PSCI 231 Chapter 9-15: Brander Textbook Notes

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PSCI 231- Midterm#2 (Brander)
Chapter 9- Environmental Policy and Externalities
9.2 Externalities: Definition, Analysis, and Examples
Externality: can be defined as rising when a consumer’s well-being or a
producer’s productive capacity is directly affected by the actions of other
consumers or producers
One example of an environmental externality problem is acid rain, which is
generated by burning coal to produce electricity. Acid rain is harmful for a
variety of plants and animals.
9.2.2 Externalities as Market Failure
Externalities cause market failure: they cause private markets to be
inefficient. The social marginal benefit should be equated with social
marginal cost.
For ex, suppose a coal- burning electric utility in Ohio can choose between
high sulphur coal, which produces a lot of acid rain, and more expensive low-
sulphur coal, which produces less acid rain. If the place chooses the lower-
cost, high polluting coal, the result is an inefficient outcome: total costs to
society (including the external costs) are higher than necessary for
producing electricity.
9.2.3 The Simple Economics of Pollution Abatement
Ex: if a firm operates a pulp mill, the only immediate way to cause less
pollution is to run the mills less, and therefore produce less pulp.
The problem here is that the private marginal benefit of abatement is much
less than the social marginal benefit of abatement.
The private firm has an incentive to undertake abatement only up to the
point where private marginal benefit of abatement equals the private
marginal cost of abatement.
9.2.4 Technological and Pecuniary Externalities
Pecuniary externality: an externality caused by price effects. For ex,
supposed that wheat farmers increase their demand for fertilizer used in
wheat production, causing the price of fertilizer to rise. Flower producer who
also use fertilizer would therefore experience higher costs and lower profits.
The actions of wheat producers in seeking to buy more fertilizer have
therefore affected the welfare of another party (flower producers). However,
this example is not a market failure because effects on other parties arising
from the normal operation of the price system do not cause inefficiency. The
pecuniary externalities are examples of the marketplace allocating resources
to efficient uses.
9.2.5 Transaction Costs and Incomplete Property Rights
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Two fundamental causes of externalities are high transaction costs (use of
time and money) and incomplete property rights (unclear rights).
Externalities are interactions between people (or firms) that are not priced
because they occur outside of markets. In short, externalities arise precisely
because certain markets fail to exist.
9.2.6 The Coase Theorem
If the only issue underlying an externality problem is incomplete property
rights, then the externality can be solved or removed by establishing
property rights.
It does not matter who gets the property rights, as long as someone gets
them. This insight is called the Coase Theorem: if there are no transaction
costs, then bargaining between economically rational parties over an
externality will lead to an efficient outcome, provided property rights are
clearly defined and enforced.
The coase theorem is helpful in understanding the nature of externalities, but
it is rarely applicable in practice. For ex, we cannot assign property rights
over the atmosphere or the ocean.
9.3 Policy Solutions to Externality Problems
- There are four basic policy solutions to market failure caused by externalities:
Internalization of the externality
Quantity controls and standards
Taxes and subsidies
Cap and trade systems
9.3.1 Internalizing Externalities
One response to externalities is to internalize them, which means placing
both the economic agent generating the externality and parties affected by it
under one management.
For ex, if a pulp mill damages a fishery, having the pulp mill’s owner acquire
the fishery would internalize the externality. The single owner would then
have an incentive to reduce the emissions from the pulp mill to the efficient
However, internalization is not mostly feasible. For one thing, the private
sector spontaneously undertakes most efficiency- improving internalizations,
leaving no particular role for public policy. The remaining cases are those
where internalization itself has very high costs.
9.3.2 Quantity Controls and Standards
The most common solution to externality problems is to use quantity
controls and standards. Factories are constrained to limit themselves to
certain levels of pollution or to install specific types of pollution abatement
9.3.3 Taxes and Subsidies
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Most economists would prefer to see less reliance on standards and quantity
controls and more on taxes and subsidies.
Economists favor taxes because of the incentive effects. If pollution is taxed,
this gives the polluting firm a continuing incentive to reduce pollution. In
addition, taxes generate revenue that can be used to pay for environmental
programs or for other purposes.
Policy makers (and the public) prefer quantity controls because standards
are like a central-planning approach. When standards are used, even if they
are enforced, the firm has an incentive to conform to the standard but go not
further. It is also very difficult to determine what the appropriate standard
should be. Another reason policy makers do not prefer taxes is that it seems
like they are paying the taxes and selling the right to pollute
9.3.4 Cap and Trade Systems
Sometimes called tradable pollution permit systems, seek to combine
quantity controls with market incentives.
One component of a cap and trade system is the cap – a maximum allowable
quantity, or quota, of a pollutant, such as sulphur dioxide. This quota is
divided into permits that grant the right to emit certain amount of the
pollutant per year.
An alternative to giving out permits is for the government to auction them off
to emitters. Whether permits are given away or auctioned or distributed in
some other way, the holders of the permits are then allow to trade them- to
sell them at whatever price they can obtain in market for the permits.
9.4 Global Warming
The average surface temperature of the earth has risen by about one degree
Celsius. This small change has had important effects, causing significant
melting of polar caps and other glaciers.
The global warming had been caused by an accumulation of greenhouse
gases in the atmosphere, which increases the net warming effect of the sun.
9.5 Hazardous Waste and the NIMBY Problem
One of the most intractable current environmental problems involves
locating hazardous waste facilities, ordinary waste facilities, and waste
incinerators. The most extreme aspect of this problem is the storage of
nuclear waste, but storage and treatment of toxic chemical waste is a larger,
more immediate concern.
NIMBY stands for “not in my backyard”, and refers to the fact that
communities will usually resist local placement of hazardous waste dumps or
other facilities that might generate negative externalities.
The location for hazardous waste should be in geologically stable areas, away
from major population centres, and easily and safely reachable on major
transportation routes.
9.6 Traffic Externalities
As population centres become more crowded due to population growth,
externalities become more important.
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