The Economics of Pollution

  • Is it a legitimate goal to have zero pollution in society?

    • Pollution, just like most things in economics, is a "how much" question that requires benefit/cost analysis

  • Marginal social cost of pollution

    • additional cost imposed on society created by a unit of pollution

    • ie. acid rain harms crops and forests

  • Marginal social benefit of pollution

    • additional benefit to society from a unit of pollution

    • ie. pollution avoidance incurs an opportunity cost and is expensive

  • Socially optimal quantity of pollution

    • point at which marginal social cost (MSC) equals the marginal social benefit (MSB)

    • MSB = MSC

Socially Optimal Quantity of Pollution

  • Upward-sloping MSC curve

  • Downward-sloping MSB curve

  • Intersection of MSC and MSB is socially optimal point

  • Market-determined quantity of pollution is where MSB is x-axis

  • Not allocatively efficient: Q too high, Price too low

    Marginal social cost at QMKT Optimal Pigouvian tax on pollution Marginal social benefit at QNk7 Marginal social cost, marginal social benefit QMKT $400 300 200 100 O Socially optimal quantity of pollution MSC0f pollution The market outcome is ineficient: marginal social cost of pollution exceeds marginal social benefit. MSB of pollution Quantity of pollution emissions (tons) Market-determined quantity of pollution

  • In the absence of government intervention, the quantity of pollution will be QMKT, the level at which the marginal social benefit of pollution is zero.

  • This is an inefficiently high quantity of pollution: the marginal social cost, $400, greatly exceeds the marginal social benefit $0.

  • An optimal Pigouvian tax of $200, the value of the marginal social cost of pollution when it equals the marginal social benefit of pollution, can move the market to the socially optimal quantity of pollution, QOPT

Negative Externality vs. Positive Externality

  • Negative externality

    • a decision that a firm or individual makes that imposes a cost to "society" as a whole (ie. the decision to pollute)

    • Impact is similar to that of a supply shift to the left on a supply and demand graph

    • Market price too low, Market Quantity too high

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    Price of Aluminum Optimum — QOPTIMUM Equilibrium Q MARKET Sodal oxt (private oxt and external cost) Supply (private cost) Demand (private value) Quantity of Aluminum

  • Positive externality

    • a decision that an individual or firm makes that yields positive benefits to society (ie. the decision to attend college and become a productive citizen)

    • Impact is similar to that of a demand shift to the right on a supply and demand graph

    • Market price too low, market quantity too low

    OSB 0

    Price of Education 0 External benefit Equilibrium QMARKET Supply (private cost) Optimum Social value (private value and external benefit) Demand (private value) QOPTIMUM Quantity of Education

Government Solution

  • By what means would the government be able to correct a nagative externality?

    • Tax

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  • By what means would the government be able to encourage a positive externality?

    • Subsidy

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Private (or Coase) Solution

  • Coase Theorem

    • Even in the presence of externalities, an economy can be efficient (assuming low transaction costs) by internalizing the externalities

  • Example

    • Let's say that Jeff and Chris are neighbors in Chino Hills and that Jeff enjoys throwing loud parties wile Chris does not

    • Chris does not enjoy the music but Jeff has a legal right to play loud music, so Chris can play Jeff a payment equal to the external cost he imposes on him

    • Or, if Jeff does not have a legal right to play loud music, Jeff can pay Chris an amount equal to the cost the music imposes on Chris

  • Pigouvian taxes

    • named after economist A.C. Pigou, these taxes were designed to reduce external costs

  • Negative Externality Example

    • Formula

      • MSC = MPC + MEC

      • MSC: Marginal Social Cost

      • MPC: Marginal Private Cost

      • MEC: Marginal External Cost

    • Smoking cigarettes is considered a negative externality

    • An optimal Pigouvian tax charges where MSC = D, so that less quantity is consumed at a higher price

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  • Positive Externality Example

    • Formula

      • MSB = MPB + MEB

      • MSB: Marginal Social Benefit

      • MPB: Marginal Private Benefit

      • MEB: Marginal External Benefit

    • Getting a flu shot not only benefits you but also reduces the number the number of others getting the flu by as much as 1.5

    • Getting a flu shot is considered a positive externality

    • An optimal Pigouvian subsidy intersects where MSB = S. Lower prices encourages consumption

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Practice Question

  • Draw a correctly labeled graph of the market for dog barking contests that is perfectly competitive. If neighbors are disturbed by dog barking, draw the marginal social cost curve, labeled MSC. Label the marginal social benefit curve, labeled MSB, and shade in the deadweight loss or DWL, if any.

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  • Draw a correctly labeled graph of the market for dog barking contests that is perfectly competitive. If neighbors now enjoy dog barking, is the market equilibrium greater, less than or equal to the socially optimal quantity? If the government bans dog barking, will the deadweight loss increase, decrease, or remain unchanged?

    • Market equilibrium is less than optimal

    • Deadweight loss will increase

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  • Assume that the market for paper bags is perfectly competitive and that they create a negative externality. Draw a graph that includes the MPC and MSC, as well as the market quantity, Qm. Label the allocatively efficient quantity as Qs and shade the area of deadweight loss and label as DWL. If a lump-sum tax is imposed, what happens to DWL?

    • Allocatively efficient: MSC = MSB

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  • The DWL stays the same

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