Lecture Outlines

Environmental Economics

Reading: Chapter 14 of Tucker

Overview:

·        Competitive Markets and Environmental Efficiency

·        Achieving Environmental Efficiency

Competitive Markets and Environmental Efficiency

The competitive market has been shown in earlier chapters to achieve economic efficiency.

·        Efficiency exists when the price to consumers, reflecting marginal benefits, equals marginal cost.

Private benefits and costs: Benefits and costs to the decision-maker, ignoring benefits and costs to third parties. Third parties are people outside the market transaction who are affected by the product.

·        Recall that benefits and costs to third parties are called third-party effects, spillovers, external benefits, or externalities.

·        Examples of externalities include air pollution that affects those not driving cars, sulfur emissions from power plants that kill fish, and the secondhand effects of cigarette smoke.

When externalities are present, competitive markets are not likely to achieve economic efficiency.

·        In order to be efficient, society requires consideration of both private and social benefits and costs.

·        Each unit of a good that is produced creates at least as much benefit to society as it does social cost.

Social benefits and costs: The sum of benefits to everyone in society, including both private benefits and external benefits. Social costs are the sum of costs to everyone in society, including both private costs and external costs.

As a society, we do not want to use up our scarce resources on items that will not enhance our collective well-being.

·        To maximize social welfare, goods should be produced up to the point where marginal benefits = marginal social costs.

Environmental regulations force market participants to include externalities in their decision-making.

·        Some regulations prescribe specific technologies that must be used.

·        Other regulations simply set a goal, without mandating how the goal should be achieved.

Competition and external costs:

·        Typical companies consider only their private costs. They choose the method of production that has the lowest cost. If a "green" firm chooses to consider social costs, its costs will be higher than the typical firm. In a competitive market, consumers perceive all products as identical and are unwilling to pay more for a "green" product. The "green" firm will lose money and in the long run will go out of business.

·        This scenario is not socially efficient, because it rewards firms that ignore externalities and punishes firms that recognize externalities.

·        When firms ignore externalities, too much of a product is produced and the market equilibrium price is too low.

Why are consumers unwilling to pay more for "green" products?

·        The individual consumer only gets a negligible benefit from the "green" product.

·        Free rider: Someone who enjoys benefits without paying the cost.

Efficient quantity of pollution

·        The efficient production level for society is where marginal social benefit equals marginal social cost.

·        The efficient quantity of pollution is not zero!

Achieving Environmental Efficiency

Market failure: A situation in which the price system creates a problem for society or fails to achieve society's goals.

·        Externalities cause market failure.

·        Government has a potential role to play in helping to achieve market efficiency.

Government failure: Government intervention that fails to correct market failure.

·        Government officials influenced by campaign contributions or constituent's desires may contribute to government failure.

Command-and-control regulations (CAC): Governmental regulations that set an environmental goal and dictate how the goal will be achieved.

·        Firms that do not reach the goal pay penalties, but firms are not rewarded for exceeding the goal.

Incentive-based regulations (IB): Governmental regulations that set an environmental goal, but are flexible in how buyers and sellers achieve the goal.

·        Many economists prefer this method to command-and-control because it is more efficient.

·        Allowing firms to choose how to achieve environmental goals will encourage firms that can improve at low cost to reduce emissions more than firms less able to achieve lower emissions.

·        IB regulations are more efficient in both the short and long run.

CAC regulations on auto emissions:

·        Inefficiencies associated with the mandated use of catalytic converters:

1. The mandate is uniform throughout the country, regardless of the level of pollution.

2. There may be other technologies that can achieve the same result at a lower cost.

3. The mandate may act as a barrier to entry to other firms.

IB regulations on auto emissions:

·        Effluent tax: A tax on the pollutant. The tax can be placed on the producer (taxes based on the pollution generated by the car) or on the consumer (gasoline taxes).

·        Emissions trading: Trading that allows firms to buy and sell the right to pollute.

o       Offsets: A reduction in one pollution source that offsets a new pollution source. For example, new or expanding factories could offer to buy old polluting cars and junk them, in order to offset their new sources of pollution.

o       The Chicago Board of Trade, or "Smog Exchange", currently allows trading in pollution permits.

Obstacles to efficient trading:

·        New-source bias: Bias that occurs when there is an incentive to keep assets past the efficient point as a result of regulation. Firms may have an incentive to keep older dirtier factories rather than face the challenge of finding offsets for a newer factory.

·        Free rider problem. Car owners may hold onto their old cars for a few more years in order to get more money from a firm when they do junk them.

·        Small numbers of buyers and sellers.

·        Imperfect information on the value of a permit.

·        Concerns about the value of a permit in the future.

·        Relocation of firms to other countries.

Reasons why the public may be more comfortable with controls and rules than with prices and trading:

·        People have difficulty accepting that any pollution is efficient.

·        Distrust of experts.

There is general concern about the government's effectiveness at achieving environmental goals.

Coase Theorem: The proposition that private market negotiations can achieve social efficiency regardless of the initial definition of property rights.

·        The private sector can achieve social efficiency with minimal government intervention.

·        The role of government should be the legal establishment of property rights.

·        Environmental disputes should be resolved in court.

Only a small number of environmental problems qualify for Coase Theorem solutions. There are several reasons why:

1.     There are no transaction costs in the Coase Theorem.

Transaction costs: The costs of negotiating and enforcing a contract.

2.     There are no income effects in the Coase Theorem. Some parties may not be able to afford the efficient solution.

3.     Coase assumes there are only two parties in the negotiation. Externalities are typically third-party problems and there may be many third parties.

Free-rider problem: The problem that if some individuals benefit, while others pay, few will be willing to pay for improvement of the environment or other public goods. As a result, these goods are underproduced.