Chapter 3

1. Pollution and Resource Degradation as Externalities Chapter 3

2. Introduction • Any economy depends on the ecological system in which it is embedded in two fundamental ways. Humans: • rely on the environment as a source of raw materials • exploit the environment as a sink for waste materials • Sources and sinks form “natural capital,” the input that nature provides for our production and consumption processes

3. Natural Capital: Sources and Sinks

4. Pollution, Resource Degradation and Externalities • Pollution is the overuse of sinks • Resource degradation is the overharvesting of sources • These two are flip sides of the same process: the excessive exploitation of natural capital • Economists define “pollution” as a negative externality: a cost of a transaction not borne by the buyer or seller

5. Three Examples of Pollution? • Tyler is eating in a smoky restaurant. Is he exposed to pollution? • Karen routinely comes in contact with low-level radioactive waste while working at a nuclear power plant. Is she exposed to pollution? • Marilyn is trying to get some sleep while his neighbor Tipper blares the sound system. Is he exposed to pollution?

6. The Answers • Maybe, maybe, and yes • If Tyler is the one smoking and he is aware of the damage it causes, then he is balancing pleasure against risk and is not being exposed to pollution • If Karen is aware of the risk posed to her by radioactive waste and is accepting this risk in exchange for a salary then she is not being exposed to pollution • Marilyn is clearly a victim of pollution. He is involuntarily being exposed to a by-product of Tipper’s listening experience

7. Why Market Systems Create Pollution • From an economist’s point of view, market systems generate pollution because many natural inputs (e.g. air and water) are “underpriced” • Because no one owns these resources, in the absence of government regulation or legal protection for pollution victims, business will use them up freely, neglecting the external costs imposed on others

8. Internalizing the Externality • If businesses were forced to compensate victims of pollution for damages they impose, firms would, in effect, be paying for the “underpriced” natural inputs they use • This would lead firms to conserve on its resource use and to seek cleaner production methods • This is known as “internalizing” the externality and is one way of dealing with the both the problems of pollution and resource degradation

9. Social and Private Costs in the Paper Market

10. Pollution as Market Failure • Many forms of natural capital are not (and cannot) be privately owned • Because of this, unregulated free-market systems will generate too much pollution by any standard, due to: • The open access problem • The public goods problem

11. The Open Access Problem • If people weigh private benefits against private (as opposed to social) costs, they will overexploit common resources when given open access • Referred to as “The Tragedy of the Commons”

12. The Open Access Problem:Global Fisheries • Close to half of America’s fisheries and more than 70% of global fisheries are overfished • The North Atlantic is estimated to contain only one-third of the biomass of edible fish that were present in 1950 • Modern technology (bottom trawling) is damaging habitat, essentially clear-cutting, and not replanting, the ocean floor • As stocks dwindle, the incentive for any individual fisherman is to increase his or her share of the remaining stock

13. Vessels and Total Catch

14. The Open Access Problem

15. The Open Access Problem • Private boats will go out as long as average revenue covers costs • By contrast, the profit-maximizing catch level occurs where marginal revenue just exceeds marginal cost • Profit earned in the industry is the sum total of the difference between marginal revenue and marginal cost for each boat that goes out • When marginal revenue is less than marginal cost, a drop in industry-wide profits will occur

16. Resource Rents • When natural capital is used efficiently, long-run economic profits will be earned by those who retain access to the resource • These long-run profits, generated by restricted access to natural capital, are called resource rents

17. Resource Rents in New England • Data suggest that fishing off the New England coast would have to be reduced by about 70% to eliminate overfishing and achieve an efficient harvest • This would generate a resource rent of about $130 million • If this were collected by the government, it would be sufficient to compensate those boats put out of business due to fishing restrictions

18. Handling the Open Access Problem • In traditional societies, informal social pressure and tradition were relied upon to prevent overexploitation • The modern equivalent advocated by free-market environmentalists would be to internalize externalities through lawsuits against an offending company or individual • Is government regulation really needed?

19. The Public Goods Problem • Private remedies to environmental degradation (eg law suits) run into what economists call the public goods problem • Public goods are goods enjoyed in common (e.g. the warning service provided by a lighthouse) • One key characteristic of public goods is that they are “non-excludable”

20. Public Goods Problems for the Free Market • Public goods pose a problem to the free market for two reasons: • Free riding: people benefit from public goods (like law suits) regardless of whether or not they pay for them. • High Transaction Costs: public goods provision require groups of people to undertake action. In addition, information about environmental damages is costly for groups to obtain. These features add extra “transactions costs”.

21. Demand for Private and Public Goods, illustrates free-riding • With a private good, the total demand is the horizontal sum of the individual demand curves • With a public good, the total demand is the vertical sum of the individual demand curves

22. Demand for Private and Public Goods

23. Summary: 1 • Pollution is a negative externality • Negative externalities often arise due to open access to common property • When access to common property resources is restricted to the efficient level, resource rents are earned • Resource rents can be taxed to compensate those who lose from restricted access.

24. Summary: 2 • Negative externalities can sometimes be internalized through lawsuits, but this runs into the .. • Public Goods Problem • Law suits are subject to free-riding and have high transaction costs, especially with regards to obtaining information about damages.

25. Summary: 3 • Because clean-up is a public good, government is generally expected to internalize negative externalities through: • Regulation of access to common property. • The promotion of clean technology alternatives.

26. Appendix 3AOverfishing, ITQs and Aquaculture • In the figure on the following slide, the point at which the curve begins to bend downwards is considered the maximum sustained yield • The efficient fishing level--the one that maximizes resource rent--occurs where total revenue exceeds total cost by the greatest amount • Where total revenue equals total cost is the open access outcome

27. Fishing Yields: Efficient, Sustainableand Open Access

28. The Liquidation Strategy • Profit-maximizing rule: • If the interest rate is less than the rate of growth of the fishery, maintain the harvest below the sustained yield level • If the fishery grows at a rate less than the interest rate, liquidate the fishery and invest the resource rent in activities generating a higher return • Higher interest rates thus make overexploitation of natural capital more likely

29. Applying the Fisheries Model

30. The Liquidation Strategy

31. Fisheries Policy • The standard regulatory recommendation for fisheries management from economists is a cap-and-trade system called an individual transferable quota (ITQ) • The advantage of an ITQ over rigid allowances is the built-in flexibility allowing for boats having good seasons to purchase quota from boats having poor seasons • Some have criticized this method as leading to the capture of large market shares by a few companies; this has not been borne out in New Zealand.

32. Problems Posed to Fisheries Regulation • Political influence over fisheries boards lead to excessive total allowable catch levels • Difficulty monitoring mobile sources like fishing boats • By-catch--fish accidentally caught for which boats don’t have permits--is a wasteful problem as these catches are often dumped overboard to avoid fines

33. Aquaculture • Aquaculture is the commercial raising and harvesting of fish in ocean environments over which fishers are granted exclusive rights • It has the potential to both significantly decrease pressure on natural fisheries and boost the productivity of the oceans

34. Problems With Aquaculture • As currently practiced, aquaculture generates significant negative externalities, including the immediate impact on the ocean environment from • Fish waste • Heavy metals • Pesticides • Antibiotics • Fish feed for carnivorous species is harvested unsustainably in the ocean • Aquaculture can destroy local habitats

35. Feeding 9 billion • Some mix of ITQ’s, sustainable aquaculture, and protection of breeding habitat will be required to supply fish for the world.