + HC + IC

P=Profits

P=

dNC dPC dHC dIC

+
+
+
dt
dt
dt
dt

max U (Return on Investment )=

0

s .t .,

dP
>0
dC

P
dt
C

Models
Comparing current models and this model we have 7:

=Profits

AC= Abatement Cost

D=Damages

C=Cost of Production

p= price of good

q=quantity of good

Current Models (Damages as Social Cost):

Net Benefits= (C ) ACD(C )

Return on Investment (ROI )=

(C ) ACD( C)
C + AC

7 Kolstad, Charles D., Environmental Economics, Oxford University Press, Oxford and New
York, 2000

Assume fixed investment capital:

max Net Benefits= p( C)qC AC D(C)

Optimal Emissions will occur when the total return on production and damages is
equal to the total return on production and abatement:

pqCD ( C ) p qCD(C) AC
=
C+ AC
C+ AC

D ' = AC '

Assuming fixed capital (abatement cost plus capital cost), in this case optimal
emissions will occur when the Marginal Cost of Abatement (including opportunity
cost) is equal to the Marginal Damages. This is a belief formalized by Weitzman,
Baulmol, Oates, and Coase, to name a few, whether using taxes, quantities, or
property rights. They do not consider damages as an investment cost.

Proposed Model (Damages as Investment Cost):

Net Benefits= (C , D) AC D(C)

Return on Investment=

(C , D) ACD( C)
C+ AC + D (C)

Again assume fixed capital; output cost plus abatement cost. Here damages are
seen as an investment (we invest our health to receive higher revenues which
hopefully outweigh the damages). For any given investment capital we desire the
largest possible return. This requires increased profits, however, now there are also
costs involved. When Marginal Cost of Abatement is equal to the Marginal Damages
the Returns are different (example below). This suggests that although profits are
equal in both cases, the Return on Investment and therefore emissions is not
optimal. .

We want to maximize profits as in the current model:

max Net Benefits= pqC ACD(C)

Optimal emissions will occur when the return from output and damages is equal to
the return from output and abatement, however here we have included damages as
an investment cost and therefore at optimal emissions marginal damages does not
equal marginal cost (again assuming fixed capital):

pqCD ( C ) pqCD(C ) AC
=
C + D ( C ) + AC
C + D ( C ) + AC

Example:
Say Damages are equal to $2, and there is currently no abatement, but $1 of
abatement reduces damages by $1 (MC=MD), and Initial Costs and Fixed Capital =
$98 and Profits are constant at $10 (maybe slight reduction with abatement).

Current Model:
ROI w/o Abatement:
AC=$0, D=$2
ROI w/ Abatement (reduced productive capital to $97):
$8/$98
AC = $1, D=$1
Proposed Model:
ROI w/o Abatement (Damages as Investment Cost of Community):
$8/$100
AC=$0, D=$2
ROI w/ Abatement (reduced productive capital to $97):
$8/$99
AC = $1, D=$1

$8/$98

In the proposed model since the returns are different at MC=MD, the return is not
maximized.

Project:
The return on investment model becomes essential when comparing different firms.
It allows us to compare them on an even field. We can use this model, to determine
relative performances and costs or benefits to the economy which we can assess as
penalty or awards. Now, consider a two company economy with one output:

DB

BTE =

Company Bs
Benefit to the
Economy
CTE =
Company As
Cost to the
Economy

(Company B
Quantity of
Pollution Cost
$)
y

DB*
=
DB,opt

Optimal
Emissions
BTE

Actual
Emissions

DB

R0
CTE

y
*
A

D
D=A,opt

DA

DA
(Company A
Quantity of
Pollution Cost
$)

We want to maximize the weighted average total return on the damage portion of
our investment, given that the current pollution level ( y ) is what is necessary to
keep the economy running.

Given:

max : weighted averagereturn on damages R0 =

AC iDi
Di
Ci + AC i + Di

Di

s .t ., D A +D B= y

Find:

DA* ,DB*, CTE, BTE

Optimal emissions are set by y (actual emissions that which is necessary to keep
the economy running). As you move away from optimal emissions you earn a lower
overall rate of return, R0.The cost to the economy of Company A is assessed as a
penalty which pays for an award to company A equal to its Benefit to the Economy.
Better management will produce higher profits, and will also manage pollution
better if there are profits at stake. Therefore more profitable companies will win
awards and the total profitability will be increased. Over time we will approach zero
emissions .

One thing we are trying to correct, in addition to creating incentive for zero
emissions is the current dislocation between Abatement levels and Pollution Levels
for a given level of Production:

Productio
n with
Abateme
nt

Public
Optimal

Actual

Industr
y

Productio
n with
Pollution

For Example:

Air Pollution in 2002 Cost $74.3 Billion (0.7%) GDP 8

Particulate Matter accounted for $26.5 Billion or 35% of total air
pollution cost (primarily health costs)9

8 Muller, M. Z., Mendelsohn, R., Yale University School of Forestry and

Environmental Studies, Measuring the Damages of Air Pollution in the United States,
Journal of Environmental Economics and Management, 54(2007)1-14
9 Ibid.

Particulate Matter Costs on average costs $3,670 per ton in pollution

related costs10
Particulate Matter costs as little as $53-$337 per ton to prevent
(abate)11,12

General Equilibrium Model Pigouvian Fee Two Firm

Simple Model (Award):

Assume a MRT = 1. We have the social planner and two firms.

Social Planner:

max [ U ( g ( p , d )) ] ( g1)

10 Muller, M. Z., Mendelsohn, R., Yale University School of Forestry and

Environmental Studies, Efficient Pollution Regulation: Getting the Prices Right, The
American Economic Review, Vol. 99, No. 5(Dec., 2009), pp1714-1739
11 United States Environmental Protection Agency, Air Pollution Control Fact Sheet,
EPA-452/F-03-026, Fabric Filter - Reverse-Air Cleaned Type
12 United States Environmental Protection Agency, AirControlNET Version 4.1, 2005

where :

g=good produced

where p= product cost

where d=damages

where =soc ial marginal value

First Order Conditions:

ug ( p ,d )1=

ug ( p ,d ) 2=

Firm 1,2:

max U ( g ( p , d ) ) (g (1+ f )1)

where :

=firmmarginal value

f =Pigouvian Fee

First Order Conditions:

ug ( p ,d ) = 1 ( 1+f 1 )
1

ug ( p ,d ) = 2 ( 1+f 2 )
2

f 1=

social marginal value

1=
1
1
firm marginal value

f 2=

social marginal value

1=
1
2
firmmarginal value

References:
Mill, J. S., On Liberty, 4th Edition, Section I.II, 1859
Baulmol, W., Oates, W., The Use of Standards and Prices for Protection of the
Environment, Swedish Journal of Economics, 1971

Weitzman, Martin, Prices vs. Quantities, The Review of Economic Studies, Vol. 41,
No. 4, 1974
Coase, R., The Problem of Social Cost, Journal of Law and Economics, 1960
Fullerton, D., Wolverton, A., The Case for a Two-Part Instrument: Presumtive Tax and
Environmental Subsidy, NBER Working Paper No. 5993, April 1997
Varian, Hal R., Microeconomic Analysis, W.W. Norton & Company, New York and
London, 1992
Hanley, Nick, Shogren, Jason F., White, Ben, Environmental Economics in Theory and
Practice 2nd Edition, Palgrave Macmillan, Chippenham and Eastbourne, 2007
Kolstad, Charles D., Environmental Economics, Oxford University Press, Oxford and
New York, 2000

Additional Sources:

Muller, M. Z., Mendelsohn, R., Yale University School of Forestry and Environmental
Studies, Measuring the Damages of Air Pollution in the United States, Journal of
Environmental Economics and Management, 54(2007)1-14

Muller, M. Z., Mendelsohn, R., Yale University School of Forestry and Environmental
Studies, Efficient Pollution Regulation: Getting the Prices Right, The American
Economic Review, Vol. 99, No. 5(Dec., 2009), pp1714-1739

United States Environmental Protection Agency, Air Pollution Control Fact Sheet,
EPA-452/F-03-026, Fabric Filter - Reverse-Air Cleaned Type
United States Environmental Protection Agency, AirControlNET Version 4.1, 2005