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CHAPTER
19
T
HE
E
NVIRONMENT
19.1
Negative Externalties and Pollution
19.3
Property Rights
19.2
Public Policy and the Environment
I
n the 1960s, fish were mysteriously disappearing
from thousands of lakes in the northeastern
portion of the United States. The culprit was
the acid rain from coal-burning power plants
that were releasing sulfur dioxide and nitric oxide
into the atmosphere; when combined with water,
it created acid rain. Acid rain was not only killing
fish but destroying crops and trees as well. Today,
acid rain is not the problem it was in the 1960s.
The Acid Rain Program introduced an allowance
trading system (cap and trade) which is a dramatic
departure from traditional command and control
regulatory methods. In this chapter, we will exam-
ine the economics of pollution: How much pollu-
tion should we allow? Why does a market produce
too much pollution? What policies can be used to
reduce pollution? What are private market solu-
tions to pollution?
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SECTION
19.1
Negative Externalities and Pollution
What are social costs?
How are negative externalities internalized?
WHAT ARE SOCIAL COSTS?
As we learned in Chapter 8, whenever an economic
activity has benefits or costs that are shared by individ-
uals other than the demanders or suppliers of a good or
service, an externality is involved. If the activity imposes
costs on individuals other than the demanders or sup-
pliers of a good or service, it is said to have negative
externalities. Put another way, negative externalities
exist any time the social costs of producing a good or
service exceed the private costs. Social costs refer to
costs that spill over to other members of society. Private
costs refer to costs incurred only by the producer of the
good or service.
SECTION
19.1
E
XHIBIT
1
The Effect of a
Negative Externality
MSC (MPC + External costs)
S = MPC
P
SOCIAL
Marginal External
Cost
P
PRIVATE
D
0
Q
SOCIAL
Q
PRIVATE
Quantity of Steel
NEGATIVE EXTERNALITIES AND POLLUTION
The classic example of a negative externality is pollu-
tion. When a steel mill puts soot and other forms of
“crud” into the air as a by-product of making steel, it
imposes costs on others not connected with the steel
mill or with buying or selling steel. The soot requires
nearby homeowners to paint their houses more often,
entailing costs. Studies show that respiratory diseases
are greater in areas with high air pollution, imposing
substantial costs, often the shortening of life itself. In
addition, the steel mill might discharge chemicals or
overheated water into a stream, thus killing wildlife,
ruining business for those who make a living fishing,
spoiling recreational activities for the local popula-
tion, and so on.
In deciding how much to produce, the steel
makers are governed by demand and supply. They do
not worry (unless forced to) about the external costs
imposed on members of society, and in all likelihood,
the steel makers would not even know the full extent
of those costs.
Consider the hypothetical steel industry in Exhibit 1.
It produces where demand and supply intersect, at
output
Q
PRIVATE
and
P
PRIVATE
. Let us assume that the
marginal social cost of producing the product is indi-
cated by the marginal social cost (
MSC
) curve, lying
above the supply curve, which represents the indus-
try’s marginal private costs (
MPC
). The marginal social
costs of production are higher at all output levels, as
those costs include all of the industry’s private costs
plus the costs that spill over to other members of
The industry would normally produce where
demand equals supply (where supply is equal to
the marginal private costs), at output
Q
PRIVATE
and
charging price
P
PRIVATE
. If, however, the industry
were forced to also pay those external costs
imposed on others, the industry would produce
where demand equals marginal social costs, at
output
Q
SOCIAL
and price
P
SOCIAL
. Where firms are
not forced to pay for negative externalities, output
tends to be larger and prices lower than at the
optimal output, where the marginal benefits to
society (as measured by demand) equal the marginal
costs to society.
society from the pollution produced by the industry—
that is, the external costs.
At output
Q
SOCIAL
, the marginal social costs to
society equal the marginal social benefits (as indicated
by the demand curve)
from the sale of the
last unit of steel. At
that output, the price of
steel is
P
SOCIAL
. If the
firm were somehow
forced to compensate
people who endure the
costs of its pollution, the
firm would produce at
output
Q
SOCIAL
and price steel at
P
SOCIAL
. In that case,
we would say that the externalities were
internalized,
internalized
externalities
when an industry is forced to
compensate those enduring some
negative externality caused by its
production.
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CHAPTER 19
Are cellular phones a negative
or positive externality? Some
would say a negative exter-
nality because cell phones can
distract drivers and cause
accidents. On the other hand,
cell phones may be a positive
externality because drivers
with cell phones can report
accidents, crimes, stranded
motorists, or drunken drivers.
This factory is clearly polluting the water downstream, creat-
ing a negative externality for those who fish downstream. It is
possible that the people who fish could try to bargain with the
factory, perhaps even pay it to pollute less. However, some-
times private bargaining does not work and the government
can provide a solution through regulation or pollution taxes.
MEASURING EXTERNALITIES
It is generally accepted that in the absence of interven-
tion, the market mechanism will underproduce goods
and services with positive externalities, such as educa-
tion, and overproduce those with negative externali-
ties, such as pollution. But the exact extent of these
market misallocations is quite difficult to establish in
the real world, because the divergence between social
and private costs and benefits is often difficult to
measure. For example, exactly how much damage at
the margin does a steel mill’s air pollution do to non-
consumers of the steel? No one really knows, because
no market fully measures those costs. Indeed, the costs
because each firm in the industry would now be
paying the entire cost to society of making steel. When
negative externalities are internalized, steel firms pro-
duce less output (
Q
SOCIAL
instead of
Q
PRIVATE
) and charge
higher prices (
P
SOCIAL
instead of
P
PRIVATE
). Optimal
output occurs where the marginal social costs are
equal to the marginal social benefits. When firms do
not pay all of the social costs they incur, and therefore
produce too much output, the result is too much pol-
lution. The output of pollution is directly related to the
output of the primary goods produced by the firm.
using what you’ve learned
Negative Externalities
After months of looking at houses he could not afford, Dean recently
bought a home near the airport. After living in his house for only a
week, Dean was so fed up with the noise that he decided to organize a group
of local homeowners in an effort to stop the noise pollution. Should Dean be
compensated for bearing this negative externality?
Q
A
Because few people want to live in noisy areas, housing prices and
rents in those areas are lower, reflecting the cost of the noise in the
area. As a result, fewer people competed with Dean for the purchase of his
house relative to houses in quieter neighborhoods, so it is likely he did not pay
as much as he might have in another area. Because Dean paid a lower price for
living in a noisier area, he has already been compensated for the noise pollution.
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MODULE 5
are partly nonpecuniary, meaning that no outlay of
money occurs. Even though we pay dollars to see the
doctor for respiratory ailments and pay dollars for
paint to repair pollution-caused peeling, we do not
make explicit money payments for the visual pollution
and undesirable odors that the mill might produce as
a by-product of making steel. Nonpecuniary costs are
real costs and potentially have a monetary value that
can be associated with them, but assessing that value
in practical terms is immensely difficult. You might be
able to decide how much you would be willing to pay
to live in a pollution-free world, but no current mech-
anism allows anyone to express the perceived mone-
tary value of having clear air to breathe and smell.
Even some pecuniary, or monetary, costs are difficult
to truly measure: How much respiratory disease is
caused by pollution and how much by other factors
such as secondhand cigarette smoke? Environmental
economists continue to make progress in valuing these
difficult damages.
SECTION
*
CHECK
1.
Social costs are those costs that accrue to the total population; private costs are incurred only by the producer of
the good or service.
2.
If the industry were somehow forced to compensate people who endure the costs of pollution, we would say that
the industry had internalized the externality.
3.
When negative externalities are internalized, the industry produces less output at a higher price.
4.
Optimal output occurs when marginal social benefits are equal to marginal social costs.
1.
What is the difference between private and social costs?
2.
Why do decision makers tend to ignore external costs?
3.
How can internalizing the external costs of production move us closer to the efficient level of output?
4.
Why is it particularly difficult to measure the value of external costs or benefits?
SECTION
19.2
Public Policy and the Environment
What are compliance standards?
What is a pollution tax?
What is the “best” level of pollution?
What are transferable pollution rights?
Even though measuring externalities, both negative and
positive, is often nearly impossible, it does not necessar-
ily mean that it is better to ignore the externality and
allow the market solution to operate. As already
explained, the market solution will almost certainly
result in excessive output by polluters unless some inter-
vention occurs. What form should the intervention take?
Act of 1970 to serve as a watchdog over the produc-
tion of goods and services in areas where externalities,
especially negative externalities, exist. The EPA’s main
duty is to enforce environmental standards.
Using the
compliance standards
approach, the
EPA identifies and then enforces a standard equal to
the maximum amount of pollution that firms can pro-
duce per unit of output per year. To be effective in pol-
lution reduction, of course, these standards must result
in less pollution than would exist in the absence of the
compliance standards. The standards, then, force com-
panies to find less pollution-intensive ways of producing
goods and services. Or in the case of consumer products
that pollute—such as automobiles, for example—
manufacturers have been forced to reduce the emis-
sions from the products themselves.
COMPLIANCE STANDARDS
One approach to dealing with externalities is to
require private enterprise to produce their outputs in
a manner that would reduce negative externalities
below the amounts that would persist in the absence
of regulation. For example, the Environmental Protec-
tion Agency (EPA) was established by the Clean Air
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Evidence exists that pollution has declined since
1970 (see Exhibit 2), although these statistics do not
measure exactly what the EPA’s impact has been, as
other things were also changing. However, it does
appear that the compliance standards approach to
limiting key pollutants has led to a reduction in pol-
lution levels. For example, the phasing out of leaded
gasoline, which started in 1984, dramatically affected
the levels of lead in our atmosphere.
in the news
Air Emissions Trends—Continued
Progress Through 2005
The Clean Air Act directs EPA to establish air quality standards to protect
public health and the environment. EPA sets national air quality standards for
six principal air pollutants (also called the criteria pollutants): nitrogen diox-
ide (NO
2
), ozone (O
3
), sulfur dioxide (SO
2
), particulate matter (PM), carbon
monoxide (CO), and lead (Pb).
From 1990 to 2002, air toxics emissions declined by 42 percent. These
reductions are the result of implementing stationary and mobile source regu-
lations. Seventy-five percent of air toxics emitted in 2002 are included as
volatile organic compound and particulate matter emissions.
ESTIMATING EMISSIONS
EPA estimates nationwide emissions of ambient air pollutants and the pollu-
tants that form them (their precursors). Four of the principal pollutants (CO,
Pb, NO
2
, and SO
2
) are emitted directly from a variety of sources. Ozone is gen-
erally not directly emitted, but is formed when oxides of nitrogen (NOx) and
volatile organic compounds (VOCs) react in the presence of sunlight. PM can
be directly emitted, or it can be formed when emissions of NOx, sulfur oxides
(SOx), ammonia, organic compounds, and other gases react in the atmosphere.
Emission estimates are based on many factors, including actual measure-
ments, levels of industrial activity, fuel consumption, vehicle miles traveled,
and other estimates of activities that cause pollution.
Emissions of air pollutants continue to play an important role in a number
of air quality issues. About 141 million tons of pollution are emitted into the
LOOKING AT GROWTH AND EMISSIONS
Each year EPA looks at emissions that impact the ambient concentrations
of these pollutants. These annual emissions estimates are used as one indi-
cator of the effectiveness of our programs. The graph in Exhibit 1 below
shows that between 1970 and 2005, gross domestic product increased 195
percent, vehicle miles traveled increased 178 percent, energy consumption
increased 48 percent, and U.S. population grew by 42 percent. During the
same time period, total emissions of the six principal air pollutants
dropped by 53 percent.
SECTION
19.2
E
XHIBIT
1
Comparison of Growth Areas and Emissions
200%
195%
178%
150%
Gross Domestic Product
Vehicle Miles Traveled
Energy Consumption
Population
Aggregate Emissions
(Six Principal Pollutants)
100%
48%
50%
42%
0%
–53%
–50%
70
80
90
95
96
97
98
99
00
01
02
03
04
05
SOURCE: U.S. Environmental Protection Agency, “Air Emissions Trends: Continued Progress Through 2005,” Air Trends, http://www.epa.gov/airtrends/2006/
econ-emissions.html.
(continued)
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