public revenues

1. Chapter 2: Externalities and the Environment
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Chapter 2 Externalities
and the Environment
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. Chapter 2: Externalities and the Environment
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Introduction
Applications: Acid rain and global warming
Economic analysis of a pollution tax and
tradable permits
The economist’s approach to pollution

3. Chapter 2: Externalities and the Environment
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Externalities and the Environment
Positive externality
Negative externality Exists whenever a producer or
consumer does not have to pay
for a cost he generates.
Exists whenever a producer or
consumer does not receive a
payment for a benefit he generates.
• Examples: air pollution,
water pollution, or noise
pollution
• Examples: immunizations or
improving your home.

4. Chapter 2: Externalities and the Environment
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The Economist’s Approach to Pollution
Pollution is an example of a market failure.
• An allocation of resources
that is not socially optimal.
When externalities exist, there is a failure of property rights.
Solution? Establish property rights and
charge a price for its use.
Who can have property rights?
• government
• private firms
• individuals

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The Economist’s Approach to Pollution
If the government has property rights,
how do they charge a price?
TAXES PERMITS
Charging polluters a price forces them to
internalize the externality.
A private solution (Coase’s prescription) is possible if:
1. Property rights exist
2. A small number of citizens are harmed
3. There are low transaction costs

6. Chapter 2: Externalities and the Environment
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Trade-off between
Environmental Quality and Output
Environmental
Quality
Output
a
b
c
d
e
f
Figure 2.1
Maximum environmental quality
Maximum output with zero
environmental quality
Increase in environmental quality
and a decrease in output

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Trade-off between
Environmental Quality and Output
Objections to pollution prices and economist’s responses
Allocation problem
• Tax method
• Command and control method
• Polluters with different technological options
• Permit method
The Virtues of Pollution Prices
• Pollution price is a “license to pollute”
• Pollution prices will raise product prices
• Pollution taxes will raise the tax burden on
the population

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Charging a Price vs. Mandating or
Subsidizing Clean Technologies
Economists recommend using pollution prices and
oppose mandating or subsidizing clean technologies.
• Pollution prices stimulate clean technologies
• Mandates lead to high costs for consumers
- CAFE standards
• Subsidies lead to a distorted playing field among
potential alternatives
• Political lobbying for subsidies cause distortion
• Clean alternatives is not always the socially optimal
response
• Subsidies require raising taxes
WHY?

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A Pollution Tax
MD
Figure 2.2
80 100 Gasoline
P
$2.50
S (MPC)
D (MB)
The right tax generates the right quantity of a polluting good
H
J
I
K
MSC
MSC = MPC + MD

10. Chapter 2: Externalities and the Environment
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A Pollution Tax
Levy a corrective tax (Pigouvian tax) equal to the MD
Figure 2.3
T Social optimum quantity
is where MSC = MB
at 80 units of gasoline
S` (MSC`)
H
J
I
K
80 100 Gasoline
P
$2.50
S (MPC)
D (MB)

11. Chapter 2: Externalities and the Environment
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A Pollution Tax
An optimal tax confers a net benefit to society
Net gain to society
= HIJK – HIK
= IJK
Gain in environmental
benefit = HIJK
Loss of output = HIK
MSC
H
J
I
K
Figure 2.4
80 100 Gasoline
P
$2.50
S (MPC)
D (MB)

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A Pollution Tax
Use pollution tax revenue to cut other taxes
Tax emissions, not the polluting good
• Pollution taxes as revenue replacers
• Whenever feasible, levy the tax per unit of
pollution – per emission – not per unit of
polluting good
• Different ways of returning the tax revenue to the
private sector will have different effects

13. Chapter 2: Externalities and the Environment
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A Pollution Tax
• To minimize cost, levy the same
tax on all firms emitting pollutant X
$60
$100
$20
$25
$40
$50
$200
10 25 30 35 40 45 50
Emissions
MACH
MACL
2 firms with different MACs
Without government policy,
each firm pollutes 50 units.
Figure 2.5

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A Pollution Tax
• To minimize cost, levy the same
tax on all firms emitting pollutant X
MACL
MD = T
• Marginal damage and tax rate is constant at $40
$60
$100
$20
$25
$40
$50
$200
10 25 30 35 40 45 50
Emissions
MACH
Figure 2.5
• After the tax is levied,
MACH will abate 10 units and
MACL will abate 40 units
• After tax, total
emission is
50 units
• Firms will abate until MAC = T
• Equi-marginal principle

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1. Government sells permits
2. Government gives the permits away
CAP and TRADE
• Cap – supply of emissions permits is fixed
• Trade – permits can be bought and sold in
the market throughout the year
How do firms get the permits?
Tradable Permits

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$60
$100
$20
$25
$40
$50
$200
10 25 30 35 40 45 50 75 Permits
DH
D
DL
Tradable Permits – Government sells permits
S
• The government decided
to supply 50 pollution permits
• Each firm’s permit demand
curve is its MAC curve
= MACH
= MACL
= market demand

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• Price where S = D
• Tax vs. permit
• A hybrid policy
Tradable Permits – Government sells permits
What is the optimal permit price?
$60
$100
$20
$25
$40
$50
$200
10 25 30 35 40 45 50 75 Permits
DH
D
DL
S
• P = $50 is too high
P=$50
• P = $20 is too low
P=$20
• P = $40 results in the
desired outcome
P=$40
Tentative prices

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giving permits to polluting firms will reduce pollution.
Tradable Permits –
Government gives the permits away
• The supply curve for each polluting good will shift to the
left
• The price of polluting goods will increase
Just like selling permits or levying a tax,
• Taxpayers want the government to sell permits
Which is best?
• Firms want the government to give permits
But, giving the permits away can lead to higher output
and emissions than is socially optimal in the long run.

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Application: Tradable Permits for Sulfur
Dioxide to Reduce Acid Rain
Old policy – a maximum sulfur dioxide emission rate for
new coal-burning electricity generating firms.
• Clean Air Act Amendments of 1990
• Total emissions have fallen with the new policy
• Two issues: long run issue, and tax revenue issue
New policy – tradable permits are given to electric power
plants
• Plants can then buy and sell permits an needed
Sulfur dioxide causes acid rain

20. Chapter 2: Externalities and the Environment
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Application: A Carbon Tax or Tradable
Permits to Reduce Global Warming
• A carbon tax treaty
• A carbon tradable permits treaty
• A hybrid carbon treaty: a permit system
with a safety valve
• The political challenge
Carbon emissions cause global warming
Policy decision – carbon tax or carbon permits?
Policy decision – how can low-income countries be
induced to participate?

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Summary
Applications: Acid rain and global warming
Economic analysis of a pollution tax and
tradable permits
The Economist’s approach to pollution

22. Chapter 2: Externalities and the Environment
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Preview of Chapter 3:
Public Goods and Political Economy
Political economy
The concept of a public good
The behavior of the government