Chapter 17

The
Economics of
Environmental
Protection

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

 In this chapter you will learn to

1. Describe how an externality can be internalized, and how

this can lead to allocative efficiency.

2. Explain why direct pollution controls are often inefficient.

3. Explain why market-based policies such as emissions

taxes and tradable pollution permits can improve
economic efficiency.

4. Describe and evaluate some of the most common

arguments against market-based environmental policies.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-2

The Economic Rationale for
Regulating Pollution

Pollution as an Externality
The production of most goods generates some pollution that
imposes costs on other members of society.

The socially optimal level of output is at the quantity where all

marginal costs, private plus external, equal the marginal
benefit to society.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-3

Negative Externality

Pollution is a negative externality.

- the social marginal cost of production exceeds the
private marginal cost of production.

One solution is to internalize the externality – a process

that results in a producer of consumer taking the account
of a previously external effect.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-4

Figure 17.1 A Pollution Externality
in a Competitive Market

With a negative
externality, MCs
exceeds MCp...
… with the result
that too much
gets produced.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-5

Internalizing Externality

The socially optimal level of output is where the social

marginal costs -- private plus external -- equal the marginal
benefit to society.

How can this be achieved?

If the externality can be internalized (by making the

producers bear the full external cost), allocative efficiency
can be achieved.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-6

Figure 17.2 The Optimal
Amount of Pollution Abatement

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-7

Pollution-Control Policies

Direct Controls

Direct control is a form of environmental regulation that either:

• stipulates the use of specific technology, or
• prohibits certain polluting behaviour altogether.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-8

 Problems with Direct Control

The use of direct controls is usually economically inefficient:

- because the MC of abatement is not equated across
different firms

Direct pollution controls are inefficient because they do not

minimize the cost of a given amount of pollution abatement

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-9

Figure 17.3 The Inefficiency of
Direct Pollution Controls

Direct pollution
controls usually
do not minimize
the cost of a
given amount
of pollution
abatement.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-10

Figure 17.4 The Efficiency of
Emissions Taxes

With a tax of $t per

unit of pollution
emitted, the tax
becomes the firm’s
marginal benefit of
pollution abatement.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-11

 Efficient amount of pollution

Set the emissions tax equal to the size of the marginal

external cost
- this fully internalizes the externality

But the information required to know the optimal tax rate is

often unavailable.

APPLYING ECONOMIC CONCEPTS 17.1

Garbage Collection and “Pay-As-You-Throw”

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-12

 Tradable Emissions Permits

The government could issue (or auction) a given number of

tradable emissions permits.

This kind of problem is also called “cap and trade.”

The price of the permit is the MB of abatement.

Firms will abate pollution until the MB equals the MC.

Pollution is abated at minimum cost.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-13

Figure 17.5 The Efficiency of
Tradable Emissions Permits

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-14

Pollution Permits

With an emissions tax, government must determine the

optimal tax rate.
With pollution permits, the market for permits determines the
equilibrium permit price, but government needs to set the
total amount of permits.
So how does the government set the optimal quantity that
leads to the optimal equilibrium price -- the one that fully
internalizes the externality?

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-15

Figure 17.6 The Market for
Tradable Emissions Permits

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-16

Technological Change

Government regulation tends to respond only slowly to

changes in technology or market conditions.

Improvements in abatement technology will lead to a

reduction in the demand for emissions permits and thus a
reduction in their equilibrium price.

The total cost of a given amount of pollution abatement will

still be minimized.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-17

Tradable Emission Permits

The U.S. Experience with Tradable Emission Permits

The cap and trade approach has been implemented in:

– California’s 2006 greenhouse gas reduction program
– Kyoto Protocol’s strategy for greenhouse gas reduction

Problems with Tradable Emissions Permits

Technical difficulties in measuring pollution and in designing
mechanisms to ensure that firms and households comply
with regulations.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-18
The Politics of Pollution Control

Several groups argue against the use of market-based

environmental policies
- especially tradable pollution permits

But the growing concern about global warming and the

debate over the Kyoto Protocol have led to more discussion
and growing acceptance of the basic principles.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-19

 Producers

Emissions taxes or permits are costly, and firms naturally

complain.
These policies, if implemented, signal the end of a free ride
that firms have been taking at society’s expense.
Firms also argue that such policies reduce overall welfare
because of reduced output and employment:
- but reduced output of the polluting products is part
of the solution that increases welfare!

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-20

 The General Public

Some people have a moral opposition to giving anyone the

“right” to pollute.

There is also opposition to having some firms reduce pollution

less than others. Shouldn’t they reduce by equal amounts?

But the relevant question is: How can society best reduce
pollution?

Emissions taxes and tradable emissions permits lead to

pollution reduction with the least cost.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-21

Environmentalists

Some argue that clean air and water are above monetary
evaluation and should be treated in special ways.

They often don’t see how private firms could ever be induced
to do what is desirable for society. As a result, they tend to
prefer the use of direct controls.

Economists can emphasize that market-based schemes are

often more efficient than other policies -- which means more
pollution abatement with a given amount of resources.

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-22

Summary

The efficient solution to pollution involves internalizing the

externality.
If properly designed, such market-based environmental
policies can reverse the effects of the pollution externality.
However, there is considerable opposition among some
environmentalists and some of the general public to market-
based environmental policies.
Tradable emission permits also generate skepticism due to
the failure to appreciate how markets work to allocate
resource efficiently.
Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 17-23