Chapter 6 externalities in action
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Chapter 6: Externalities In Action. Outline Addressing externalities: should we focus on prices or on quantities? Understand why the answer is that “it depends…” Two problems Some highlights from Chapter 6 Acid rain: the problems with the 1970 Clean Air Act Emissions trading

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Chapter 6: Externalities In Action

  • Outline

    • Addressing externalities: should we focus on prices or on quantities?

      • Understand why the answer is that “it depends…”

    • Two problems

    • Some highlights from Chapter 6

      • Acid rain: the problems with the 1970 Clean Air Act

        • Emissions trading

      • Global warming: Kyoto and beyond

      • Smoking: when is it a policy problem and when is it not?

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A More Realistic Externality Example: Acid Rain

  • Sulfur dioxide (SO2) and nitrogen oxides (NOX) released into the atmosphere, form sulfuric and nitric acids.

  • These acids may fall back to earth hundreds of miles away from their original source, known as acid rain.

  • Majority of acid rain in North America caused by SO2, much coming from coal-fired power plants concentrated in the Ohio River Valley.

    • Acid rain is a negative production externality. It:

      • Makes lakes more acidic.

      • Erodes forests.

      • Causes damage to property ($5 billion/year).

      • Reduces visibility.

      • Leads to adverse health outcomes

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History of Acid Rain Regulation

  • 1970 Clean Air Act set maximum standards for various substances, including SO2.

  • It set New Source Performance Standards (NSPS) for any new power plant, forcing the plant to either reduce emissions or install scrubbers.

    • New plants, therefore, were made more expensive relative to older plants. Companies thus kept older, dirtier plants on line longer that they otherwise would.

      • There’s an analogy to imposing regulation on new autos.

    • Gruber calls this a consequence of “partial policy reform.”

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History of Acid Rain Regulation

  • 1990 Clean Air Act Amendments mandated a reduction of more than 50% of the level of SO2 nationwide, and included all plants.

  • It offered an SO2 allowance system that granted plants permits to emit SO2 in limited quantities, based on their historical fuel utilization.

  • Plants were allowed to buy, sell, or save their allowances.

  • The allowances involved very few restrictions– trading could occur anywhere within the United States, with no approval or review, and the frequency and mechanism of trading were unlimited.

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History of Acid Rain Regulation

  • The 1990 amendments and emissions trading drew opposition from two very diverse groups:

    • Those opposed on economic grounds, like utilities and coal miners.

      • An industry study predicted the full cost of the regulations to be up to $7.4 billion, with a loss of up to 4 million jobs.

    • It was also opposed by environmentalists.

      • They opposed the 1990 amendments on the grounds that they created a “market for vice and virtue.”

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History of Acid Rain Regulation

  • Estimates suggest that emissions trading significantly lowered the costs of the 1990 amendments.

    • Over the 1995-2007 period, costs were lowered from $35 billion to $15 billion.

    • Thus, trading has worked to greatly improve the efficiency of regulation.

  • Even environmentalists are now more sympathetic to emissions trading, because it reduces economic opposition.

    • “In less than a decade, emissions trading has gone from being a pariah among policymakers to being a star.” -- Daniel Ellerman, expert on acid rain regulations

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Has the Clean Air Act Been a Success?

  • The overall success of the Clean Air Act is much harder to determine.

    • The regulations were costly. In its first 15 years, the Clean Air Act cost:

      • 600,000 jobs.

      • $75 billion in output.

    • They did result in benefits, too.

      • Health improvements, such as reductions in infant mortality.

  • Burtraw, et al. (1997) estimate that the health benefits alone exceed the cost of reduction by a factor of seven, once the lower-cost trading regime was implemented.

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A Second Externality Example: Global Warming

  • The earth is heated by solar radiation that passes through our atmosphere and warms the earth’s surface.

  • A large portion of the heat is trapped by certain gasses in the earth’s atmosphere, which reflect the heat back toward the earth again.

  • This is known as the greenhouse effect.

    • The concentration of greenhouse gasses like carbon dioxide and methane has increased due to human activity.

    • Using fossil fuels like coal, oil, and natural gas produce carbon dioxide and contribute to this effect.

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  • The surface temperatures have increased by more than 1 degree Fahrenheit in the past 30 years.

  • Projections for the next 100 years suggest an unprecedented increase by as much as 6-10 degrees.

    • Carbon emissions in Boston and Bangkok have the same effect on the global environment.

    • The stock, not the flow, of carbon dioxide cause the warming. Thus, it takes a long time to undo the damage.

  • Global warming is a thus a complicated externality involving many nations and many generations of emitters.

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Table 2

The U.S. is currently responsible for nearly 25% of the planet’s carbon dioxide emissions.

Developing counties like China and India emit large quantities of greenhouse gasses.

Japan contributes only 5% of annual emissions.

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The Kyoto Treaty

  • The goal of the Kyoto treaty in 1997 was to reduce the emissions of greenhouse gasses to 5% below their 1990 levels.

  • United States and Russia have not signed on; many other of the 38 industrialized nations have, however.

  • For the United States, the Kyoto treaty would:

    • Mean reducing emissions in 2010 by roughly 30%

    • With a present discounted cost of $1,100,000,000,000 ($1.1 trillion)

    • The United States would bear 90% of the total world cost, even though it contributes only 25% of annual greenhouse gas emissions.

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Can Trading Make Kyoto More Cost-Effective?

  • Kyoto treaty introduced international emissions trading.

    • Under the Kyoto treaty, the industrialized signatories are allowed to trade emissions rights among themselves, as long as the total emissions goals are met.

  • There are tremendous differences across developed nations in terms of meeting these goals, for two reasons:

    • Slow growth in some countries: Relatively easy for a country like Russia to meet its goal. Estimates suggest that emissions trading (say, from Russia to United States) could lower the cost of the treaty by 75%.

    • Environmentally conscious growth: Other countries, like Japan, tend to use more gas and nuclear-powered production.

  • Figure 3 shows the benefits of international emissions trading (the readings for today give an update from the Montreal, the site of the most recent international climate change meetings).

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The benefits of trading

Figure 3

Yet the treaty calls for the U.S. to reduce emissions a lot.

It is fairly expensive for the U.S. to reduce its emissions.

And the requirements are lower, too.

It is easier for Russia and others to reduce their emissions.

Price of carbon reduction


The total cost to the U.S. is 440x$210.




The overall cost, with emissions trading, is $32 billion.

With emissions trading, the supply curve is summed horizontally.

The cost of worldwide emission reduction is $50 per ton with ST.

The total cost to Russia and others is 190x$20.


The U.S. buys 400 permits (440-40).

The overall cost, with no emissions trading, is $96 billion.







Carbon Reduction (millions of metric tons)


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A Third Externality Example: The Economics of Smoking

  • Smoking causes more than 440,000 deaths each year, four times as much as AIDS, motor vehicle accidents, homicide, and suicide combined.

  • What is the role for government intervention in the case of a decision like smoking? Several possible arguments:

    • Smoking is bad for you.

    • Smoking is addictive.

    • It generates negative externalities to the health system, workplace, and fire departments.

    • It generates positive externalities to the Social Security and Medicare system.

    • It creates negative externalities to other family members through secondhand smoke.

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  • Smoking is bad for you.

  • Smoker lives about 6 fewer years than a nonsmoker.

    • A year of life is valued by economists at about $200,000.

  • In standard utility-maximization, any damage individuals do to themselves from dangerous activities results from a rational tradeoff of benefits against potential costs.

    • Perhaps a rationalization can be given because young people make decisions to smoke when they are not capable of sensibly assessing the benefits and costs of their decisions

    • Or cigarettes are so additive that people don’t understand they can’t quit (or have a very hard time quitting).

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  • Smoking is addictive.

    • “Rational addicts” understand that each cigarette that they smoke today increases their addiction.

    • Smokers consider not only the cost of today’s pack of cigarettes, but the cost of all additional future packs that will now be purchased because their addiction is deepened.

    • Smokers also understand that smoking doesn’t just reduce health through the current cigarette, but all future cigarettes that will be consumed because of the addiction.

  • With this model, smoking remains a rational choice.

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The Externalities of Smoking

  • Smoking generates negative externalities due to higher health costs.

  • Smoking-related disease increases U.S. medical care costs by $75 billion annually, 5% of the total.

  • If insurance companies can make actuarial adjustments, they simply charge smokers higher rates.

    • Such adjustments internalize the medical cost externality from smoking. In a simple model, there are no health externalities because smokers pay for the high medical costs through higher premiums.

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The Externalities of Smoking

  • In fact, actuarial adjustments are often not made with employer health insurance.

    • In this case, the externality is financial, not physical. This is an externality because the social marginal benefit from an individual’s cigarette consumption is below the private marginal benefit–the individual’s coworkers have to pay higher premiums.

  • In addition to higher health costs to the private sector, individuals who receive government insurance exert a negative externality onto taxpayers.

  • The same is true of the uninsured (smokers and non-smokers alike)–they exert negative externalities onto medical providers, who pass along the costs to consumers.

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The Economics of Smoking

  • Smoking generates negative externalities due to lower workplace productivity and more frequent absences.

  • Firms may be able to adjust wages to compensate for this type of problem.

    • If workers’ wages adjust to compensate for their lower expected productivity, then the externality is internalized, akin to the adjustments in health premiums.

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The Economics of Smoking

  • Smoking generates negative externalities due to fires, mostly due to falling asleep with a burning cigarette.

  • To the extent the smoker only damages himself and his own property, there is not an externality. But if the fire spreads to other properties, there is an externality.

  • Also costs to fire departments and insurance companies that may not be fully internalized.

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The Externalities of Smoking

  • Smoking generates positive externalities to taxpayers due to the early deaths of smokers and lower payouts for some social insurance programs.

    • Often contribute payroll tax for Social Security and Medicare during working life, but smokers may not be alive to collect benefits when they are elderly.

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The Economics of Smoking

  • Smoking generates negative externalities (mostly to other family members) through secondhand smoke.

    • Considerable medical uncertainty about the damages done from this.

    • Moreover, if the smoker maximizes family utility rather than individual utility, he/she rationally trades off the benefits to himself/herself versus the harm to his/her family.

    • Evidence suggest family utility maximization is incomplete, however.

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The Economics of Smoking

  • Taken together, the external costs of smoking are roughly 40¢ per pack of cigarettes in 2003 dollars.

  • Estimates of external costs of secondhand smoke vary widely, from 1¢ to $1.16 per pack.

  • The average federal plus state cigarette tax is over $1 per pack.

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Should We Care Only About Externalities, or Do “Internalities” Matter Also?

  • Traditional economics approach cares only about externalities that smokers impose on others.

  • Model ignores some key features of the smoking decision that may motivate government intervention.

    • Youth smoking decisions

    • Inability of adults to quit

      • Maybe policymakers should decide that people are unable to do what is best for them, and consequently policy should try to influence choices. This, of course, is a slippery slope.

        • Information/outreach campaigns–these have reduced the smoking rate a lot over the last 30 years.

        • Reducing access to cigarettes for teenagers.

        • Taxation–elasticity of demand for cigarettes is around -0.5, and higher for youth smokers.