Externalities Ch18. and the Environment
Part A 2001, Kwan Choi Wisconsin Power and Light, a Madison utility company, wrote a new page in the history of environmental policy in 1992, when it sold rights to dump 15,000 tons of airborne sulfur dioxide to Duquesne Light, a Pittsburgh utility. (Tregarthen) Federal legislation passed in 1990 set tough new standards for the dumping of sulfur dioxide, a pollutant associated with acid rain. The standards went into effect in 1995, and imposed ceilings specifying the maximum quantity of sulfur dioxide each utility company can dump per year. Utilities that dump less than that quantity are permitted to sell rights to other firms, which can then dump more. Wisconsin Power and Light's sale was the first under the new program. Today, rights to dump sulfur dioxide are traded at the Chicago Board of Trade, where commodities such as gold and silver and wheat are traded. The effort represents a major thrust in environmental policy-- the use of markets to solve environmental problems. Externality occurs when an activity carried on by one decision maker affects the decisions by others. Benefits occur due to external economies (a.k.a. spillover benefits) Costs occur due to external diseconomies (a.k.a. spillover costs) Benefits: apple orchards and beekeeper. Beekeepers provide cross fertilization. Costs: Flower shop and steel mill. A Paper mill pours toxic chemicals into the river, downstream swimmers and fishermen are adversely affected. Ex. River in Hong Kong: not good for swimming. Only rowing contests are made annually. A CIVIL ACTION: John Travolta is a lawyer trying to show the adverse health effects on property owners. ERIN BROCKOVITCH: A former Miss Wichita goes through a lot of trouble, but eventually succeed in forcing the utility company to pay $333 million to the residents of Hinkley, CA, whose health was adversely affected by the contaminants (Chromium 6) poured into the area. Because of growth of world population and its concentration in a few cities, externalities have mushroomed during the modern era of industrial production. There is no indication that this trend will abate in the future. There is need for international agreement. Social Costs and Benefits The private cost of producing a good is the cost paid by the private firms. Sometimes producing a good imposes costs on other people. For example, a factory may cause air pollution that harms people who live nearby. Consumption of some goods also imposes costs on other people; when driving a car the driver is polluting the air. The social cost of producing a good is the total private cost plus the cost to other people.
Drunken driving also kills people. Mistakes made by a drunken driver imposes huge costs on other drivers that cannot be recovered. The private benefit of consuming a good is its benefit to the people who consume it. The social benefit is the private benefit plus the benefit that accrues to other people. An externality occurs when the private benefit/cost differs from the social benefit/cost. A negative externality occurs when the social cost of a good exceeds the private cost. A positive externality occurs when the social benefit exceeds the private benefit. Effects of Externalities
In a closed economy, the problem is to maximize utility subject to the production possibility frontier. Along an indifference curve, U U y1 + y2 = 0, y1 y 2 2
or dy2 MU1 =- (a.k.a. Marginal Rate of Substitution) dy1 MU 2 Along the production possibility frontier (PPF), cost is given, wL + rK = C. Thus, along the PPF, C C y1 + y2 = 0, y1 y2 or dy2 MC1 =- (a.k.a. Marginal Rate of Transformation) dy1 MC2 Maximization of utility subject to the budget constraint implies that at an optimal solution on the PPF, MRS = MRT. That is, it is a tangency point, like point A in Figure 1, between the highest indifference curve and the PPF. Equilibrium price ratio is the slope of the line tangent to both the indifference curve and the PPF. Here, MRT is the ratio of marginal costs incurred by the society as a whole, not private costs. That is, at point A, output price ratio is equal to the ratio of social marginal costs, i.e., p1 MSC1 = MRT = . p2 MSC2 This would be the end of the story, if there were no externalities. However, the presence of external costs or benefits disturbs the equilibrium and introduces a distortion in a market economy. At point B, marginal social costs deviate from marginal private costs. Line (3) reflects the ratio of social marginal costs, MSC1 . MSC2 However, the private sector faces a different price ratio, p1 MPC1 = . p2 MPC2 3
In the presence of external costs in Sector or industry1, MPC1 < MSC1. Thus, p1 MPC1 MSC1 = < , p2 MPC2 MSC2 and an equilibrium occurs at a point like B, where the above inequality holds. As a result, Excessive production of y1 ( ) Insufficient production of y2 ( ). Remark: While ignoring the externality causes inefficient allocation of resources, it does not imply that complete elimination of pollution is optimal. The optimal output mix occurs at point A, not either of end the PPF in Figure 1. Maximizing the Net Benefits of Pollution Pollution exists when human activity generates a sufficient concentration of a substance in the environment to cause harm to people or to valuable resources. Harmful substances naturally exist in the environment and they are not considered as pollutants. Pollutants are by definition, the products of people, not nature. What about pollution that harms plants or animals? Economists generally argue that such pollution imposes a cost if the plants or animals are valued by people. Negative Externality The intersection of MSC and D represents an economically efficient quantity. Without intervention, however, the free market equilibrium occurs at the intersection of MPC and D.
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If no output is produced, pollution is completely eliminated. However, it would not be economically efficient to eliminate pollution completely. This implies no production, which is not allocatively efficient. The deadweight loss from overproduction is ABC.
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HOW TO INTERNALIZE EXTERNALITIES TAX ON THE POLLUTER:
If property rights are well defined, the government can impose taxes on the polluter. It all depends on who owns the property right. If the non-polluters own the property right, Pigouvian tax may be appropriate. However, sometimes the property right is not well defined. (e.g., in the suburb of Kief, people build houses as they please, but at private costs.) Internalizing an externality means changing private costs or benefits so that they equal social costs or benefits. People can make side payments to others in return for a specific action. This side payment is in effect a bribe. People that suffer harm from a factory's pollution may offer to pay the polluter to stop. This may be unfair, but it works. Figure
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SIDE PAYMENTS Who should pay? The party that does not have the right. However, these rights are not often defined clearly. If rights are not clearly defined, then pollution is an inevitable outcome. Suppose there are two firms, Y and X, producing two goods Y and X, respectively. Y is an upstream firm and pollutes the water, thereby increasing the production cost of X.
Case I: X has the Riparian right (The upstream firm have the right to water) Then the downstream firm Y bribes the upstream firm X. Let p be the price of X, and let b be the amount of money X receives per unit of output reduced. Then the downstream firm's profit is:
= pX + b( X - X ) - c ( X ),
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where X is the amount of output the upstream firm would produce in the absence of any bribe. Optimal production of the polluter is given by: d = p - b - MC = 0. or p = b + MC. dX Case II: Y has the riparian right. (The downstream firm or residents have the right to water) In this case the upstream firm or the polluter X bribes the downstream firm X, b dollars per unit of output produced. Then the polluter's profit is: = pX - bX - C ( X ). The First order condition (FOC) is: d = p - b - MC = 0. or p = b + MC. dy The two problems yield an identical solution. The only difference between the two is that profit of the upstream firm changes by the amount of bribe, bY , or the value of the right to water. The Coase Theorem states that if transactions costs are sufficiently low and income effects are negligible, the equilibrium is efficient, regardless of whether the polluters have the right to pollute. Remark: Negotiation (transactions) cost is not negligible. It is difficult to organize the interested parties. It is not easy to get unanimity for negotiation. Side payments may not be realized. People harmed by pollution may find it impractical to get together, identify polluters, agree on the side payments, and on how to share their costs, make the offers, and make sure that polluters honor the agreements. It requires patience and time. If the transactions costs are too high, side payments may not be materialized.
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Common Property Resources Common properties are resources to which everyone has free access. Sometimes simply called "Commons." Private property: one can exclude others from using the property. http://www.dieoff.org/page95.htm Tragedy of the Commons Each household feels it has the right to take resources from the Commons and dump wastes on the Commons. If there are n individual, when an individual dumps a waste on the Commons, it bears only a small fraction of the external cost (1/n). However, whenever he takes resources, he becomes the single beneficiary. Thus, resources in the Commons are overexploited, and excessive wastes are dumped on the Commons. If the Commons were owned by a single individual, he would utilize the resources so that
MB - MC = 0.
However, if it is a common property, he uses the Commons until MB - MC = 0. n
Thus, each individual has an incentive to overexploit. Likewise, all individuals behave the same way. That is, the Commons is overexploited. Thus, the "tragedy of the Commons," Moreover, to get rich some households use their surplus to take more resources from the Commons, thereby expediting this process of ruining the Commons.
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