Pollution: How much is too much? 

Externalities: Social versus Private Decisions

We can apply The Marginal Principle when deciding how much to pollute. Here is our rule of thumb: If the marginal benefit of producing one unit less of pollution is greater than the marginal cost of the pollution, we should go a head and produce one less unit of pollution. We keep cutting back pollution until the Marginal Social Benefit (MSB) is equal to the Marginal Social Cost (MSC). If we cut back further, the extra costs are greater than the extra benefits. Thus, if society is concerned with maximizing total social net benefits, we pollute until MSB=MSC. 

Generally the "no pollution" solution is not socially optimal.  This is because at some point the benefits of reducing pollution levels are smaller than the costs.  Of course, the point at which reducing pollution further makes no sense may be very far away. 

Will the private market decision (about how much to produce) yield the socially optimal amount? Usually so, but not in the case of externalities. When there are externalities, the private decision (how much of a good to produce) does not correspond to the social decision (that maximizes total social welfare). 
Market forces, if left to themselves, generate too much pollution. The reason for this is that pollution is a negative externality.  An activity generates a negative externality when the activity imposes unwanted costs on an uninvolved party, and those who bear the costs are not compensated by those responsible. 

An example of a negative externality is air pollution by an oil refinery. If the pollution spills over into the neighborhood and damages people's lungs and houses, then a negative externality exists. The social costs of production exceed the private costs of production that the oil refinery directly incurs. Those living near the firm pay some of the costs yet are not compensated by the oil refinery. 

Another example is the building of a dam that prevents the fish from swimming upstream, thus destroying the fishing industry in towns upstream. Note that if the fishermen are compensated by the dam builders for the full value of their loss, then no negative externality exists. 

Because of negative externalities we have too much pollution, even if we use the efficiency standard to decide the appropriate amount of pollution. This is shown to the right. Taking the oil refinery as an example, the marginal benefits (MB) are derived from the production (and ultimate consumption) of gasoline. The marginal private costs (MPC) are the costs that the refinery must pay, i.e. the wages, cost of materials, rent, etc. The marginal social costs (MSC) are the total costs that society must pay for production of the gasoline. These include the private costs plus the externalities, i.e. the costs imposed on those who live near the refinery who must breathe the dirty air and repair their homes and cars more often. Notice that the MSC curve lies above the MPC curve. For any given quantity of output, MSC are greater than MPC. 

The efficient level of production for the refinery occurs at Qe where MB=MSC. If pollution is "free" for the oil refinery, then the level of production occurs at Qa because the firms operates such that MB=MPC. In other words, more production and hence more pollution is generated than is efficient. 

This inefficiency leaves room for government intervention. The role of government should not be to eliminate pollution completely (as discussed above) but to force the oil refinery to behave efficiently. One way for the government to do this is to tax the refinery by the amount of the externality that is generated. This will shift the MPC upward until it lies on top of the MSC curve and the efficient outcome will prevail at Qe. 

Externalities and Property Rights

The Coase Theorem states that if property are well defined and costlessly enforced, and the costs of bargaining are zero, no matter who owns the right, the socially desirable outcome will be reached. 

How to achieve the socially optimal solution?

Taxes. Essentially, the government tries to internalize the externality by making firms pay for the cost to society of the pollution. Consider the graph above. If the government taxes the firm, the supply curve shifts back, since costs to the firm have risen. If the tax is just enough, the supply curve (MPC) will coincide with the MSC curve. 

Under an emissions tax system, pollution is automatically monitored by a metering system and a tax bill is then sent to each firm according to the amount it pollutes. There is no provision as to how much the firm can pollute nor what type of technology it should use. If the EPA decides to reduce pollution, it simply raises the pollution tax. 

Under this system the enforcement is immediate and much less costly. The EPA generates money instead of spending it. The funds can be used to support the EPA's activities or be put towards cleaning up the environment. A tax system is also much more efficient in that it can reduce a given amount of pollution at lower costs to society. This is because it gives firms the flexibility in deciding how they are going to reduce their emissions, if at all. With this flexibility, the firms who find it easiest to clean up their emissions will do so first. 

Note that the 'tax' does not need to fall directly on producers.  Gasoline taxes are paid by consumers yet these have the same effect of increasing the price and reducing the quantity demanded of gasoline.  Unfortunately, as the recent increase in gasoline prices shows, most people are strongly opposed to higher increases in gasoline prices despite the benefits from decreased consumption. 

Permits. The government could issue emissions permits. Under this scenario, the EPA decides what quantity of emissions in a particular area over a certain amount of time is allowable. Then it sells permits (or "rights") to those emissions. The firms who need to pollute the most will buy the permits. Ideally the sale is public so environmental groups can purchase the permits as well, reducing pollution even further. If the firm does not hold a permit, it cannot pollute. The EPA can then reduce the quantity of permits over time, forcing firms to gradually cut emissions, but to do so in a flexible way. 

One variant of permits is an inflexible permit system.  In this case, the government assigns pollution output levels to individual firms (perhaps based on existing emission levels).  This is the traditional command approach taken by governments.  In this case, the government may force all firms to cut back pollution levels by the same amount.  This inflexible system does not allow firms to trade the right to pollute.  Without careful thought by the government about firms' costs, this inflexible system reduces pollution at a greater cost than a tradable permit system.  It is thus inefficient. 

Links

California's Headwaters Page.

The EPA's Watershed-based Trading Page.

EPA's Environmental Economics in plain English.

Read about the cost savings of various market-based pollution reduction programs.

Yahoo's Global Warming Coverage.

Lehrer Newshour's Kyoto Conference Coverage (on Global Warming).

Click here for a moderate view on the current state of the environment. 

Recycling is Garbage!  Click here for a rebuttal.