Chapter 17: The Economics of Environmental Protection
17.1 The Economics of Regulating pollution
• Pollution as an Externality
• Polluting firms that are profit maximizers do not regard a clean environment as a scarce resources
and so fail to consider the full costs of using this resource when producing their product.
• Pollution is a negative externality.
o MCpriv < MCsoc
o MCsoc = MCpriv + MEC
o MEC = Marginal external cost
• When there are negative externalities, social marginal cost exceeds private marginal cost because
the act of production generates costs for society that are not faced by the producer.
• Internalize the externality: make producers and/or consumers pay (absorb cost of externality)
o ex carbon tax
To internalize the externality successfully, it is necessary to measure its size accurately—we
must be able to measure the marginal external cost.
• Including social cost = produce at Q*
• Allocative efficiency = Q*
• Pd = MCp + MEC (=MCsoc) • MC of further abatement = marginal benefit (on future generations)
16.2 Pollution-Control Policies
• Direct control is the form of environmental regulation that is used most often in Canada and the
o Automobile emissions standards
o Prohibition of certain polluting behaviours, such as the prohibition of weed-control and
• But in some/many cases, direct controls are inefficient • This outcome is inefficient. If firm A increases pollution abatement by one unit and firm B
decreases pollution abatement by one unit, total pollution remains the same but total costs fall.
• Equal abatement (Qr) gives MCB > MCA
• Each firm abates the same amount of pollution at different costs
Ex for firm to cut back, MC rises
• Logical solution: Firm B pays Firm A to cut back extra (cheaper to pay them and Firm A still makes
o Still get Qr, both firms are better off and it still uses less of society's resources
o But it is still inefficient
• Same total abatement at lower cost if:
o A abates more
o B abates less
• Lowest costs where MCA = MCB • Suppose the regulatory authority imposes a tax of t dollars per unit of pollution emitted
• A firm saves t dollars for each unit of pollution it does not produce
• t is a firm’s marginal benefit from pollution abatement
• Firm B cuts back on pollution until QB = T --> this is where the marginal benefit of cutting back on
pollution stops exceeding the cost of the tax
• Firm A continues cutting back until QA = T
• Firm A reduces its pollution by QA and firm B reduces its pollution by QB.
• Since marginal cost of abatement is equated across firms, the total amount of pollution
abatement is achieved at minimum cost
Each minimizes costs by abating to MC = MB = t
• Profit motive gets most efficient allocation of abatement *without costly monitoring
• This is efficient pollution abatement
• The advantage of imposing a tax on each unit of pollution emitted is that each individual polluting
firm is forced to internalize the negative externality associated with the pollution it is producing.
• This can lead to efficient pollution abatement.
• A second advantage of using emissions taxes is that regulators are not required to specify anything
about how polluters should abate pollution and thus are not required to have expertise about the
• The profit motive leads firms to find the most efficient abatement techniques. • Permits 'cap' total amount of pollution (2 X Q*)
o Firms can sell pollution permits to other firms (but then you have to reduce your pollution)
o How much of your permits to sell? MC = MB
o If selling permit brings in more money than the cost of cutting back on pollution--> sell your
o Another firm will be allowed to pollute more bc for them, buying the extra permits costs less
• Permits trade at market price p*
• P* = MB of abating --> sell permit
• Cost minimum for each firm: abate to p* = MC
• If the price is p*, Firm A sells X permits to Firm B.
• Firm B reduces its abatement to QB and reduce its costs by the red area, while Firm A would
increase its abatement to QA and increase its net earnings by the blue area.
• Because marginal costs of abatement are equal across firms, this is efficient pollution
o At cost-min (efficient) distribution of abatement: MCA = MCB (=p*)
• Both policies let market give the efficient distribution of abatement
Total abatement =
• With an emissions tax, the government must determine the optimal tax rate.
• With pollution permits, the market for permits determines the equilibrium permit price, but the
government needs to set the total amount of permits to give optimal P (using demand and supply)
So how does the government set the optimal quantity that leads to the optimal equilibrium price—the
one that fully internalizes the externality? Technological Improvement
• One problem with direct pollution controls is that they tend to respond only slowly to changes in
technology or market conditions.
• Tradable pollution permits, because they are a market-based method of pollution control,
maintain their efficiency even in the midst of substantial changes in technology.
• As technological advances occur that reduce the marginal costs of pollution abatement, profit-
maximizing firms choose to abate more pollution at any given price for the pollution permits
o Technological change in abatement methods
o Finding cheaper alternatives to fossil fuels
• Ex of Problem: use ethanol in gas to reduce pollution. Ethanol comes from corn so the US
government subsidizes corn. But the processing of corn produces more pollution than just not
using ethanol --> need to look further
• Lower MC gives less pollution (more abatement ) bc:
o For cap and trade, p* = MC at higher abatement level
o For emission tax, t = MC at higher abatement level
• The economic advantage of using emissions taxes or tradable emissions permits as opposed to
direct controls is that these policies “attach a price” to pollution and then rely on firms’ natural
inclination to maximize profits.
• Firms seek out the lowest cost way to reduce their polluting activities.
17.3 The Economic Challenge of Global Climate Change
• Also for applying economic concepts 17.1
• Important but most not eligible for examinations
• Eligible for examination: Energy Use, GDP, and Greenhouse-Gas Emissions
• Greenhouse gases include carbon dioxide, methane, and nitrous oxide.
The Effect on Global Climate
• Melting of the world’s glaciers, resulting in a loss of fresh-water supplies. • Melting of the Greenland and Antarctic ice caps, resulting in rising seal levels and the likely
displacement of tens of millions of