Chapter 2: Externalities and the

Environment

Chapter 2 Externalities
and the Environment

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
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 Chapter 2: Externalities and the
Environment

Introduction

The economist’s approach to pollution

Economic analysis of a pollution tax and

tradable permits

Applications: Acid rain and global warming

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 Chapter 2: Externalities and the
Environment

Externalities and the Environment

Negative externality Exists whenever a producer or
consumer does not have to pay
for a cost he generates.
• Examples: air pollution,
water pollution, or noise
pollution
Positive externality Exists whenever a producer or
consumer does not receive a
payment for a benefit he generates.
• Examples: immunizations or
improving your home.

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 Chapter 2: Externalities and the
Environment

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.

• government
Who can have property rights? • private firms
• individuals

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 Chapter 2: Externalities and the
Environment

The Economist’s Approach to Pollution

If 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 exist
2. A small number of citizens are harmed
3. There are low transaction costs

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 Chapter 2: Externalities and the
Environment
Trade-off between
Environmental Quality and Output
Figure 2.1

Environmental
Quality
Maximum environmental quality
a
b Increase in environmental quality
c and a decrease in output

d
Maximum output with zero
e environmental quality
f
Output

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 Chapter 2: Externalities and the
Environment
Trade-off between
Environmental Quality and Output
The Virtues of Pollution Prices
Allocation problem
• Command and control method
• Tax method
• Polluters with different technological options
• Permit method
Objections to pollution prices and economist’s responses
• Pollution price is a “license to pollute”
• Pollution prices will raise product prices
• Pollution taxes will raise the tax burden on
the population

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 Chapter 2: Externalities and the
Environment
Charging a Price vs. Mandating or
Subsidizing Clean Technologies
Economists recommend using pollution prices and
oppose mandating or subsidizing clean technologies.

WHY? • 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

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 Chapter 2: Externalities and the
Environment

A Pollution Tax
The right tax generates the right quantity of a polluting good

Figure 2.2
P MSC
J
S (MPC)
I MD
MSC = MPC + MD
$2.50
K
H
D (MB)

80 100 Gasoline

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 Chapter 2: Externalities and the
Environment

A Pollution Tax
Levy a corrective tax (Pigouvian tax) equal to the MD

Figure 2.3
P S` (MSC`)
J
S (MPC)
I T Social optimum quantity
$2.50 is where MSC = MB
K
at 80 units of gasoline
H
D (MB)

80 100 Gasoline

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 Chapter 2: Externalities and the
Environment

A Pollution Tax
An optimal tax confers a net benefit to society

Figure 2.4
P MSC Gain in environmental
J benefit = HIJK
S (MPC)
I
Loss of output = HIK
$2.50
K
Net gain to society
H
= HIJK – HIK
D (MB) = IJK

80 100 Gasoline

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 Chapter 2: Externalities and the
Environment

A Pollution Tax
Use pollution tax revenue to cut other taxes
• Pollution taxes as revenue replacers
• Different ways of returning the tax revenue to the
private sector will have different effects

Tax emissions, not the polluting good

• Whenever feasible, levy the tax per unit of
pollution – per emission – not per unit of
polluting good

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 Chapter 2: Externalities and the
Environment

A Pollution Tax
$200 MACH
Figure 2.5 • To minimize cost, levy the same
tax on all firms emitting pollutant X

2 firms with different MACs

$100

Without government policy,

$60
each firm pollutes 50 units.
$50
MACL
$40

$25
$20

10 25 30 35 40 45 50
Emissions

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 Chapter 2: Externalities and the
Environment

MACH
A Pollution Tax
$200 Figure 2.5
• To minimize cost, levy the same
tax on all firms emitting pollutant X
• Marginal damage and tax rate is constant at $40
• Firms will abate until MAC = T
• Equi-marginal principle
$100
• After the tax is levied,
MACH will abate 10 units and
MACL will abate 40 units
$60
$50
MACL
$40 MD = T • After tax, total
$25 emission is
$20
50 units
10 25 30 35 40 45 50
Emissions

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 Chapter 2: Externalities and the
Environment

Tradable Permits

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?

1. Government sells permits
2. Government gives the permits away

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 Chapter 2: Externalities and the
Environment

Tradable Permits – Government sells permits

$200 DH = MACH
• Each firm’s permit demand
curve is its MAC curve
• The government decided
to supply 50 pollution permits

$100 S

$60
$50 DL= MACL
$40

$25 D = market demand

$20

10 25 30 35 40 45 50 75 Permits

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 Chapter 2: Externalities and the
Environment

Tradable Permits – Government sells permits

$200 DH
What is the optimal permit price?
• Price where S = D
Tentative prices
• P = $50 is too high
• P = $20 is too low
• P = $40 results in the
$100 S desired outcome

• Tax vs. permit

• A hybrid policy
$60 DL
$50 P=$50
$40 P=$40
$25 D
$20 P=$20

10 25 30 35 40 45 50 75 Permits

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 Chapter 2: Externalities and the
Environment

Tradable Permits –
Government gives the permits away
Just like selling permits or levying a tax,
giving permits to polluting firms will reduce pollution.
• The supply curve for each polluting good will shift to the
left
• The price of polluting goods will increase
But, giving the permits away can lead to higher output
and emissions than is socially optimal in the long run.
Which is best?
• Firms want the government to give permits
• Taxpayers want the government to sell permits

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 Chapter 2: Externalities and the
Environment

Application: Tradable Permits for Sulfur

Dioxide to Reduce Acid Rain
Sulfur dioxide causes acid rain
Old policy – a maximum sulfur dioxide emission rate for
new coal-burning electricity generating firms.
New policy – tradable permits are given to electric power
plants
• Clean Air Act Amendments of 1990
• Plants can then buy and sell permits an needed
• Total emissions have fallen with the new policy
• Two issues: long run issue, and tax revenue issue

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 Chapter 2: Externalities and the
Environment

Application: A Carbon Tax or Tradable

Permits to Reduce Global Warming
Carbon emissions cause 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
Policy decision – carbon tax or carbon permits?
Policy decision – how can low-income countries be
induced to participate?

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 Chapter 2: Externalities and the
Environment

Summary

The Economist’s approach to pollution

Economic analysis of a pollution tax and

tradable permits

Applications: Acid rain and global warming

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 Chapter 2: Externalities and the
Environment

Preview of Chapter 3:

Public Goods and Political Economy

The concept of a public good

Political economy

The behavior of the government

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