Externalities and the
Environment
CHAPTER
17
© 2003 South-Western/Thomson Learning
1
Introduction
Must begin by distinguishing between
exhaustible and renewable resources
Exhaustible resource does not renew
itself  available in a finite amount
Coal, oil, etc
A resource is renewable if, when used
conservatively, it can be drawn on
indefinitely
Trees, fish, atmosphere, water
2
Renewable Resources
Some renewable resources are openaccess goods
Open-access resource is rival in
consumption but exclusion is costly
For example, fish caught in the ocean
are not available for others to catch 
rival in consumption
3
Renewable Resources
However, it would be difficult for a
person or firm to “own” fish still in the
ocean and prevent others from catching
them  exclusion is costly
An open-access good is often subject to
the common-pool problem  results
because people consume a good until
the marginal value of additional use
drops to zero  they are often overused
4
Renewable Resources
In a market system, specific individuals
usually own the rights to resources and
therefore have a strong interest in using
those resources efficiently
Private property rights allow individuals
to use resources or to charge others for
their use
Defined and enforced by government, by
social actions, and by ethical norms
For open-access resources, specifying and
enforcing property rights is costly
5
Renewable Resources
Pollution and other negative
externalities arise because there are no
practical, enforceable, private property
rights to open-access resources, such as
air and water
Market prices usually fail to include the
costs that negative externalities impose
on society
6
Resolving the Common-Pool Problem
By imposing restrictions on resource
use, government regulations may be
able to reduce common-pool problems
Output restrictions or taxes could force
firms to use the resources at a rate that
is socially optimal
More generally, when imposing and
enforcing property rights would be too
costly, government regulations may
improve allocative efficiency
7
Resolving the Common-Pool Problem
Not all regulations are equally efficient
For example, the specific regulation
may lead each firm to act rationally, but
the collective effect of the regulation
and their actions is grossly inefficient in
terms of social welfare
8
Negative Externalities: Fixed Technology
How could output be restricted to the
socially efficient level?
If government policy makers knew the
demand and marginal cost curves, they
could simply restrict electric utilities to
produce that optimal level
Alternatively, they could impose a
pollution tax on each unit of output
equal to the marginal external cost
9
Negative Externalities: Fixed Technology
In the case of the pollution tax, the
marginal private cost curve would shift
upward to the marginal cost curve 
private costs are brought in line with
public costs
Thus, setting the tax equal to the
marginal external cost results in a level
of output that is socially efficient  the
marginal social cost of production
equals the marginal benefit
10
Negative Externalities: Variable Technology
The preceding example assumes that the
only way to reduce the total amount of
pollution is to reduce output
However, power companies can usually
change their resource mix to reduce
emissions for a given level of output,
particularly in the long run
Because pollution can be reduced by altering
the production process rather than by simply
adjusting the rate of output, these
externalities are said to be produced under
conditions of variable technology 
11
Negative Externalities: Variable Technology
Thus, the idea that all air pollution should
be eliminated is a popular misconception
Some pollution is consistent with
efficiency  improving air quality
benefits society as a whole as long as the
marginal benefit of cleaner air exceeds its
marginal cost
What would happen to the optimal level
of air quality if either the marginal cost or
the marginal benefit changed 
12
The Coase Theorem
The traditional analysis of externalities
assumes that market failures arise
because people ignore the external
effects of their actions
Consider the following example
A research laboratory that tests delicate
equipment locates next to a manufacturer
of heavy machinery
The vibrations caused by the manufacturing
process throw off the delicate machinery in
the lab
13
The Coase Theorem
Coase pointed out that the negative
externality in this case is not necessarily
imposed by the machinery producer on
the testing lab
Rather, it arises from the incompatible
activities of the two parties  the
externality is the result both of
vibrations created by the factory and of
the location of the testing lab next door
14
The Coase Theorem
There are two efficient solutions in this
situation
Modify the machines in the factory, or
Move the lab elsewhere
According to Coase, the efficient solution
depends on which party can avoid the
problem at the lower cost
15
The Coase Theorem
Suppose the following
The factory determines that it would cost $2
million to reduce vibrations enough to allow
the lab to function normally
The testing lab concludes that it cannot
alter its equipment to reduce the effects of
the vibrations  its only recourse is to move
at a cost of $1 million
Thus, the least-cost, or most efficient
resolution to the externality problem is
for the testing lab to relocate
16
The Coase Theorem
Coase argued that when property rights
are assigned to one party or another,
the two parties will agree on the
efficient solution to an externality
problem as long as the transaction costs
are low  the efficient solution will be
achieved regardless of which party gets
the property rights
17
The Coase Theorem
Suppose the testing lab is granted the
right to operate free of vibrations  it has
the right to ask the factory to reduce its
vibrations
Rather than cut vibrations at a cost of $2
million, the factory can offer to pay the
lab to relocate
Any payment by the factory owners that is
greater than $1 million but less than $2
million will make both better off  the lab
will move, which is the efficient outcome
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The Coase Theorem
Alternatively, suppose the factory is
granted the right to generate vibrations
regardless of any effects on the testing
lab  business as usual
The lab may consider paying the factory
to alter its production method, but since
the minimum payment the factory
would accept is $2 million, the lab
would rather move at a cost of $1
million
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The Coase Theorem
Thus, whether property rights are
granted to the lab or to the factory, the
lab will move which is the most efficient
solution
Note
Regardless of who is given the property
rights, an efficient outcome results
A particular assignment of property rights
determines only who incurs the externality
cost not the efficient outcome
20
Markets for Pollution Rights
The primary implication of the Coase
Theorem is that assignment of property
rights is often sufficient to resolve the
market failure associated with
externalities  no further government
intervention is necessary
If pollution can be easily monitored and
polluters easily identified, the government
may be able to achieve an efficient solution
to the problem of pollution simply by
assigning the right to pollute
21
Markets for Pollution Rights
Consider the following example:
Firms that dump waste into a river
evidently value the ability to discharge
waste in this fashion  provides an
inexpensive outlet for pollutants that
would have to be disposed of at a greater
cost
The river provides disposal services, and
the demand curve for this pollutant  the
demand curve slopes downward 
22
Markets for Pollution Rights
The beauty of this system is that
producers who value the discharge rights
the most will ultimately end up with them
Producers who attach a lower marginal
value obviously have cheaper ways of
resolving their waste problems
And if conservation groups want a higher
quality than the government’s standard,
such as waste clean enough to drink, they
can purchase the pollution permits
23
Markets for Pollution Rights
If the right to pollute could be granted,
monitored, and enforced, then what had
been a negative externality problem
could be solved through market
allocation
In 1989, a pollution-rights market for
fluorocarbon emissions was established
and was followed in 1990 by a market
for sulfur dioxide and during the 1990s
sulfur-dioxide emissions fell by more
than half
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Markets for Pollution Rights
Unfortunately, legislation dealing with
pollution is affected by the same
problems of representative democracy
that trouble other public policy
questions
Polluters have a special interest in
government proposals relating to
pollution  they fight measures to
reduce pollution
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Markets for Pollution Rights
However, members of the public remain
rationally ignorant about pollution
legislation
So pollution regulations may be less in
accord with the public interest than
with the special interests of polluters
This is why a portion of pollution
permits are often given free to existing
firms
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Markets for Pollution Rights
Prior to 1990, traditional commandand-control environmental regulations
were the norm
This approach required polluters to
introduce particular technologies to reduce
emissions by specific amounts
These regulations were based on
engineering standards and did not recognize
unique circumstances across generating
plants
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Markets for Pollution Rights
Economic efficiency approach
Reflected by the pollution rights approach
Offers each polluter the flexibility to reduce
emissions in the most cost-effective manner
given its unique costs
Firms with the lowest emission control costs
have an incentive to implement the largest
reduction in emissions, and then sell unused
allowances to those with greater control costs
28
Environmental Protection
Environmental Protection Agency, EPA,
coordinates federal efforts to address
common-pool problems
Four federal laws and subsequent
amendments underpin U.S. efforts
The Clean Air Act of 1970
The Clean Water Act of 1972
The Resource Conservation and Recovery Act
of 1976 which governs solid waste disposal
The Superfund law of 1980 focusing on toxic
waste dumps
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Environmental Protection
Compliance with pollution-control
regulations costs U.S. producers and
consumers an amount equivalent to 2%
of gross domestic product
Pollution-abatement spending can be
divided into three categories
Spending for air-pollution abatement: 40%
toward cleaner air
Spending for water-pollution abatement:
40% toward cleaner water
Spending for solid waste disposal: 20%
30
Air Pollution
In the Clean Air Act of 1970, Congress set
national standards for the amount of
pollution that could be emitted into the
atmosphere  recognized the atmosphere
as an economic resource with alternative
uses
Smog is the most visible form of air
pollution
Automobile emissions account for 40% of smog
40% from consumer products
15% from manufacturing
31
Air Pollution
Despite recent improvements in air quality,
the United States is still a major source of
carbon dioxide emissions
Kyoto accord would require the 38
industrial countries to reduce emissions by
one-third over ten years  cost to U.S. of
$300 billion a year
Problem is that this accord requires nothing
from developing countries like China and
India which are major polluters
32
Water Pollution
Two major sources of water pollution
Sewage
• For decades, U.S. cities had an economic incentive to
dump their sewage directly into waterways
• Federal money over the years has funded sewage
treatment plants that have cut water pollution
substantially  nearly all cities now have modern
sewage control systems
• New York City is the exception and still dumps raw
sewage into the Atlantic Ocean
Chemicals
• 10% comes from point pollution  pollution from
factories and other industrial sites
• Two-thirds comes from nonpoint pollution  runoff
from agricultural pesticides and fertilizers
33
Water Pollution
The EPA has turned pesticide regulation
over to the states which gave the job to
their departments of agriculture
However, these state agencies usually
promote the interests of farmers, not
restrict what they can do
The EPA now reports that pesticide
residues on food pose more health
problems than do toxic waste dumps or
air pollution
34
Hazardous Waste and the Superfund
The chemicals posed by the synthetic
chemical industry occur at every stage
in their production, use, and disposal
New Jersey manufactures more toxic
chemicals than any other state and has
the worst toxic waste burden
Prior to 1980, once a company paid
someone to haul away its hazardous
waste, the company was no longer
responsible
35
Hazardous Waste and the Superfund
The Comprehensive Environmental
Response, Compensation, and Liability
Act of 1980 – Superfund law – now
requires any company that generates,
stores, or transports hazardous wastes
to clean up any wastes that are
improperly disposed of
Gives the federal government authority
over sites contaminated with toxins
36
Hazardous Waste and the Superfund
To get an offending company to comply,
the EPA frequently must sue
This process is slow, and nearly half the
budget goes to lawyers, consultants and
administrators rather than to site
cleanups
The law did not require that benefits
exceed costs or even that such
comparisons be attempted
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Hazardous Waste and the Superfund
Although billions have been spent so
far, an EPA study concluded that the
health hazards of Superfund sites have
been vastly exaggerated
Because of their greater political
urgency and media appeal, toxic waste
dumps tend to receive more attention
and air or water pollution
38
Solid Waste: Paper or Plastic
About 70% of the nation’s garbage is
bulldozed and covered with soil in
landfills
As the cost of solid-waste disposal
increases, state and local governments
are charging for trash pickups and
requiring recycling  the process of
converting waste products into reusable
material
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Solid Waste: Paper or Plastic
Still, according to the EPA, only about
15% of U.S. garbage gets recycled,
about 15% is incinerated, and the
remaining 70% goes into landfills
Of the recycled material, three quarters
consists of paper related materials
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Solid Waste: Paper or Plastic
Some recycling is clearly economical,
but recycling imposes its own cost on
the environment
Curbside recycling requires fleets of trucks
that pollute the air
Newsprint must first be de-inked, creating a
sludge that must be disposed of
Cost of more efficient packaging material
41
Positive Externalities
Positive externalities occur when the
unpriced by-products of consumption or
production benefit other consumers or
other firms
For example, people who get inoculated
against a disease reduce their own
likelihood of contacting the disease, but
in the process they also reduce the risk
of transmitting the disease to others 
external benefits to others
42
Positive Externalities
Education also confers external benefits
on society as a whole because those
who acquire more education
Become better citizens
Are better able to support themselves and
their families
Less likely to require public assistance
Less likely to resort to crime
Thus, education confers private benefits
and additional social benefits to others
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Positive Externalities
When positive externalities are present,
decisions based on private marginal
benefits result in less than the socially
optimal quantity of the good
Hence, they typically point to a market
failure, which is why government often
gets into the act
When there are external benefits, public
policy aims to increase the level of
output beyond the private optimum
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