1. Environmental Economics • Perfectly competitive markets usually produce efficient outcome • When they don’t, we have a market failure • Imperfect information • Imperfect competition • Equity vs. efficiency • Externalities

2. Externalities • Exist when there are extra costs or benefits not captured by the market transaction • Costs of producing good and benefits of selling it accrue not only to sellers, but others as well • Benefits of receiving good and costs of buying it accrue not only to buyers, but others as well • Can be positive or negative

3. Positive externalities: • Individuals enjoy extra benefits they did not pay for • Market will supply less than socially optimal quantity • Ex., research and development • Negative externalities: • Individuals suffer from extra costs they did not incur themselves • Market will supply more than socially optimal quantity • Ex., environmental pollution • Government intervention is necessary

4. Why? • Suppose producing steel causes pollution (a negative externality) • Social marginal cost = marginal cost to all individuals in economy • Private marginal cost = marginal cost to producer alone • With negative externality, SMC > PMC

6. Without externality, point E is efficient (MC = MB) • With externality, must consider SMC SMC = SMB at lower quantity of steel (and less pollution) Government regulation required to correct inefficiency

7. Policy Responses to Pollution • Property rights (Coase theorem) • With appropriately designed property rights, government may not need to intervene directly • Consider a cattle rancher who lives next to a farmer • Cattle keep breaking fence and overgrazing farmer’s land • Suppose gov’t assigns property rights to rancher • If the cost of grazing to farmer outweighs the benefit to rancher, farmer will pay rancher to keep cattle away • Suppose property rights are assigned to farmer • If benefit to rancher outweighs cost to farmer, rancher will compensate farmer for damages • Either way, efficient outcome will emerge when MB to one party equals MC to other

8. Regulation • Command and control approach • Government sets pollution limits and requires uniform standards for all firms • Same benefits can be achieved at lower cost • Regulations don’t allow for variations across firms • Some firms can reduce pollution more efficiently than others; these firms should do the majority of pollution abatement

9. Emissions Taxes • More efficient than regulation • From steel example, MSC > MPC and output levels are higher than socially efficient level • By imposing a tax on each unit of emissions, the cost of pollution is internalized by firms • Cost of production is now higher – MPC  to MSC (supply curve shifts left) • New equilibrium is socially efficient – lower quantity and higher price (price reflects social cost of producing steel)

11. Taxes are more efficient than regulation • Under regulation, firms have incentive to stay “just under” specified level • Taxes increase firms’ costs • Provides incentive to reduce pollution as far as possible and find new abatement technologies or less-polluting production methods

12. Marketable Permits • Gov’t chooses socially efficient level of and issues corresponding number of permits • Each permit allows firm to emit one unit of specified pollutant • Firms can sell their permits • Just like taxes, provides incentive to reduce emissions below regulated standard • Also reaches same reduction in pollution as regulation, but at lower cost

13. Consider two firms emitting SO2 (in tons) If left unregulated, each firm will release 6 tons of SO2 (12 tons total) Suppose goal is to reduce emissions to 6 tons total (3 tons each) Each plant’s cost of pollution abatement is as follows:

14. Plant A Plant B

15. Plant B can reduce emissions at a lower cost than Plant A • Goal is to  emissions by 6 tons total • Regulation: each plant cuts emissions by 3 tons • Total Cost = $6 (Plant A) + $3 (Plant B) = $9

16. Marketable Permits Goal is to ↓ emissions by 6 tons total Each firm is given 3 permits: • Plant A buys a permit from Plant B (at what price?) • Plant A saves $3 by eliminating only 2 tons • Plant B must eliminate 4 tons, but this additional ton costs only $2 to abate • Overall, 6 tons of emissions are eliminated • Total cost = $3 (Plant A) + $5 (Plant B) = $8 • Firms with lower marginal cost of abatement eliminate more  efficient (least-cost) outcome