Economics of pollution

• The Coase Theorem states that once property rights are established and transaction costs are small, then one of the parties will bribe the other to attain the socially efficient qua

2 Economics of pollution

2.3 How to meet optimal pollution

- The Coase Theorem

Property rights?

Property right of Environment?

Suppose that we have two groups: Polluters and Receptors

What defines

What defines property rights property rights ?

Property rights are established by

Property rights are established by formal and informal rules formal and informal rules about the privileges and limitations on the

privileges and limitations on the ownership ownership , use, and transfer , use, and transfer of goods and resources These rights are specified in various municipal ordinances, other legislation, court decisions (common law), tradition and custom.

Property rights need to be:1) clearly defined

2) exclusive

3) enforceable

4) transferable

Coase Theorem

• Insight: root of the inefficiencies from externalities

is the absence of property rights.

• The Coase Theorem states that once property rights

are established and transaction costs are small,

then one of the parties will bribe the other to attain

the socially efficient quantity.

• The socially efficient quantity is attained regardless

of whom the property rights were initially assigned.

Illustration of the Coase Theorem

• Recall the steel firm / fishery example If the steel

firm was assigned property rights, it would initially

produce Q 1, which maximizes its profits.

• If the fishery was assigned property rights, it would

initially mandate zero production, which minimizes

its damages.

Figure 5.3

Coase Theorem – assign property

rights to steel firm

• Consider the effects of the steel firm reducing production in

the direction of the socially efficient level, Q * This entails a

cost to the steel firm and a benefit to the fishery:

– The steel firm (and its customers) would lose surplus between

the MB and MPC curves between Q1and Q1-1, while the

fishery’s damages are reduced by the area under the MD curve

between Q1and Q1-1.

– Note that the marginal loss in profits is extremely small,

because the steel firm was profit maximizing, while the

reduction in damages to the fishery is substantial.

– A bribe from the fishery to the steel firm could therefore make

all parties better off.

Coase Theorem – assign property

rights to steel firm

• When would the process of bribes (and pollution reduction)

stop?

– When the parties no longer find it beneficial to bribe.

– The fishery will not offer a bribe larger than it’s MD for a given

quantity, and the steel firm will not accept a bribe smaller than

its loss in profits (MB-MPC) for a given quantity.

– Thus, the quantity where MD=(MB-MPC) will be where the

parties stop bribing and reducing output.

– Rearranging, MC+MPC=MB, or MSC=MB, which is equal at Q * ,

the socially efficient level.

Coase Theorem – assign property

rights to fishery

• Similar reasoning follows when the fishery has property

rights, and initially allows zero production.

– The fishery’s damages are increased by the area under the MD

curve by moving from 0 to 1 On the other hand, the steel

firm’s surplus is increased.

– The increase in damages to the fishery is initially very small,

while the gain in surplus to the steel firm is large.

– A bribe from the steel firm to the fishery could therefore make

all parties better off.

Coase Theorem – assign property

rights to fishery

• When would the process of bribes now stop?

– Again, when the parties no longer find it beneficial to

bribe.

– The fishery will not accept a bribe smaller than it’s MD for

a given quantity, and the steel firm will not offer a bribe

larger than its gain in profits (MB-MPC) for a given

quantity.

– Again, the quantity where MD=(MB-MPC) will be where

the parties stop bribing and reducing output This still

occurs at Q *

When is the Coase Theorem relevant or

not?

• Low transaction costs

– Few parties involved

• Source of externality well

• Example: Air pollution

Coase Theorem

Building the graph

Building the graph

Building the graph, cont’d

“ Optimal ” solution (max social benefit)

without actual transactions ??

Total Benefit to Company

Total Costs to Community

“ Optimal ” solution (max social benefit)

without actual transactions ??

Coase Theorem says same “ optimal ” outcome obtained via market transactions

Both parties benefit, thus, both agree

What has been achieved?

Case 2

Company owns “right” to determine how much

pollution they make

Case 2 Company owns “right”, Cont’d

What has been achieved? For

What has been achieved? For

Company Holds Rights

6,000 Remain Costs 21,000 Remain benefits

Ending position $14,000 Total pmts made

& remain costs $29,000 Total pmts rec’d &

Community Holds Rights

“Optimal” solution for both parties without actual transactions

@ output

that emits

90 units of

effluent

Coase Theorem says same “optimal” outcome obtained via market transactions

2 Economics of pollution

The Coase Theorem

If there are no legal, strategic,

or informational barriers to

bargaining, and if property

rights are clearly defined,…

Ronald Coase Nobel Prize in Economics, 1993

The Coase Theorem

… then people can always

negotiate to an efficient

outcome

Note the minimal role this

implies for government

Problems With The Coase Theorem

Transaction Costs May Exist

– bargaining may be expensive

Property Rights May Not Be Clearly Assigned

Problems With The Coase Theorem

•Sometimes there are

legal impediments to

what society considers

immoral This can effect

the achievement of an

economically efficient

solution

Problems With The Coase Theorem

•Sometimes there are

Property Rights Must Be Secure and Transferable

Property Rights Must Be Secure and Transferable

work That is, they

will not tend to be

Result of the Difficulties?

• Many arrangements are not made through private negotiation, but through

Example of The Coase Theorem:

Assigning Property Rights for a Railroad through Farm Country

The Railroad and The Farmer

– how many trains to run (before fires start)

– how many acres to plant (and how close to

tracks)

What is the socially optimal number of trains

to run and acres of crops to plant?

Example of The Coase Theorem:

Assigning Property Rights for a Railroad through Farm Country

The socially optimal number of trains to run or acres of crops to plant depends on whether

the railroads or the farms are assigned

property rights for the land on which the

2 Economics of pollution

It has to do with the elasticity of the supply curve and the

amount of consumer/producer surplus

ice

Quantity

Consumer Surplus

S

Q

P P

D D

With DIAMONDS,

supply is very inelastic. With WATER, supply is very elastic.

Regulatory Approach

• Area I represents abatement cost in

excess of benefits for firm A

• Area II represents opportunity cost loss of firm B for stopping abatement while

marginal benefits were still greater than marginal costs

Adjustments at the Margin:

Pollution Taxes

• In efficient markets P = MC.

• True only when firms marginal cost equals the real cost of the next unit of production.

• If pollution create costs on society not incurred

by business (externality), then an over allocation

of resources into production will occur.

• Taxes can correct for this over allocation by

internalizing the externality.

Adjustments at the Margin:

Pollution Taxes

Spillover costs

Overallocation Corrected

P

Q

MC t MC

D

TAX

P e

P 0

Adjustments at the Margin:

Subsidies

• R&D that leads to reduction in pollution has positive societal benefits

• R&D will only be invested in if profitable

• Subsidizing R&D can reduce the time it takes to develop new technology

• R&D doesn’t always generate a outcome

on the income statement The subsidy

helps offset the risk of investment

Adjustments at the Margin:

Subsidies

P

Q

R&D Subsidy to producers Decreases marginal cost

D

P e

P 0

Adjustments at the Margin:

Markets for Pollution Rights

• Politically more palatable to business because it

relies on markets rather than taxes for corrections.

• Firms (such as public utilities in the market for SO2 ) receive a fixed number of pollution allowances.

• These credits can be sold and bought on the CBOT.

• If firms use more pollution than they own credits for they pay a fine.

Adjustments at the Margin: Markets for Pollution Rights

Allowance Trading Basics

• An emissions "cap": A limit on the total amount

of pollution that can be emitted (released) from all regulated sources (e.g., power plants); the

cap is set lower than historical emissions in

order to reduce emissions

• Allowances: An authorization to emit a fixed

amount of a pollutant

• Measurement: Accurate tracking of all

emissions

Source:http://www.epa.gov/airmarkets/trading/basics.html

Allowance Trading Basics

• Flexibility: Sources can choose how to reduce

emissions, including whether to buy additional allowances from other sources that reduce

emissions

• Allowance trading: Sources can buy or sell

allowances on the open market Because the

total number of allowances is limited by the cap, emission reductions are assured

• Compliance: At the end of each compliance

period, each source must own at least as many allowances as its emissions

Source:http://www.epa.gov/airmarkets/trading/basics.html

Trading the Right to Pollute

market-based cap and trade program

created to reduce emissions of nitrogen

large combustion sources in the eastern United States

Source : http://www.epa.gov/airmarkets/progsregs/nox/sip.html

Trading the Right to Pollute

• Market-based sulfur dioxide (SO2) allowance

trading component of the Acid Rain Program

• Utilities regulated under the program, decide the most cost-effective way to use available

resources to comply with the acid rain

requirements of the Clean Air Act

– Purchase pollution allowances.

– Switching to lower sulfur fuel.

– Reduce emissions by employing energy conservation measures

Source: http://www.epa.gov/airmarkets/trading/factsheet.html

Exercise

A Pigovian tax sets the

Pollution permits sets the

quantity of pollution…

Supply of pollution permits

Supply of pollution permits

Q

P

Notice that in both cases, price and quantity are the same .

Supply of pollution permits

Q

P

Notice also that the pigovian tax line is perfectly elastic firms can pollute as

much as they want as long as they pay a tax .

Supply of pollution permits

Q

P

.while in the second panel, the EPA sets the quantity of pollution, and the

supply of pollution is completely inelastic.

Economists usually prefer pigovian taxes to regulation as a way to deal with

pollution because they reduce pollution at a lower cost to society.

Using pigovian taxes to internalize externalities will cause market price to reflect the true social costs of production and force firms to bear the full social cost of their

production activities.

Now, suppose that two firms are awarded permits and have met the

government standard.

Firm 1 then decides it wants to increase its emissions by 100 tons and firm

2 agrees to reduce its emissions by 100 tons if firm 1 pays it $5 million.

Should the government allow two factories to make this deal?

If the EPA allows the firms to make this deal, it will have created a

new scarce resource:

new scarce resource: pollution permits pollution permits

A market to trade these permits will develop and that market will

be governed by the forces of supply and demand.

The CLEAN AIR ACT of 1990 established the right to buy and sell emission rights for sulfur-

dioxide pollution.

• Competitive markets, firms maximize profits

– Note that steel firm only care’s about its own profits, not the fishery’s

– Fishery only cares about its profits, not the steel firm’s.

Graphical Analysis, continued

• MB = marginal benefit to steel firm

• MPC = marginal private cost to steel firm

• MD = marginal damage to fishery

• MSC = MPC+MD = marginal social cost

Figure 5.1

Graphical Analysis, continued

• From figure 5.1, as usual, the steel firm

maximizes profits at MB=MPC This quantity

is denoted as Q1 in the figure

• Social welfare is maximized at MB=MSC,

which is denoted as Q* in the figure

Graphical Analysis, Implications

• Result 1: Q1>Q *

– Steel firm privately produces “too much” steel, because it does not

account for the damages to the fishery.

• Result 2: Fishery’s preferred amount is 0.

– Fishery’s damages are minimized at MD=0.

• Result 3: Q* is not the preferred quantity for either party, but is the best compromise between fishery and steel firm.

• Result 4: Socially efficient level entails some pollution

– Zero pollution is not socially desirable.

Figure 5.2

Graphical Analysis, Intuition

• In Figure 5.2, loss to steel firm of moving to Q * is shaded

triangle dcg.

– This is the area between the MB and MPC curve going from Q1

to Q *

• Fishery gains by an amount abfe.

– This is the area under the MD curve going from Q1 to Q * By

construction, this equals area cdhg.

• Difference between fishery’s gain and steel firm’s loss is the efficiency loss from producing Q1 instead of Q *

Numerical Example, continued

• The steel firm therefore chooses Q1:

Numerical Example, continued

• The deadweight loss of steel firm choosing Q1=140 is calculated as the

triangle between the MB and MSC curves from Q1 to Q *

Numerical Example, continued

• By moving to Q * the steel firm loses profits equal to the triangle between

the MB and MPC curve from Q1 to Q *

By moving to Q * the fishery reduces its damages by an amount equal to the

trapezoid under the MD curve from Q1 to Q *

Calculating gains & losses raises

practical questions

• What activities produce pollutants?

– With acid rain it is not known how much is associated with

factory production versus natural activities like plant decay.

• Which pollutants do harm?

– Pinpointing a pollutant’s effect is difficult Some studies show very limited damage from acid rain.

• What is the value of the damage done?

– Difficult to value because pollution not bought/sold in market Housing values may capitalize in pollution’s effect.

Private responses, continued

• Mergers

• Social conventions

Mergers

• Mergers between firms “internalize” the

externality.

• A firm that consisted of both the steel firm & fishery

would only care about maximizing the joint profits

of the two firms, not either’s profits individually.

• Thus, it would take into account the effects of

increased steel production on the fishery.

Social Conventions

• Certain social conventions can be viewed as

attempts to force people to account for the

externalities they generate.

• Examples include conventions about not littering,

not talking in a movie theatre, etc.

SAMPLE AP TEST QUESTION

Taxes

• Again, return to the steel firm / fishery example.

• Steel firm produces inefficiently because the prices

for inputs incorrectly signal social costs Input

prices are too low Natural solution is to levy a tax

on a polluter.

• A Pigouvian tax is a tax levied on each unit of a

polluter’s output in an amount just equal to the

marginal damage it inflicts at the efficient level of

output.