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Chapter05

# Chapter05 - Chapter 5 Pollution Control under Heterogeneity...

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Chapter 5 Pollution Control under Heterogeneity Contents: Positive Externalities Polluter Heterogeneity and Markets for Pollution The Benefits of Pollution Trading Problems Associated with Pollution Permit Markets Choice of Pollution Taxes or Standards Specification of Pollution in Productive Activities Components of Externality Policy Technology Diffusion Positive Externalities A positive externality exists if the activities of one individual (or group) lead to increases in the utility or productive ability of some other individual (or group), when the benefits are not transmitted through a market. For example, an apple farmer might receive unpaid benefits from a neighboring honey producer if the honey producer’s bees pollinate the apple trees. Because the benefits associated with positive externalities are not paid for in market transactions, the activities producing these benefits are carried out at an inefficiently low level. In the first example above, unless the apple farmer pays the beekeeper for the marginal value of pollinating services, the beekeeper will not recognize this value in her objective function and thus keep an inefficiently low number of bees. An Economic Model of Positive Externalities Consider a fertilizer manufacturers who uses animal waste as an input and generates a positive externality by removing the waste from the environment. Let: X = the amount of animal waste used by fertilizer manufacturers. D(P) = the fertilizer manufacturers’ demand for X PB(X) = the fertilizer manufacturers’ private benefit from output X (i.e., the area under the demand curve). EB(X) = environmental benefit of removed waste X. SB(X) = social benefit of X = PB(X) + EB(X). C(X) = cost of obtaining X. SW(X) = social welfare of using X = PB(X) + EB(X) - C(X) Now Consider the Market for Animal Waste Social optimization problem : { } Max SW X PB X EB X C X X . ( ) ( ) ( ) ( ) = + First-Order Condition: PB x +EB x - C x = 0, or,

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- 2- MPB + MEB = MC. Hence, the socially optimal solution is to use X* animal waste, such that: MSB(X*) = MC(X*) Figure 5.1 Positive Externalities Q*= optimal output P * c = optimal consumer price P p * = (P * c + S*) = optimal producer price Q c = competitive output P c = competitive price S*= P * p - P * c = MEB = optimal subsidy [note that S* = MEB(Q*)] In Figure 5.1, the socially optimal solution, where MSB = MC, occurs at point A. In contrast, the competitive solution is to use fertilizer until MPB = MC, which occurs at point B. At point B, the quantity of fertilizer used is lower than under the socially optimal solution ( Q c < Q*), which means that the competitive solution results in an insufficient utilization of X. A subsidy S* = MEB(X*) will achieve the optimal solution. With subsidy S*, the following welfare implications arise: consumer gain = P c * P c BC
- 3- producers gain = AB P c P p * environmental gain = MBCA subsidy cost = P c * CA P p * net social gain = BAM.

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Chapter05 - Chapter 5 Pollution Control under Heterogeneity...

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