Externalities like pollution are costs not considered by buyers and sellers. This leads markets to produce inefficiently high pollution. Government intervention can correct market failures, but may also fail if it does not use incentive-based policies like effluent taxes and emissions trading rather than command-and-control regulations. The Coase Theorem finds private bargaining can achieve efficiency if property rights and low transaction costs allow negotiations, though obstacles often remain.

1. Chapter 14
Environmental Economics
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1

2. In this chapter, you will
learn to solve these
economic puzzles:
Why do competitive markets
How can government
Can government
produce too largereduce
a quantity
legislation, taxes, and
intervention
permits achieve
and charge too low a price
environmental quality?
environmental efficiency?
for products that pollute?
2

3. What assumption is
made in this chapter?
There is sufficient foreign
and domestic competition to
allow us to use the perfectly
competitive model
3

4. When does Economic
Efficiency exist?
Efficiency exists when the
price to consumers,
reflecting marginal benefit,
equals marginal cost
4

5. Who is a Third Party?
People outside the market
transaction who are
affected by the product
5

6. What are Private
Benefits and Costs?
Benefits and costs to the
decision maker,
ignoring benefits and
costs to third parties
6

7. What are Externalities?
Benefits or costs that are
not considered by market
buyers and sellers
7

8. What is an example of
an Externality?
Air pollution is an
externality that affects
third parties not
driving automobiles
8

9. What is an example of
a Positive Externality?
The enjoyment you
derive from your
neighbors well-kept yard
9

10. What happens when
Externalities are present?
Competitive markets are
not likely to achieve
economic efficiency
10

11. What are
Social Benefits?
The sum of benefits to
everyone, including
both private benefits
and external benefits
11

12. What are Private Costs?
Production costs of
capital, labor, land,
and entrepreneurship
12

13. What are Social Costs?
The sum of costs to
everyone, including
both private costs
and external costs
13

14. When is Social Welfare
maximized?
It is achieved when
marginal social benefit
equals marginal social cost
14

15. Why can’t businesses
acting on their own solve
the problem of Pollution?
The added costs of cleaning
up the environment will
make them less competitive
in the market place
15

16. What may happen to a
firm that takes on the
added costs of Anti-
pollution Devices?
They eventually will be
driven out of business
by lower cost firms
16

17. The following graphs show the
short-run marginal cost
curves and the long-run
average cost curves for two
firms; one pays private costs
(typical) and the other pays
both private and external
costs (green firm)
17

18. P Short-run Marginal Cost
PMC (typical)
SMC (green)
PSR=SRPMC
QS QP
Q
18

19. P Long-run Average Cost
SAC (green)
PLR=LRSAC
PAC (typical)
PLR=LRPAC
QLR
Q
19

20. What happens
when External
Costs are ignored?
Competitive firms produce
“too much,” and the
market equilibrium price is
“too low,” compared to a
socially efficient industry
20

21. Comparisons of Equilibriums for Typical
P Competitive and “Green Industries”
SS = ∑ SMC
(green)
PS PS = ∑ PMC
(typical)
PC
D
QS QC
Q
21

22. Do Markets Fail when
Externalities are present?
Externalities illustrate
that private markets fail
to produce society’s
preferred outcome
22

23. How can society
achieve Efficiency
when markets fail?
Government has a
potential role when
there is market failure
23

24. What is an example of
Government Failure?
Government can fail to
correct market failure by
doing too little or too
much about pollution
24

25. What are two
Government Approaches?
• Incentive-based regulations
• Command-and-control
regulations
25

26. What is a Command-
and-control Regulation?
Government regulations
that set an environmental
goal and dictate how the
goal will be achieved
26

27. What is an example of
a Command-and-
control Regulation?
Mandatory installation
of catalytic converters
on automobiles
27

28. What is an Incentive-
based Regulation?
Government regulations
that set an environmental
goal, but are flexible in
how buyers and sellers
achieve the goal
28

29. What is an Effluent Tax?
A tax on the pollutant
29

30. P Using an Effluent Tax to Achieve
Environmental Efficiency
SS = ∑ (MC, t)
(green)
PS tax
PS = ∑ MC =
PC ∑ PMC
(typical)
D
QS QC
Q
30

31. What is
Emissions Trading?
Trading that allows
firms to buy and sell
the right to pollute
31

32. What is
New-source Bias?
Bias that occurs when there is
an incentive to keep assets
past the efficient point as a
result of regulation
32

33. Is the Efficient amount of
Pollution typically Zero?
No, the marginal social
cost of achieving one
more unit of clean air
may be greater than the
marginal social benefit
33

34. What is the
Coase Theorem?
The proposition that private
market negotiations can
achieve social efficiency,
regardless of the initial
definition of property rights
34

35. How comprehensive is
the Coase Theorem?
Only a small number of
environmental problems
qualify for Coase
Theorem solutions
35

36. Which cases qualify for
the Coase Theorem?
• no transaction costs
• no income effects
• only two parties in
the negotiation
36

37. What is a
Transaction Cost?
The costs of negotiating
and enforcing a contract
37

38. What is the
Free-rider Problem?
If some people benefit
while others pay, few
will be willing to pay
for improvement of
the environment or
other public goods
38

39. What is the result of the
Free-rider Problem?
Goods affected are
underproduced
39

40. Key Concepts
40

41. Key Concepts
• When does Economic Efficiency exist?
• Who is a Third Party?
• What are Private Benefits and Costs?
• What are Externalities?
• What are Social Benefits?
• What are Private Costs?
• What are Social Costs?
• Where is Social Welfare maximized?
• Why can’t businesses action on their own solv
41

42. Key Concepts cont.
• How can society achieve Efficiency when mark
• What is a Command-and-control Regulation?
• What is an Incentive-based Regulation?
• What is an Effluent Tax?
• What is Emissions Trading?
• What is New-source Bias?
• What is the Coase Theorem?
42

43. Summary
43

44. Externalities are benefits or
costs that fall on third parties who
are neither buyers nor sellers.
Pollution is a negative externality or
external cost that is a byproduct of
many industrial production
processes.
44

45. Market failure is present when the
market produces a socially inefficient
outcome. One instance is when there
are externalities All firms , including
competitive firms, consider private
costs, but disregard external costs, in
making decisions..
45

46. Government failure occurs
when public-sector actions move us
away from desired outcomes, such
as efficiency. Government officials
seeking campaign contributions and
votes may choose environmental
measures that favor wealthy
contributors over society’s best
interests.
46

47. Command-and-control
regulations occur when the
government dictates the approach to
achieving an environmental goal.
47

48. Command-and-control (CAC)
regulations are generally inefficient
on three grounds: They do not
distinguish between high and low
pollution areas, they do not allow
firms to choose lower cost
technologies that could achieve the
environmental standard, and they do
not encourage improved technology
to lower future emissions.
48

49. Incentive-based regulations
build on markets to achieve
environmental efficiency. Effluent
taxes are taxes that reflect external
costs. Emissions-trading allows firms
to buy and sell the “right to pollute.”
49

50. The Coase Theorem maintains
that markets can be efficient in the
presence of externalities with
minimal government intervention.
Even in the presence of externalities,
markets may produce efficient
outcomes so long as property rights
are clearly established.
50

51. Transactions costs, income effects,
and free-rider problems are obstacles to
achieving environmental efficiency
through markets. Transactions costs are
the costs of negotiating an agreement,
income effects are present when limited
income prevents one party from being
able to afford the efficient solution, and
free-rider problems are present when
participants are better off hiding than
revealing their willingness to pay for an
environmental improvement.
51

52. Chapter 14 Quiz
©2000 South-Western College Publishing
52

53. 1. Recently the city of New Orleans discovered
chemical compounds in its drinking water.
The source is the waste discharges of
industrial plants upstream. This is an example
of
a. an external cost imposed on the citizens of
New Orleans by the industrial plants
upstream.
b. a market failure where the market price of
the output of these industrial plants does
not fully reflect the social cost of producing
these goods.
c. an externality where the marginal social
costs of producing these industrial goods
differ from the marginal private costs.
d. all of the above.
53

54. 1.
D. The upstream firm is releasing chemicals
into the water, an external cost to the citizens
of New Orleans. The upstream firm is not
including these costs when pricing its
product; hence, the market price is too low.
Marginal social costs would include the
marginal private cost of the industrial
product (their costs of labor, capital,
materials, etc.) and the external cost of the
chemicals released into the water. Choices
(a), (b), and (c)each are correct, so that all of
the above is the correct choice.
54

55. 2. A government policy that charges steel
firms a fee per ton of steel produced (an
effluent charge) where the fee is determined
by the amount of pollutants discharged into
the air or water will lead to
a. a decrease in the market equilibrium
quantity of steel produced.
b. a decrease in the market equilibrium
price of steel.
c. an increase in the market equilibrium
price of steel.
d. the results in (a) and (b).
e. the results in (a) and (c ).
55

56. 2.
E. Essentially, the government is employing an
effluent tax to reduce pollution. The tax
increases the cost of production. Supply
decreases, leading to a higher price and
smaller quantity. So choice (e), where (a)
quantity decreases and (c)price increases, is
the best choice.
56

57. 3. Social costs are
a. the full resource costs of an economic
activity.
b. usually less than private costs.
c. the costs of an economic activity borne by
the producer.
d. all of the above.
57

58. 3.
A. Social costs include both private costs (the
costs of the firm’s inputs, including labor,
capital, land, etc.) and external costs (the
costs to third parties, such as pollution
emitted by the producer). Social costs are at
least as large as private costs. Producers will
not consider external costs, which are a part
of social costs, unless they are forced to do so
by government or court.
58

59. 4. As a general rule, if pollution costs are
external, firms will produce
a. too much of a polluting good.
b. too little of a polluting good.
c. an optimal amount of a polluting good.
d. an amount that cannot be determined
without additional information.
59

60. 4.
A. Private firms will make their production
decision using private costs. If there are
external costs, social costs exceed private
costs. If production decisions included
external costs, supply would be smaller than
when private costs alone are considered. So
if external costs are ignored, the firm will
produce too much, as compared to the social
efficient level.
60

61. 5. Many economists would argue
a. the optimal amount of pollution is
greater than zero.
b. all pollution should be eliminated.
c. the market mechanism can handle
pollution without any government
intervention.
d. central planning is the most efficient
way to eliminate pollution.
61

62. 5.
A. The optimal amount of pollution is where
marginal social cost equals marginal social
benefit. This amount typically exceeds zero.
The marginal cost of eliminating all pollution
would likely be very high. For example, we
would have to eliminate all cars. However,
firms tend to ignore external costs such as
pollution, in an unfettered market. While
government is likely to be needed, pollution
has actually been worse in centrally planned
economies.
62

63. 6. Which of the following used marketable
pollution permits as an incentive for
reducing pollution?
a. The 1970 Clean Air Act.
b. The Comprehensive Environmental
Response, Compensation, and Liability
Act of 1980.
c. The 1990 Clean Air Act amendments.
d. The Water Quality and Improvement
Act of 1970.
63

64. 6.
C. The 1990 Clean Air Act was the first piece
of federal legislation to introduce emissions
trading. It introduced this approach for
sulfur emissions, thought to contribute to
acid rain.
64

65. 7. The disposable diaper industry is perfectly
competitive. Which of the following is true?
a. Since the industry is perfectly
competitive, price and quantity are at the
socially efficient levels.
b. Competitive price is higher and
competitive quantity lower than the
socially efficient point.
c. Competitive price is higher and
competitive quantity higher than the
socially efficient point.
d. Competitive price is lower and
competitive quantity higher than the
socially efficient point.
65

66. 7.
D. Disposable diapers have an external cost, to
the extent that they are not biodegradable and
sit in landfills. Producers in a competitive
market consider only private costs, ignoring
disposal issues. Similarly, consumers just
want to prevent leaks that affect them, but
ignore leaks that affect landfills. So
producers and consumers use private costs
and benefits. Social costs are higher, so that
social supply is smaller. The competitive
price, based on private costs and benefits, is
lower than the social cost. Competitive
quantity is larger, given the larger supply,
than the socially efficient quantity.
66

67. 8. An example of the command-and-control
approach to environmental policy is
a. placing a tax on high-sulfur coal to
reduce its use and the corresponding
sulfur emissions (which contribute to acid
rain).
b. requiring electric utilities to install
scrubbers to reduce sulfur dioxide
emissions (which contribute to acid rain).
c. allowing coal producers to buy and sell
permits to allow sulfur emissions.
d. allowing individuals to sue coal
producers if sulfur emissions exceed
government-set standard.
67

68. 8.
B. Command-and-control is a regulation
whereby the government establishes a
pollution target and dictates the method to
achieve the target. An example is requiring
scrubbers to reduce sulfur emissions.
Sulfur emission permits and effluent taxes
are example of incentive-based approaches.
With taxes, for example, the firm can
choose low-sulfur coal to avoid the tax.
68

69. P EXHIBIT 6
Social Private
MC Social MC
Private
P1 Demand G ATC
H ATC
L C
A
K
J F E
B
Q1 Q2 Q3 Q4 Q
69

70. 9. The profit-maximizing firm in Exhibit 6
creates water and air pollution as a
consequence of producing its output of
beef cattle. If pollution costs are borne by
third parties, the firm will maximize
economic profit by choosing to
a. voluntarily incur costs to reduce its
pollution.
b. produce at output rate Q3
c. produce at output rate Q2
d. produce at output rate Q4..
D. The firm will produce at Q4 where
demand (MR) intersects Private MC.
70

71. 10. Use Exhibit 6 to complete the
following: To maximize social welfare,
the firm should produce at output rate
a. Q1
b. Q2
c. Q3
d. Q4
B. The firm will produce at Q2, where
demand (MR) intersects Social MC.
71

72. Exhibit 7
Impact of Flights on House Value
Number Total Marginal Value of
of Flights Profits Profits Wilbur’s House
1 $10,000 $10,000 $100,000
2 18,000 8,000 95,000
3 24,000 6,000 90,000
4 28,000 4,000 85,000
5 30,000 2,000 80,000
72

73. 11. As shown in Exhibit 7, if Orville has the
property right to fly over Wilbur’s house,
but Wilbur is allowed to negotiate with
Orville on the number of flights, what will
be the number of flights?
a. 2.
b. 3.
c. 4.
d. 5.
B. At 3 flights, marginal profits for Orville
is $6,000 and the value of Wilbur’s
property goes down by $5,000.
73

74. 12. As shown in Exhibit 7, Wilbur has the
property right to have no planes flying
over his house, but Orville is allowed to
negotiate with Wilbur, what will be the
number of flights?
a. 2.
b. 3
c. 4
d. 5
B. At 3 flights, marginal profits for
Orville is $6,000 and the value of
Wilbur’s property goes down by $5,000.
74

75. 13. As shown in Exhibit 7, at the socially
efficient number of flights, what will be
the market value of Orville’s house?
a. $100,000.
b. $95,000.
c. $90,000.
d. $85,000.
C. At 3 flights, this is the last number of
flights that the marginal profits are greater
than the marginal costs (ie. the amount that
Orville’s house declines in value)
75

76. Internet Exercises
Click on the picture of the book,
choose updates by chapter for
the latest internet exercises
76

77. END
77