Chapter 31 Environmental Economics

1. Chapter 31Environmental Economics

2. Introduction “Cap and trade” is an approach to air-pollution control under which governments place a limit on allowed emissions, create rights to emit polluting substances, and permit firms to trade those rights in a free market. A cap and trade program applied to sulfur dioxide emissions from electrical plants in the U.S. has reduced polluting emissions by one-half. This program recently collapsed, however. What can be learned from the breakdown of this program? You will explore this question in Chapter 31.

3. Learning Objectives • Distinguish between private costs and social costs • Understand market externalities and possible ways to correct externalities • Explain how economists can conceptually determine the optimum quantity of pollution

4. Learning Objectives (cont'd) • Contrast the roles of private and common property rights in alternative approaches to addressing the problem of pollution • Describe how many of the world’s governments are seeking to reduce pollution by capping and controlling the use of pollution generating resources • Discuss how the assignment of property rights may influence the fates of endangered species

5. Chapter Outline • Private versus Social Costs • Correcting for Externalities • Pollution • Common Property • Reducing Humanity’s Carbon Footprint: Restraining Pollution-Causing Activities • Wild Species, Common Property and Tradeoffs

6. Did You Know That ... • By 2025, the Environmental Protection Agency (EPA) will require all passenger vehicles to operate at an average of 54.5 miles per gallon? • This improvement in fuel economy will translate into a 10 percent increase in the average price of a vehicle. • Economists want to help policymakers and citizens opt for informed policies that have the maximum possible net benefits. • As you will see, every decision made in favor of “the environment” involves a trade-off.

7. Private versus Social Costs • Private Costs • Costs borne solely by the individuals who incur them • Also called internal costs

8. Private versus Social Costs (cont'd) • Social Costs • The full costs borne by society whenever a resource use occurs • Measured by adding internal to external costs

9. Private versus Social Costs (cont'd) • Environmental issues occur when social costs exceed private cost • The cost of polluted air—consider both private and social costs • Question • What if you had to pay the social cost of driving a car?

10. Private versus Social Costs (cont'd) • Externality • A situation in which a private cost (or benefit) diverges from a social cost (or benefit) • A situation in which the costs (or benefits) of an action are not fully borne (or gained) by the two parties engaged in a scarce-resource-using activity

11. Figure 31-1 Reckoning with Full Social Costs

12. Correcting for Externalities • An externality arises when there is a divergence between private cost and social cost • The remedy is to change the signal for decision making • In the case of industrial pollution, the firm must be forced to internalize the cost of the environmental damage

13. Correcting for Externalities (cont'd) • The polluters’ choice • Install pollution abatement equipment or change production techniques • Reduce pollution-causing activity • Pay the price to pollute

14. Correcting for Externalities (cont'd) • Is a uniform tax appropriate? • It may be appropriate to levy a uniform tax, as external costs might vary from location to location • We must establish the amount of economic damages;we have to come up with a measure of economic costs

15. Pollution • Question • How much pollution is too much? • Answer • The optimal quantity is determined by a comparison of marginal costs and benefits.

16. Pollution (cont'd) • Optimal Quantity of Pollution • The level of pollution for which the marginal benefit of one additional unit of pollution abatement just equals the marginal cost of that additional unit

17. Figure 31-2 The Optimal Quantity of Air Pollution

18. Policy Example: Raising the Marginal Cost of U.S. Air Pollution Abatement • Coal-fired plants generate nearly half of all electricity produced in the United States each year. • The Environmental Protection Agency has issued regulations that require 20 percent of these plants to shut down or be retro-fitted with scrubbers in 2015.

19. Policy Example: Raising the Marginal Cost of U.S. Air Pollution Abatement (cont’d) • Estimates indicate that the additional cost to the electrical power industry and its customers of complying with this requirement will be about $30 billion per year through the end of the 2010s. • Thus, attaining a hoped-for higher degree of air cleanliness will entail a higher marginal cost of pollution abatement for society.

20. Common Property • Private Property Rights • Exclusive rights of ownership that allow the use, transfer, and exchange of property

21. Common Property (cont'd) • Common Property • Property that is owned by everyone and therefore by no one • Examples are air and water

22. Common Property (cont'd) • Question • What do you think: Why does pollution occur when property rights are poorly defined? • Answer • When no one owns a particular resource, no one has any incentive (conscience aside) to consider misusing it.

23. Common Property (cont'd) • Voluntary agreements and transactions costs • Is it possible for externalities to be internalized via voluntary agreement? • What are the costs incurred by the parties who seek to negotiate an agreement?

24. Common Property (cont'd) • Voluntary agreements and transactions costs • Voluntary agreements: contracting • Opportunity cost always exists, whoever has property rights

25. Common Property (cont'd) • Voluntary agreements and transactions costs • Transaction Costs • All costs associated with making, reaching, and enforcing agreements • Must be low relative the expected benefits

26. Common Property (cont'd) • Changing property rights • Closing the gap between private costs and social costs • Taxation • Subsidization • Regulation

27. Reducing Humanity’s Carbon Footprint: Restraining Pollution-Causing Activities • Mixing government controls and market processes: cap and trade • In light of the costs arising from spillovers that polluting activities create, one solution might seem to be for governments to try to stop them from taking place • Why don’t more governments simply require businesses and households to cut back on pollution-causing activities?

28. Reducing Humanity’s Carbon Footprint: Restraining Pollution-Causing Activities (cont’d) • Kyoto Protocol (1997) aims to reduce overall emissions of greenhouse gases by 2020 by as much as 20% below 1990 levels • The EU’s Emissions Trading Scheme (2005) • Each EU nation is established an allowance of emissions that a company can release • If a firm exceeds its limit, it must purchase additional allowances (at the market clearing price) from companies who are emitting less than their quota

29. Policy Example: California Dreaming: A Western Cap-and-Trade Pact? • Preceding implementation of California’s cap-and-trade program, state officials tried to persuade governments of other western states to enter into a “regional cap-and-trade pact.” • Every state that California officials approached said no, however, as the induced reduction in the energy supply would bring about higher energy prices.

30. Policy Example: California Dreaming: A Western Cap-and-Trade Pact? (cont’d) • Most estimates indicate the costs will amount to hundreds of dollars per household per year. • Businesses will face significant cost increases as well, which may decrease employment. • Some California firms may respond to higher energy costs by moving their operations to other western states.

31. International Example: Passengers Help to Pay for Emissions on EU Airline Routes • In 2012, the European Union implemented a new, independently administered cap-and-trade program aimed at reducing carbon emissions from airplane engines. • The EU allocated pollution total allowances to each airline operating at EU airports. • To exceed its limit, an airline can purchase allowances from another airline that has total emissions below its allowances.

32. Reducing Humanity’s Carbon Footprint: Restraining Pollution-Causing Activities (cont'd) • Are there alternatives to pollution-causing resource use? • Why aren’t we shifting to solar panels and electric cars? • The plain fact is that the cost of generating solar power in many circumstances is much higher than generating that same power through conventional means • In addition, the manufacturing of solar panels could itself cause pollution

33. Wild Species, Common Property, and Trade-Offs • One of the most distressing common property problems involves endangered species • Virtually all species not endangered are private property (dogs, cats, cattle, sheep and horses) • Endangered species (spotted owls, bighorn sheep and condors) are typically common property

34. Wild Species, Common Property, and Trade-Offs (cont'd) • In 1973, the federal government passed the Endangered Species Act in an attempt to keep species from dying out • As more and more species were put on the endangered list, a trade-off became apparent

35. What If . . . Governments allowed people to own endangered animals as private property? • If endangered animals could be owned as private property, some of them undoubtedly would be mishandled. • Nevertheless, they are also scarce resources that have positive values in private markets. • This would provide incentives for the life of these animals and health of the species to be preserved.

36. You Are There: A Mayor Faces the Grimy Economics of Trash Removal • For Chicago mayor Rahm Emanuel, how to go about moving trash for disposal or recycling has become a substantial economic issue. • Currently, the trash removal system in Chicago is different for each one of the city’s 50 wards. • Emanuel examines a study that proposes a reorganization of the city’s trash removal procedures. The study suggests that switching to a more efficient citywide system for trash disposal and recycling could accomplish the same task each year with 25 percent fewer workers and at an annual cost savings of $40 million.

37. Issues & Applications: The New Sulfur Dioxide “Cap and Fade” Program • For years, coal-fired electrical-power-generating plants in Midwestern states emitted smoke containing sulfur dioxide. These emissions have contributed to a phenomenon known as “acid rain”. • In 1995, the U.S. government placed a cap on emissions of sulfur dioxide states. • A fixed number of emission allowances were handed out to the electric utilities. If firms reduced emissions by switching to low-sulfur coals or by adding emission-control equipment, they could sell unused allowances to other electrical-power producers.

38. Issues & Applications: The New Sulfur Dioxide “Cap and Fade” Program • By 2005, the equilibrium price of a sulfur-dioxide-emission allowance had reached $1,600. This price was sufficiently high to induce many firms to reduce their emissions. • In 2008, however, the EPA began ordering plant operators to cut back directly on their emissions. The EPA also decided not to allow firms to purchase allowances to avoid the new emissions restrictions. • Since then, the equilibrium price of a sulfur dioxide-emission allowance has “faded away” to zero—hence the new “cap and fade” term used to describe the program.

39. Summary Discussion of Learning Objectives • Private costs versus social costs • Private costs are borne solely by those who use resources • Social costs are the full costs that society bears when resources are used • Market externalities and ways to correct externalities • Tax those who create externalities

40. Summary Discussion of Learning Objectives (cont'd) • Determining the optimal amount of pollution • The level of pollution at which the marginal benefit of pollution abatement equals the marginal cost of pollution abatement • Private and common property rights and the pollution problem • Private property rights permit exchange and use of a resource • Common property is owned by everyone and thus by no one

41. Summary Discussion of Learning Objectives (cont'd) • Restraining pollution-causing activities through caps and allowances • The EU has established the Emissions Trading Scheme • Each EU nation’s government establishes an overall target level of greenhouse gas emissions and distributes allowances, granting companies the right to emit a certain amount of gases • If exceeded, the company must purchase more allowances from firms emitting less than their quota

42. Summary Discussion of Learning Objectives (cont'd) • Endangered species and the assignment of property rights • Animals that are privately owned (e.g., dogs and livestock are abundant) • Owners have incentives to take care of these animals • Wild animals are common property resources and many are endangered because no one has an incentive to protect these animals