Economics NINTH EDITION Chapter 31 Insert Cover Picture External Costs and Environmental Policy Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved Learning Objectives 31.1 Use the marginal principle to describe the optimum level of pollution 31.2 Describe the role of taxation in promoting efficient environmental policy 31.3 Explain the superiority of taxation over traditional regulation 31.4 Describe the virtues of marketable pollution permits and the factors that determine their price 31.5 List three external costs associated with automobiles Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.1 THE OPTIMAL LEVEL OF POLLUTION (1 of 4) In a recent report, the IPCC presents three key Concerns Observed Changes in Climate Causes of Change Projected Climate Change and its Impacts Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.1 THE OPTIMAL LEVEL OF POLLUTION (2 of 4) Using the Marginal Principle MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal cost Choose the level at which the marginal benefit equals the marginal cost From society’s perspective, there are many benefits from pollution abatement: Better health Increased enjoyment of the natural environment Lower production costs Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.1 THE OPTIMAL LEVEL OF POLLUTION (3 of 4) Example: The Optimal Level of Water Pollution The efficient level of pollution abatement, where marginal benefit equals marginal cost, is 300 tons (200 tons of waste) If the polluter has property rights we start with zero abatement and the other party pays for 300 tons of abatement If the other party has property rights, we start with zero abatement and the polluter pays to increase pollution to 200 tons of waste Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.1 THE OPTIMAL LEVEL OF POLLUTION (3 of 3) Coase Bargaining Coase bargaining solution, named after economist Ronald Coase, applies to a situation when there is a small number of affected parties, and the transactions costs of bargaining are relatively low We can illustrate the bargaining solution with our example of a lake shared by a steel mill and a fishing firm If the steel mill has the property rights to the lake, it can dump waste into the lake The fishing firm benefits from abatement, and would be willing to pay the mill to reduce pollution For the first ton of abatement, the fishing firm is willing to pay $21, the cost of abating the first ton is only $3, and the two parties can cut a deal If they split the difference between the benefit and the cost, the fishing firm will pay $12 to the mill for one ton of abatement, and both will be better off The fishing firm pays $12 to get $21 in additional fish, while the mill gets $12 to incur an abatement cost of $3 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION REDUCING METHANE EMISSIONS APPLYING THE CONCEPTS #1: How we determine the optimum level of pollution? Methane is one of the greenhouse gases that contributes to global warming It is released into the atmosphere from landfills, natural gas systems, coal mining, and livestock management Pollution abatement requires capturing methane before it is released and using it to generate electricity •Marginal cost is $10 per ton up to 36 million ton •Rising to $150 per ton up to 69 million tons The optimal level of abatement is where the marginal benefit equals the marginal cost Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.2 TAXING POLLUTION (1 of 6) Private cost of production The production cost borne by a producer, which typically includes the costs of labor, capital, and materials External cost of production A cost incurred by someone other than the producer Social cost of production Private cost plus external cost Pollution tax A tax or charge equal to the external cost per unit of pollution Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.2 TAXING POLLUTION (2 of 6) A Firm’s Response to a Pollution Tax From the perspective of a firm subject to a pollution tax, the marginal benefit of abatement is the $3,500 pollution tax that can be avoided by cutting pollution by one ton The firm satisfies the marginal principle at point c, with six tons of abatement, leaving two tons of SO2 discharged into the atmosphere Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.2 TAXING POLLUTION (3 of 6) The Market Effects of a Pollution Tax The production of electricity generates two major pollutants: Sulfur dioxide Electric power plants are responsible for about two-thirds of SO2 emissions As we saw earlier in the chapter, the marginal damage from SO2 is $3,500 per ton, so that’s the appropriate pollution tax Nitrogen oxides (NOx) Power plants are also responsible for about one-quarter of the nation’s NOx emissions, a contributing factor in acid rain and the most important factor in urban smog The study cited earlier in the chapter estimated that the appropriate tax for NOx is about $1,100 per ton Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.2 TAXING POLLUTION (5 of 6) Taxes on SO2 and NOx cause electricity generators to switch to low-sulfur coal and to alternative energy sources that generate less SO2 and NOx SOURCE: Based on Spencer Banzhaf, Dallas Burtraw, and Karen Palmer, “Efficient Emission Fees in the U.S Electricity Sector,” Resource and Energy Economics 26 (2004): 317–341 Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION WASHING CARBON OUT OF THE AIR APPLYING THE CONCEPTS #2: What are the possible responses to a pollution tax? A carbon tax would reduce greenhouse emissions in several ways: The price of gasoline would increase, causing people to drive less and buy more energy-efficient vehicles The tax would increase the price of electricity, decreasing the quantity of electricity demanded and the quantity of fossil fuels burned The higher price of home heating would cause people to turn down their thermostats and improve the heating efficiency of their homes, perhaps by installing energy-efficient windows or more insulation Some electricity producers would switch from coal to natural gas, which has a lower carbon content, and thus a lower carbon tax Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.3 TRADITIONAL REGULATION (1 of 4) Uniform Abatement with Permits Consider an area with two electricity generators, firm L (for low cost) and firm H (for high cost) Suppose that in the absence of pollution-abatement efforts, each firm would discharge five tons of pollution per hour The government sets a target abatement level of two tons of SO per hour, divided equally between the two firms Under this uniform abatement policy, the government will issue four pollution permits to each firm, forcing each firm to cut pollution from five tons to four tons ▼ TABLE 31.1 Uniform Reduction versus Pollution Tax Abatement Cost Marginal Uniform Pollution Tax = Abatement Cost Abatement Policy $3,000 per Ton Low-Cost Firm $2,000 $2,000 $4,000 High-Cost Firm $5,000 $5,000 $ $7,000 $4,000 Total Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.3 TRADITIONAL REGULATION (2 of 4) Command and Control The problem with this approach is that the mandated abatement technology—the control part of the policy—is unlikely to be the most efficient technology for two reasons: The regulatory policy specifies a single abatement technology for all firms Because the producers of a polluting good often use different materials and production techniques, an abatement technology that is efficient for one firm may be inefficient for others The regulatory policy decreases the incentives to develop more efficient abatement technologies The command part of the policy specifies a maximum volume of waste for each firm, so there is no incentive to cut the volume of waste below the maximum allowed Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.3 TRADITIONAL REGULATION (3 of 4) Market Effects of Pollution Regulations How the market effects of pollution regulation compare to the effects of a pollution tax? Recall that the uniform abatement policy achieves the same reduction in pollution at a higher cost because it doesn’t exploit differences in abatement costs across firms In addition, the control part of command and control may lead to relatively costly abatement techniques because there’s no incentive to develop better ones This will cause the supply curve for the polluting good to shift upward by a larger amount than it would with a tax A larger supply shift causes a larger increase in the equilibrium price and a larger reduction in quantity The inefficiency of regulations is passed on to consumers, who pay higher prices Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.3 TRADITIONAL REGULATION (4 of 4) Lesson from Dear Abby: Options for Pollution Abatement The readers of “Dear Abby”offered the following suggestions to Dreading Winter: Buy the neighbors a catalytic add-on for the wood stove or a wood-chip gasifier for an oil furnace In either case, there would be much less air pollution from burning wood Soak a towel in water, swish it around the room, and watch the smoke disappear Leave a saucer of vinegar in each room to eliminate the smoke odor Pay your neighbors to hire a chimney sweep to clean their flue Seal and caulk your windows to keep the smoke outside at a cost of less than $500 Use the $500 to purchase an air purifier for your home There is usually more than one way to deal with a pollution problem Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION OPTIONS FOR REDUCING CO2 EMISSIONS FROM INTERNATIONAL SHIPPING APPLYING THE CONCEPTS #3: What is the most efficient way to reduce pollution ? International shipping is responsible for about 3% of global CO2 emissions, and there are many ways to reduce (abate) CO2 emissions As a tool for comparing the cost of alternative reduction methods, policy analysts compute the marginal abatement cost (MAC) of each method, defined as the cost per ton of CO2 abated For low-cost methods such as propeller maintenance and weather-sensitive routing, the fuel savings cover the cost of the abatement method, so the MAC for these methods is close to zero For other abatement methods, the MAC are higher: Switch from diesel to gas-powered engines: $20 per ton Reduce speed and increase fleet size: $90 per ton Install fixed sails and wings to tap wind power: $105 per ton Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.4 MARKETABLE POLLUTION PERMITS (1 of 3) Marketable pollution permits A system under which the government picks a target pollution level for a particular area, issues just enough pollution permits to meet the pollution target, and allows firms to buy and sell the permits; also known as a cap-and-trade system Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.4 MARKETABLE POLLUTION PERMITS (2 of 3) Voluntary Exchange and Marketable Permits Making pollution permits marketable is sensible because it allows mutually beneficial exchanges between firms with different abatement costs PRINCIPLE OF VOLUNTARY EXCHANGE A voluntary exchange between two people makes both people better off Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.4 MARKETABLE POLLUTION PERMITS (3 of 3) Supply, Demand, and the Price of Marketable Permits The equilibrium price of permits is shown by the intersection of the demand curve and the vertical supply curve The supply curve is vertical because each year the government specifies a fixed number of permits A decrease in the number of permits shifts the supply curve to the left, increasing the equilibrium price Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION WEATHER AND THE PRICE OF POLLUTION PERMITS APPLYING THE CONCEPTS #4: How is the price of pollution permits determined? The European Climate Exchange is a market for pollution allowances issued to European Union countries under the EU cap-and-trade system The equilibrium price is determined by supply and demand The EU determines supply and issues the permits to energy intensive industries Demand is based on the level of economic activity, fuel prices and the weather The Nordic countries shift from hydro electric to coal fired electric generation in dry years Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.5 EXTERNAL COSTS FROM AUTOMOBILES (1 of 2) External Costs from Pollution A gasoline tax of $0.68 per gallon shifts the supply curve upward by the amount of the tax The equilibrium price increases by $0.40 The tax is shifted forward onto consumers, who pay $0.40 more per gallon, and backward onto input suppliers, who receive lower prices for crude oil Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved 31.5 EXTERNAL COSTS FROM AUTOMOBILES (2 of 2) External Costs from Congestion The economic approach to congestion is to internalize the external cost by imposing a tax on drivers equal to the external costs they impose on others Modern technology allows the efficient collection of congestion taxes The use of congestion taxes and other time-sensitive pricing of highways is spreading External Costs from Collisions In the United States, the annual cost of property damage, injuries, and deaths from traffic collisions is about $300 billion per year About two-thirds of these costs are incurred by the driver who causes the accident, and the other third is borne by someone else In other words, traffic collisions have substantial external costs On average, the collision-related external cost of travel is about 4.4 cents per mile driven By way of comparison, the fuel cost per mile is about 10 to 15 cents The direct approach to internalize this externality would be to impose a tax of 4.4 cents per vehicle-mile traveled, a VMT tax Such a tax would improve traffic safety by reducing the number of miles driven Alternatively, the premium for automobile insurance could be based on miles driven or a gasoline tax could be imposed Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved APPLICATION YOUNG DRIVERS AND COLLISIONS APPLYING THE CONCEPTS #5: What is the external cost of young drivers? A VMT tax of 4.4 cents per mile would internalize the external cost from collisions on average, but the external cost varies with the age of the driver The external cost per mile is 11 cents for young drivers (age less than 25 years), 3.4 cents for middle-aged drivers (age 25 to 70), and 5.4 cents for older drivers A precise VMT tax would involve a higher tax rate for young drivers and generate a relatively large decrease in the miles driven by drivers with the highest collision rates and external costs Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved KEY TERMS External cost of production Marketable pollution permits Pollution tax Private cost of production Social cost of production Copyright © 2015, 2012, 2009 Pearson Education, Inc All Rights Reserved ... Reserved 31. 4 MARKETABLE POLLUTION PERMITS (3 of 3) Supply, Demand, and the Price of Marketable Permits The equilibrium price of permits is shown by the intersection of the demand curve and the... under the EU cap -and- trade system The equilibrium price is determined by supply and demand The EU determines supply and issues the permits to energy intensive industries Demand is based on the... 2009 Pearson Education, Inc All Rights Reserved 31. 3 TRADITIONAL REGULATION (2 of 4) Command and Control The problem with this approach is that the mandated abatement technology—the control part