Topic 2: Production Externalities

1. Topic 2: Production Externalities • Externalities  the market outcome will be inefficient, in the sense that: • total net benefits (NB) are not maximized; or (equivalently) • it is possible to make at least one individual better off without making any other individual better off. • In the case of negative production externalities this stems in that external costs (EC) are not borne by firms and hence, firms do not consider them when they make decisions.

2. Topic 2: Production Externalities • Example: the production of electricity at a coal-fired power plant. • Burning coal  emissions of (among other things) sulfur dioxide (SO2). • In US, power plants emit 2/3 of SO2 emissions. • In Canada, power plants emit 1/3 of SO2 emissions. • Why do we care? • Respiratory illnesses such as asthma • Worsening of existing heart conditions (death) • Aesthetically unpleasant haze • Acid rain • These are all costly effects, but - unlike costs of labor, raw materials etc - the costs are not paid by firms, but by others.

3. Topic 2: Production Externalities • Firm’s costs are measured in dollars. • If we want to account for EC in the same way as we account for PC, we need to put a dollar value on the environmental impacts of firms polluting activities. • Translating environmental costs into dollar costs is • Methodologically controversial • Morally controversial • Not easy • For now, we will look briefly at this question. If time allows we can look into this valuation in more detail.

4. Topic 2: Production Externalities • How to place a dollar value on the effects of SO2 emissions? • Illness such as asthma? • Value of lost wages due to asthma-related absences from work? • Expenditures on medical care and treatment? • Death? • Much harder. • Factors such as value of lost wages, etc.? • Can also look at changes in probabilities of death (or indeed illness). • Haze? • Aesthetic cost - for example, national parks are “less pleasant” to be in if they are hazy. • Harder to measure cost of this - related to how we value environmental assets like parks.

5. Topic 2: Production Externalities • How to place a dollar value on the effects of SO2 emissions? • Acid Rain • Is the one of the biggest problems associated with SO2 emissions, esp. true in Eastern Canada and US (and other parts of the world). • lowers ph levels in lakes, rivers streams, negatively impacting (i.e., killing) aquatic species (fish, frogs, plants etc). • lowers growth rates of woody plants (i.e., trees) and can kill entire forests. • corrodes automotive coatings and can cause damage to buildings, statues, monuments etc. • Think about how to place a dollar value on these effects?

6. Topic 2: Production Externalities • Recall we are thinking about how to estimate EC, or more specifically, MEC: a dollar value of the environmental effects resulting from SO2 emissions (E) for each additional unit of output produced. • That is, if electricity production, how much damage is caused? •  MEC = (E/Q)  ($ value of damages resulting from E). • Definitions: • Total Damages (TD) = $ value of damages resulting from a given level of emissions E • Marginal damages (MD) = $ value of damages resulting from E = TD/ E  MEC = (E/Q)  (MD) = (E/Q)  (TD/E ) = TD/Q

7. Topic 2: Production Externalities Simple example to illustrate the calculation of MEC: Suppose that: • each kwh of electricity produced results in 1/10,000th of a ton of SO2 emissions, irrespective of the level of electricity production; and • each ton of SO2 results in $300 of damage, irrespective of the level of SO2 emissions.  MEC = 1/10,000th of a ton of SO2  $300 = $0.03. • That is, each extra kwh of electricity produced results in external costs of 3cents. • These external costs = medical costs and lost wages of asthma sufferers + costs of ecosystem damage + costs of damage to automobiles + etc. etc. etc. • Graphical (and slightly more formal) derivation of MEC…

8. Topic 2: Production Externalities Total Damages as a function of E Total External Costs as a function of Q (EC) Total E as a function of Q E (tons of SO2) EC ($) TD ($) TD= 300E TD= 300E(Q) = 300(1/10,000)Q = (3/100)Q = EC E = (1/10,000)Q 600 0.06 2 10,000 300 0.03 1 10,000 2 1 Q (kwh) 2 Q 1 E 2 1 Marginal E as a function of Q Marginal Damages as a function of E Marginal External Costs MD($) MEC($) E MEC = 0.03 = E/QMD MD= 300 E/Q = 1/10,000 300 0.03 1 10,000 Q Q E 2 1 2 2 1 1

9. Topic 2: Production Externalities • Note that here we have the simplest possible relationship between MEC and Q. • MEC is constant in Q because we have assumed that: • E/Q is constant in Q • i.e, production does not get “dirtier” (on the margin) as Q • MD is constant in E • i.e., pollution not more damaging (on the margin) as E

10. Topic 2: Production Externalities • There are reasons to believe that - in reality - MEC as Q • That is, pollution costs per unit of Q are likely to be higher at higher levels of Q than at lower levels. • Could be because: • E/Q is increasing in Q; or • MD is increasing in E; or both