17 EXTERNALITIES AND THE ENVIRONMENT After studying this chapter you will be able to Explain why external costs bring market failure and too much pollution and how property rights and public choices might achieve an efficient outcome Explain the tragedy of the commons and its possible solutions 2014 Pearson Addison Wesley How can we use less coal natural gas and oil to reduce the air pollution and global warming we re causing What can we do to conserve the ocean s fish stocks and save endangered species from extinction These questions arise because some of our choices impose costs on others external costs that we don t think about when we make those choices How can we be made to take these costs into account 2014 Pearson Addison Wesley Negative Externalities Pollution An externality is a cost or benefit that arises from production and falls on someone other than the producer or a cost or benefit that arises from consumption and falls on someone other than the consumer A negative externality imposes an external cost 2014 Pearson Addison Wesley Negative Externalities Pollution Sources and Consequences of Air Pollution The problems of local air quality and the global problem of climate change are related but distinct problems Local air quality is influenced by 180 airborne substances Most important are carbon monoxide lead nitrogen dioxide ground level ozone particulate matter and sulfur dioxide Global temperature is influenced by human emissions of greenhouse gases Most important is carbon dioxide CO2 2014 Pearson Addison Wesley Negative Externalities Pollution CO2 emission is a global phenomenon and problem The United States and China each account for about one quarter of the CO2 emitted into the global atmosphere in a year Electric power utilities highway vehicles and industrial processes are the main sources of both local air pollution and global CO2 emissions The effects of pollution mean that production and consumption decisions impose costs that are not taken fully into account when decisions are made 2014 Pearson Addison Wesley Negative Externalities Pollution Production and Pollution How Much A private cost of production is a cost that is borne by the producer Marginal private cost MC is the private cost of producing one more unit of a good or service An external cost of production is a cost that is not borne by the producer but is borne by others Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer 2014 Pearson Addison Wesley Negative Externalities Pollution Marginal social cost MSC is the marginal cost incurred by the entire society by the producer and by everyone else on whom the cost falls Marginal social cost is the sum of marginal private cost and marginal external cost MSC MC Marginal external cost We express costs in dollars but remember that the dollars represent the value of a forgone opportunity Marginal private cost marginal external cost and marginal social cost increase with output 2014 Pearson Addison Wesley Negative Externalities Pollution Valuing an External Cost Suppose that there are two similar rivers one polluted and the other clean with 10 identical riverside homes The homes on the clean river rent for 2 000 a month and those on the polluted river rent for 1 500 a month If the pollution is the only detectable difference between the houses then the rent difference of 500 per month is the pollution cost per home With 10 homes on the side of a polluted river the external cost of pollution is 5 000 a month 2014 Pearson Addison Wesley Negative Externalities Pollution External Cost and Output Figure 17 1 shows the relationship between external cost and output in a paint industry that pollutes a river The MC curve shows the marginal private cost of producing paint It costs producer 1 a gallon to produce 3 million gallons of paint 2014 Pearson Addison Wesley Negative Externalities Pollution If a firm pollutes a river it imposes an external cost that is borne by other users of the river The figure shows the marginal social cost of producing paint the MSC curve The vertical distance between the MC and MSC curves is marginal external cost of the pollution MSC MC External cost 2014 Pearson Addison Wesley Negative Externalities Pollution Equilibrium and Amount of Pollution Equilibrium in the market for paint determines the amount of pollution Figure 17 2 shows the equilibrium in an unregulated market The quantity of the good produced is where marginal private cost MC equals marginal social benefit MSB 2014 Pearson Addison Wesley Negative Externalities Pollution At the market equilibrium MSB is less than MSC so the market produces an inefficient quantity of the good At the efficient quantity of the good MSC MSB With no regulation the market produces too much paint and creates a deadweight loss 2014 Pearson Addison Wesley Negative Externalities Pollution Three approaches to overcoming the inefficiency are Establish property rights Mandate clean technology Tax or price pollution Establish Property Rights Property rights are legally established titles to the ownership use and disposal of factors of production and goods and services that are enforceable in the courts Establishing property rights can confront producers with the costs of their actions and provide the incentives that allocate resources efficiently 2014 Pearson Addison Wesley Negative Externalities Pollution Producers with property rights have two possible responses Use an abatement technology Produce less and pollute less An abatement technology is a production technology that reduces or prevents pollution A producer will consider these two alternatives and adopt the least cost alternative 2014 Pearson Addison Wesley Negative Externalities Pollution Efficient Market Equilibrium Figure 17 3 illustrates how property rights achieve an efficient outcome The producer of the good bears all the costs so MC equals MSC The market outcome is efficient because at the quantity of the good produced MSC equals MSB The producer bears the cost of pollution or abatement 2014 Pearson Addison Wesley Negative Externalities Pollution The Coase Theorem The Coase theorem is a proposition that if property rights exist only a small number of parties are involved and transactions costs are low then private transactions are efficient There are no externalities because all parties take into account the externalities involved The outcome is independent of who