Unit 13 - Externalities and Pollution
Many types of production and consumption involve the generation of externalities. An
externality results when the actions of a producer or individual has an impact on the well
being of a bystander. The market fails to properly allocate resources since the market is
only concerned with buyers and sellers that participate in the market transaction and not
the interests of society. When externalities are present, the well being of society is
impacted by the market transaction and the government may want to step in to help remedy
the situation. The role of the government is to help adjust the market outcome to
correspond more closely to what society desires.
Examples of externalities include:
The exhaust from automobiles has an adverse effect on others and is considered a negative
externality. A negative externality is something that society desires less of. In
the case of automobile exhaust the government can help reduce this problem by setting
emissions and fuel efficiency standards for automobiles. The government also collects a
gasoline tax that increases the price of gasoline and hopefully, reduces the amount that
people drive.
An example of a positive externality is the World Wide Web. As is well
recognized, the Web offers seemingly unlimited access to information, opportunity to
increase individual knowledge and undertake lower cost and more convenient transactions.
Due to the tremendous fixed cost of building a comprehensive Internet infrastructure, the
government has played an important role in subsidizing costs and developing technology
that makes the Internet accessible to most individuals.
Negative Externalities and Pollution
In this unit we will focus our attention on the negative externalities caused by
pollution. Assume that we have a firm or industry (e.g. steel, paper, leather, etc.) that
creates air or water pollution during the production process. When not treated the
wastewater is dumped into the local river or pollutants are pumped into the air. The
consequences of water pollution include the degradation of fish and animals that depend on
the water, the surrounding environment, recreational and business uses of the water,
possible human health consequences and the need for extensive treatment by downstream
communities that use the water for drinking. Although perhaps not as directly
identifiable, air pollution creates a long list of significant problems.
One of the reasons that pollution results in the production process is the lack of
property rights. If the paper manufacturer tries to dump waste in the pond of a local
landowner, legal action can be taken against the paper firm. The property owner subject to
pollution can identify the loss in property value caused by the industrial effluents and
sue the firm for compensation. In contrast, the air and most waterways are not owned by
individuals or businesses and are public goods. Public goods are common
property, shared by all including firms that generate pollution when they produce goods
and services. Public goods are defined as when a person's consumption of that good does
not exclude others from the same good. When you take a breath of air, no one else is being
excluded from breathing. Firms have an incentive to use public goods in the production
process since it costs the firm nothing to use that good. If a steel mill can minimize
production costs by dumping wastes for free into the local river than it will do so unless
the government takes steps to prevent or discourage polluting. An important role of the
government and the legal system is to protect public goods that have many purposes from
being over polluted by industry that seeks to minimize costs and to maximize profits.
Society desires clean water for recreation, drinking and the ecosystem and the government
and legal system have a role in protecting the broad interests of society from the narrow
focus of industry.
When externalities are present there is a divergence between the firm's private
production cost and the social cost of production. The firm does not consider the cost of
pollution cleanup to be relevant while society does. As a result, the social costs of
production include the negative effects of pollution and the costs of treatment and end up
exceeding private production costs. The relationship is shown in Figure 13-1. The firm's
private supply curve is labeled S and equals marginal private costs (MPC). The market
equilibrium of MPC and the demand curve yields the price and quantity when the negative
effects of pollution are not considered. Production costs that are externalized
by the firm include the negative effects of pollution and cost of treatment. The marginal
social cost (MSC) curve adds external costs to private production costs.
As we can see, when pollution and treatment (external) costs are included, less of
the good should be produced and it should be sold at a higher price. As we will discuss
shortly, the government can help correct the private market outcome when pollution is part
of the production process by taxing firms that pollute or requiring them to purchase
pollution permits.
The next issue to address is how much pollution is economically desirable.
Optimally, we would live in a perfect world with zero pollution. However, technology is
far from allowing producers and consumers to achieve that outcome. If people drive cars,
pollution is the consequence and unless automobiles are completely banned, pollution will
persist. Obviously, given our love of the automobile, it is not in the interests of
society to have zero pollution. As a whole, we are willing to accept some pollution as
part of the modern economy, comforts and freedom that we have access to. Figure 13-2 gives
us an idea of the economically efficient level of pollution abatement. In our analysis it
is best to think of a specific pollutant such as chlorofluorocarbons,
carbon dioxide or sulfur dioxide.
As we move to the right along the horizontal axis of Figure 13-2, pollution abatement
increases and so does the amount of money spent to reduce pollution. Near the origin,
minimal pollution control takes place and the cost of pollution abatement (MSC) is low.
For many pollutants, is it relatively inexpensive to clean up the majority of the
pollution. As pollution abatement approaches 100% (zero emissions) the marginal cost of
reducing emissions by another unit rise dramatically. The slope of the marginal social
cost curve reflects this fact as it rises steeply with nearly complete abatement.
Marginal social benefits of abatement reflect the health, esthetic, and other
environmental benefits as pollution is reduced. In the 1970s, many American rivers were a
mess due to high levels of toxic pollutants. Swimming in many was prohibited as a health
hazard, fish in these rivers contained high levels of mercury, cadmium, DDT and other
distasteful contaminants and a few Midwestern rivers even caught on fire. As the marginal
social benefit curve shows, a little pollution reduction yields high benefits; at least
you don't have to explain why the local river is in flames. As pollution abatement
approaches 100%, the incremental benefit of reducing pollution falls as the benefits as
less noticeable. If we can swim, fish, boat and picnic at the local river, we are not
likely to notice the pollutants that remain in the sediment. Certainly, the cost of
removing the entire contaminated river bottom would be astronomical and economically
undesirable.
In Figure 13-2, we can find a balance between the benefits of pollution abatement and
the cost of achieving a better environment. Q* is the optimal economic level of abatement.
We must remember that although we desire minimal pollution and maximum abatement, it costs
money. And public funds spent on pollution abatement are not available for other purposes
such as education, health care, parks, fire and police services and many other public
goods and services. Pollution abatement and treatment is part of a large social menu.
Points to the right of Q* represent too much pollution abatement as the added benefit of
further abatement is less than the cost of reducing pollution further. In other words,
when abatement is budgeted beyond Q*, society as a whole prefers that the money is spent
elsewhere (e.g. for schools).
It is best to think of Figure 13-2 in a dynamic sense. As the technology used in
pollution control improves over time, the cost curve for abatement shifts outward and it
is efficient to increase abatement. As our understanding of the hazards of pollution are
better understood, the benefits from abatement increase and the benefit curve will shift
outward, also making a greater level of abatement economically desirable.
Reducing Emissions: Applying a Pollution Tax
Looking at Figure 13-1 above, one way to raise production costs when pollution is a
byproduct of the production process is to tax pollution. When applied a pollution tax
requires polluting firms pay a tax based on the air, water and land pollution that they
generate. The benefit of a tax is that raises production costs, shifting the firm's
private supply curve upward toward the social cost of production. In addition, the tax
generates revenues that the government can use to help mitigate the damages of pollution
and compensate individuals and businesses that are directly hurt by the pollution.
On the negative side, environmental taxes and regulations tend to discourage economic
activity because they raise the cost of producing output to firms affected by the tax. For
example, a tax on carbon emissions would increase the costs to firms of purchasing coal
and oil in particular and in turn would increase the cost of electricity and gasoline.
Most likely, firms would scale back their production activities in response to these
higher costs, leading to a fall in the level of investment and employment (as happened,
for example, in the 1970s when the price of energy increased).
To offset the impact on a firm or an industry, a carbon tax would raise revenues for
the government. These revenues can be used to reduce other taxes in the economy, such as
personal and corporate taxes, and thereby reduce the distortion in the macroeconomic level
of employment and investment. Environmental taxes can both reduce pollution emissions and
reduce the overall economic costs associated with the tax system. When unemployment is a
significant problem, environmental tax revenues can be used to reduce taxes on labor
income, and as a result, unemployment and pollution might be reduced simultaneously.
Studies have found that there is a limit to using taxes as a revenue source before they
begin to have a detrimental impact on the macroeconomy. Recent research generally supports
carbon taxes so long as the tax rates are not too high (that is, so long as they do not
exceed the incremental value of environmental benefits).
Paradoxically, using pollution taxes to substitute for conventional revenue sources may
become too effective in reducing pollution as clean, lightly taxed substitutes can replace
heavily taxed goods resulting in a decline in a major source of tax revenue. In Sweden,
where dirtier automotive diesel has been taxed relatively heavily since 1991, almost all
diesel fuel is now of the cleanest type and sulfur emissions from diesel vehicles have
fallen by 75%. In Norway, the carbon-dioxide tax has prompted a switch away from fossil
fuels, cutting emissions from power stations and factories by one-fifth since 1991. Taxes
that cut pollution dramatically will not yield much revenue in the long run and
governments would have to go back to more traditional sources of revenue.
As an alternative to taxes, regulation may be the most obvious way to cut pollution.
Using regulation governments can simply ban dirty activities, or force companies to use
“clean” technology. But regulation tends to make polluters use a specific
technology, rather than investing in cleaner production methods, and it often forces all
polluters to undertake the same sort of clean-up although individual clean-up costs vary
enormously.
Reducing Emissions: Tradable Pollution Permits (TPP)
Instead of imposing a tax or regulations, in 1994 the U.S. government inaugurated a
program to reduce sulfur dioxide (SO2) emissions by requiring that firms have a
permit for each ton of SO2 they emit. The program is run by the U.S.
Environmental Protection Agency (EPA). The major source of sulfur dioxide is coal-fired
electric plants and it is the primary source of acid rain. Unlike taxes or regulations
that treat firms uniformly, TPPs give firms flexibility in how they respond. Starting in
1995, the government set a cap that reduced the number of tons of SO2 it would
allow in the air and declining thereafter. Firms were each allocated permits based on
their historical level of SO2 emissions.
The program allows permits to be bought and sold among firms that emit SO2.
A firm can invest in scrubbers or switch from high sulfur to more expensive low sulfur
coal to reduce its SO2 emissions and sell its excess permits, offsetting part
of the cost of reducing pollution. Other firms may have older factories and desire to
avoid the expense of pollution control and will purchase permits to emit SO2.
At a national level, SO2 remains at the target level and firms can respond in
the best way that current technology and plant allows them to. Furthermore, the permits
are tradable on the Chicago Mercantile Exchange and the Chicago Board of Trade allowing
anyone to purchase permits. Governments, organizations and individual can purchase permits
in order to reduce the total amount of SO2 that can be emitted. The utility
industry estimates that trades have doubled every year and actual volume is probably
double that-or equal to the $1.2 billion cash market for U.S. soft red winter wheat. The
price of a permit is slowly rising to the $100 range and is expected to continue to
increase.
Looking for a unique gift for your spouse, buy them a permit to emit one ton of SO2,
and if they don't use it, then you are helping the environment by reducing sulfur dioxide
emissions by the same amount. More typically, organizations such as the Sierra Club will
buy permits to help reduce total SO2 emissions over time. As part of a
sixth-grade science project, students in Glens Falls, N.Y. held raffles, bake sales and
auctions over a three-year period, and raised $25,000 to buy 330 certificates in the
acid-rain-emissions trading program. The Los Angeles area's South Coast Air Quality
Management District, for example, established a program in which it gave four oil
refineries credit in the form of certificates for removing the equivalent 2,000 tons of
smog after they bought and junked 17,502 pre-1982 cars, which, the agency says, spewed an
equivalent amount of pollution over the four-county district. The EPA expects sulfur
dioxide trading to reach $648 million by 1999.
Limits on the emissions of the “greenhouse gases”, notably carbon dioxide (CO2),
that have caused the gradual rise in the earth’s temperature are an obvious way to
tackle the problem of global warming. In December 1997, representatives of 150 nations
gathered in Kyoto, Japan to discuss placing constraints on greenhouse gasses. One proposal
that headlined discussions was the idea of international tradable pollution permits to
limit CO2 emissions. In the beginning, only the industrial developed countries
would participate in the program, while poorer countries would focus on economic
development and reducing poverty. Under this concept, each of the 33 countries the
initially participate in curbing emissions would accept a target and a standard for
determining how much it is emitting—two items that are basically settled already.
Each government could allocate its allowable emissions to different uses. On average,
about half of these come from non-point sources, such as cars and home heating systems,
that would be hard to monitor with a permit system. Each government would divide the
remainder of its allowable emissions among the handful of big industries, such as oil
refineries and steelworks, that spew out greenhouse gases in large amounts. Allocations
would be made annually, and would diminish over time. Industrial nations that curb
emissions below 1990 levels would have allowances to sell. Countries that can't curb it,
or won't, must buy them.
On a national basis, emissions trading would be straightforward. An aging coal-fired power
station might conclude that it would be cheaper to buy extra emissions capacity than to
switch fuel sources. It finds a nearby power plant that has switched to clean coal and
therefore is emitting less than its entitlement. They make a deal. The national emissions
targets are still met, just redistributed.
Trading could work across borders as well. Suppose an America coal-fired power station
finds that meeting its allocation of emissions is unexpectedly expensive. It might
contract to buy the unused emissions of a Russian chemical plant working far below
capacity. This leaves some tricky accounting: American emissions will rise, perhaps
alarming environmentalists, even though those in Russia will fall. The catch is the rapid
development taking place in many poorer countries. If poor countries increase their
emissions of greenhouse gases, overall emissions worldwide will rise, even if wealthier
countries succeed in scaling back the use of coal-burning power plants and petrol-driven
cars.
A subset of emissions trading is “joint implementation,” in which one country
does something that reduces carbon dioxide levels in another country, perhaps replanting a
logged-out forest or modernizing a smoke-belching smelter, and applies part of that
reduction against its own commitments. Many such projects would probably involve poorer
countries, because they have more opportunities for inexpensive emissions reduction. In
this scenario, a company in a developed country could help a firm in a developing country
modernize production and reduce carbon dioxide emissions. A U.S. company could go over to
a developing nation, make a major investment to reduce the carbon dioxide emissions and
receive credit for the investment. The U.S. Energy Department has been helping Costa Rica
develop a program based on reforestation. For outside investors, Costa Rica will agree to
protect a portion of its rain forest that would otherwise be logged. Because standing
forests remove carbon dioxide from the air, Costa Rica will then issue trading
certificates.
The real problems are not theoretical but logistical. America’s sulfur-reduction
program has an enforceable target and a limited number of players. The measurement and
monitoring systems are effective. The bureaucracy has resisted pressure to hand out more
pollution rights to companies that complain about the difficulty of reducing emissions.
All of those things have to happen to make an emissions-trading system work. Adapting the
U.S. acid-rain program to do that means stretching a trading program designed to cover
hundreds of emitters to one that would cover millions and allowing international
transactions. An international permit system would require monitoring of each participant
and countries would have an incentive to under report. When a country is caught cheating,
enforcing a penalty could be very difficult.
One of the major beneficiaries of the program's 1990 target date for emissions is Russia.
Russia will have a great many allowances to sell because its industrial economy has
collapsed since 1990, sharply cutting its emissions. Selling excess permits could
represent a lucrative source of foreign money for Russia. Chinese diplomats reject
carbon-dioxide controls as "ecocolonialism." But some officials see trading as
an additional means of getting outside investors to clean up most of China's severe
pollution problems in exchange for trading certificates.
Annual carbon-dioxide emissions
|
Total Tons
(millions) |
Tons per
Capita |
| U.S. |
5,475 |
20.52 |
| China |
3,196 |
2.68 |
| Russian Federation |
1,820 |
12.26 |
| Japan |
1,126 |
9.03 |
| India |
910 |
0.90 |
| Germany |
833 |
10.24 |
| U.K. |
539 |
9.29 |
| Ukraine |
437 |
8.48 |
| Canada |
433 |
14.83 |
| Italy |
411 |
7.19 |
| South Korea |
370 |
8.33 |
| Mexico |
359 |
3.93 |
Source: Oak Ridge National Laboratory assessment of 1995 data
Copyright © 1999, Jay Kaplan
All rights reserved
Last updated July 1999