Part I. Principles
A.
B.
C.
D.
E.
F.
Markets
Market failure
Discounting & PV
Markets 2
Dynamic efficiency
Pollution solutions
F. Pollution Solutions
Chapter 3
Introduction
• Should society intervene to correct market
failures associated with environmental
externalities?
• If so, how?
Pigou
• Use taxes to correct divergence between
MPC and MSC
• Set Pigouvian tax = divergence (measured
at Q*) – this raises firm’s private costs,
forcing MPC=MSC
• “Internalizing the externality”
Figure 3.1 –
An Externality Tax on Output
Coase Theorem
• Ronald Coase (1960) argued that not only is
a tax unnecessary, it is often undesirable.
• Coase argued:
• The market will automatically generate the
optimal level of the externality.
• This optimal level of the externality will be
generated regardless of the initial allocation
of property rights.
Rancher & farmer
• Cattle occasionally leave pasture for
farmer’s property, damaging his crops
• Numerical example: if rancher ↑ herd by 1
unit, receives profits of $3 ,but farmer
suffers loss $10
• Will rancher pursue private benefit and add
the cow?
Rancher & farmer cont.
• No! The rancher and the farmer will
negotiate, because an agreement will make
them both better off
• Farmer WTP rancher < 10 to forgo adding
cow
• Rancher WTA > 3 to forgo adding cow
• Clearly, room for agreement
Problems applying Coase to
environmental problems
• Assumes zero or insignificant transactions
costs
• Property rights matter – affects number of
potential participants in market (if rancher
rights, more ranchers than if farmer rights)
• Income effects – differences in victim’s
WTP to reduce externality and WTA
compensation for increases in externality
Types of
Government Intervention
1. Moral suasion “give a hoot, don’t pollute”
2. Direct production of environmental
quality (reforestation, stocking fish,
cleaning toxic sites, etc.)
3. Pollution prevention (to address imperfect
info)
4. Command and control regulations
5. Economic incentives
Command & Control Regulation
• Place constraints on the behavior of
households and firms
• Generally in form of limits on inputs or
outputs to consumption/production process
• Inputs: scrubbers on smokestacks, banning
use of leaded gasoline
• Outputs: auto exhaust limits, no littering
Economic Incentives
• Goal: to make self-interest coincide with the
social interest
– Pollution taxes/subsidies
– Marketable pollution permits
– Performance bonds
– Liability systems
The correct level of
environmental quality
• Whether employ C & C or economic
incentives – first need to determine the
optimal level of environmental degradation
• What is the desirable level? Is this illogical?
Isn’t all pollution bad?
The correct level of
environmental quality
• Zero level pollution impossible by physics –
law of mass balance
• An activity cannot destroy matter in the
reaction (can only change form)
• Mass outputs = mass inputs
• Burn 10 lbs. wood → 10 lbs not destroyed
(just changed form: smoke, ash, etc.)
The correct level of
environmental quality cont.
• Therefore, eliminating all air pollution →
eliminating all production and consumption
activities
• Some pollution inevitable, zero pollution
neither desirable nor achievable
• Correct level? Depends on MAC and MDC
The Marginal Damage Function
• Damage pollution creates by degrading the
physical, natural, and social environment.
• Include effects on ecosystems, human
health, inhibition of economic activity,
damage to human made structures, aesthetic
effects
Figure 3.3
Marginal Damage Function
MDF
• The marginal damage function in Figure 3.3
specifies the damages associated with an
additional unit of pollution.
• The total damages generated by a particular
level of pollution is represented by the area
under the marginal damage function.
MDF
• An upward sloping marginal damage
function indicates that as the level of
pollution becomes larger, the damages
associated with the marginal unit of
pollution become larger.
• Increasing at increasing rate – rate of
increase increasing
Marginal Abatement Cost Function
• Represents the costs of reducing pollution
by one more unit.
• Abatement costs include:
–
–
–
–
Labor
Capital
Energy needed to lessen emissions
Opportunity costs from reducing levels of
production or consumption.
Marginal Abatement Cost Function
MAC
• In the figure, Eu represents the level of
pollution that would be generated in
absence of any government intervention
(MAC = 0)
• Reading from R to L, as pollution is
reduced below Eu, the marginal abatement
cost increases.
MAC
• MAC rises as cheaper options for reducing
pollution are exhausted and more expensive
steps must be taken.
• Slope decreasing @ decreasing rate– costs
of reducing pollution increases at an
increasing rate.
• High vertical intercept – cost of eliminating
the last few units of pollutants would be
extremely high.
The Optimal Level of Pollution
• Optimal level of pollution minimizes the
total social costs of pollution (the sum of
total abatement costs and total damages).
• This level occurs at the point where
MAC = MDF
• Why?
The Optimal Level of Pollution
The Optimal Level of Pollution
• If E < E1, then MAC > MDF that the unit of
pollution would have caused.
 Doesn’t make sense to reduce pollution.
• If E > E1, then MDF > MAC associated with
reducing pollution by one unit.
 Better off eliminating unit of pollution.
Social Costs When Pollution Level
is Greater than Optimal
Social Costs When Pollution Level
is Greater than Optimal
• The optimal level of pollution is E1.
• The actual level of pollution is E2.
• Total costs associated with pollution have
been increased by the area of triangle abc.
• This represents marginal damages greater
than marginal abatement costs for the range
of pollution emissions between E1 and E2.
Social Costs When Pollution Level
is Less than Optimal
Social Costs When Pollution Level
is Less than Optimal
• The optimal level of pollution is E1.
• The actual level of pollution is E3.
• Total costs associated with pollution have
been increased by the area of triangle ade.
• This represents marginal abatement costs
greater than marginal damage for the range
of pollution emissions between E1 and E3.