The Economics of Pollution Pollution is a bad

The Economics of Pollution § Pollution is a bad thing. Yet most pollution is a side effect of activities that provide us with good things. § Pollution is a side effect of useful activities, so the optimal quantity of pollution isn’t zero. § Then, how much pollution should a society have? What are the costs and benefits of pollution?

Costs and Benefits of Pollution § The marginal social cost of pollution is the additional cost imposed on society as a whole by an additional unit of pollution. § The marginal social benefit of pollution is the additional gain to society as a whole from an additional unit of pollution. § The socially optimal quantity of pollution is the quantity of pollution that society would choose if all the costs and benefits of pollution were fully accounted for.

The Socially Optimal Quantity of Pollution Marginal social cost, marginal social benefit Marginal social cost, MSC, of pollution Socially optimal point O $200 Marginal social benefit, MSB, of pollution 0 Q OPT Socially optimal quantity of pollution Quantity of pollution emissions (tons)

Pollution: An External Cost § An external cost is an uncompensated cost that an individual or firm imposes on others. § An external benefit is a benefit that an individual or firm confers on others without receiving compensation.

Pollution: An External Cost § Pollution is an example of an external cost, or negative externality; in contrast, some activities can give rise to external benefits, or positive externalities. External costs and benefits are known as externalities. § Left to itself, a market economy will typically generate too much pollution because polluters have no incentive to take into account the costs they impose on others.

Why a Market Economy Produces Too Much Pollution Marginal social cost, marginal social benefit Marginal social cost at QMKT MSC of pollution $400 The market outcome is inefficient: marginal social cost of pollution exceeds marginal social benefit 300 Optimal Pigouvian tax on pollution O 200 100 Marginal social benefit at QMKT 0 MSB of pollution Q OPT Q H Q MKT Socially optimal quantity Market-determined of pollution quantity of pollution Quantity of pollution emissions (tons)

Policies Toward Pollution § Environmental standards are rules that protect the environment by specifying actions by producers and consumers. Generally such standards are inefficient because they are inflexible. § An emissions tax is a tax that depends on the amount of pollution a firm produces. § Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters. § Taxes designed to reduce external costs are known as Pigouvian taxes.

Policies Toward Pollution § When the quantity of pollution emitted can be directly observed and controlled, environmental goals can be achieved efficiently in two ways: emissions taxes and tradable emissions permits. § These methods are efficient because they are flexible, allocating more pollution reduction to those who can do it more cheaply. § An emissions tax is a form of Pigouvian tax, a tax designed to reduce external costs. § The optimal Pigouvian tax is equal to the marginal social cost of pollution at the socially optimal quantity of pollution.

Production, Consumption, and Externalities § When there are external costs, the marginal social cost of a good or activity exceeds the industry’s marginal cost of producing the good. § In the absence of government intervention, the industry typically produces too much of the good. § The socially optimal quantity can be achieved by an optimal Pigouvian tax, equal to the marginal external cost, or by a system of tradable production permits.

Positive Externalities and Consumption (a) Positive Externality (b) Optimal Pigouvian Subsidy Price, marginal social benefit of flu shot Marginal external benefit P MSB P OPT P MKT Price of flu shot S S Price to producers after subsidy O E MKT MSB of flu shots D Q Q MKT OPT Optimal Pigouvian subsidy O E MKT Price to consumers after subsidy Quantity of flu shots D Q Q MKT OPT Quantity of flu shots

Positive Externalities and Consumption (b) Optimal Pigouvian Subsidy Price of flu shot S Price to producers after subsidy Optimal Pigouvian subsidy O E MKT Price to consumers after subsidy MSB of flu shots D Q Q MKT OPT Quantity of flu shots

Private Versus Social Benefits § The marginal social benefit of a good or activity is equal to the marginal benefit that accrues to consumers plus its marginal external benefit.

Private Versus Social Benefits § § § A Pigouvian subsidy is a payment designed to encourage activities that yield external benefits. A technology spillover is an external benefit that results when knowledge spreads among individuals and firms. The socially optimal quantity can be achieved by an optimal Pigouvian subsidy equal to the marginal external benefit. An industrial policy is a policy that supports industries believed to yield positive externalities.

Private Versus Social Costs § The marginal social cost of a good or activity is equal to the marginal cost of production plus its marginal external cost.

Negative Externalities and Production (a) Negative Externality Price, marginal social cost of livestock P MSC P OPT PMKT (b) Optimal Pigouvian Tax Price of livestock Marginal external cost MSC of livestock S O E Optimal Pigouvian tax MKT D Q Q OPT MKT Price to consumers after tax Quantity of livestock S O E MKT D Price to producers after tax Q Q OPT MKT Quantity of livestock