CHAPTER 3: THE THEORY OF ENVIRONMENTAL EXTERNALITIES

TOPICS FOR THIS CHAPTER

� How can pollution and environmental damage be represented in economics? � What economic policies are effective in responding to environmental problems?� How do property rights and market processes relate to environmental issues?

1. EXTERNAL COSTS AND BENEFITS

Economic theory deals with costs and benefits. For most goods and services, thebenefits are represented in neoclassical economic theory by a demand curve, and the costsby a supply curve. The demand and supply curves show us the marginal benefits andmarginal costs – that is, the benefits and costs of producing or consuming one more unit.

Consider, for example, the automobile industry. The market demand schedule forautomobiles shows how many automobiles consumers are willing to purchase, generallyindicating that more will be purchased at lower prices. The market supply schedule showshow many automobiles the producers will be willing to put on the market at various prices,reflecting their costs of production. Combining the two schedules gives a marketequilibrium, showing the price and quantity traded. So far so good. But, as we know, theproduction and operation of automobiles has significant environmental effects. Where dothese appear in economic analysis?

The answer is that they do not appear in basic supply and demand analysis, nor arethey reflected in the real-world market equilibrium of automobile price and quantityproduced, unless specific laws and institutions are created to address them. They are whateconomists call environmental externalities.

Automobiles are a major contributor to air pollution, including both urban smog andregional problems such as acid rain. In addition, their emissions of carbon dioxidecontribute to global warming, and coolants escaping from automobile air conditionerscontribute to depletion of the ozone layer. Automobile oil is a significant cause of ground-water pollution. The production of automobiles involves toxic materials which may bereleased to the environment, or may remain as toxic wastes. The road system required forautomobiles paves over many acres of rural and open land, and salt runoff from roadsdamages watersheds.

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1See, for example, Cobb , 1998.

Clearly, there are many real costs associated with the production and use ofautomobiles which are not included in the manufacturer's cost schedule.1 Neglecting thesecosts will give us a distorted picture of reality. How can we improve our supply anddemand analysis so as to include them? We must look for ways of internalizing theexternalities -- bringing these environmental costs into our market analysis.

The first problem we have in doing this is assigning a money value to environmentaldamages. How can we reduce the complex environmental effects we have identified to asingle dollar value? There is no clear-cut answer to this question. In some cases,economic damages may be identifiable: for example, if road runoff pollutes a town's watersupply, the cost of water treatment gives at least one estimate of environmental damage --but this doesn't include such less tangible factors as damage to lake and river ecosystems.

If we can identify the health effects of air pollution, the resulting medical expenseswill give another monetary damage estimate -- but this doesn't capture the aesthetic damagedone by air pollution. Smoggy air is unpleasant, even if it has a measurable effect on yourhealth. Issues such as these are difficult to compress into a monetary indicator. Yet if wedon't assign some value to environmental damage, the market will automatically assign avalue of zero, since none of these issues are directly reflected in consumer and producerdecisions about automobiles.

There are some quite sophisticated techniques for estimating environmentalexternalities. We will examine some of these in more detail in Chapter 6. But supposewe agree for now that there are some significant costs, even if we can't measure themprecisely. How can these costs be introduced into supply and demand analysis?

Figure 3-1 shows a simple way of doing this. The supply curve for automobiles (S)already embodies all the production costs of automobiles -- labor, capital, raw materials,etc. Together with the demand curve (D), it determines a market equilibrium e, with priceP1 and quantity Q1. We can simply add to these costs an estimate of the external costsassociated with environmental damage. This gives us a new, higher curve showing thecombination of market costs and external costs. This curve S'is referred to as a social costschedule -- it shows the real costs to society of operating automobiles, taking into accountboth production costs and environmental externalities.

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FIGURES 3-1 AND 3-23-1: AUTOMOBILE MARKET WITH EXTERNAL COSTS

Social Optimum

Market Equilibrium

e’

e

External costs

Private costs ofsupply

Social costs:private + external

S

S’Price

Quantity of automobiles

P1

P2

Q2 Q1

3-2: AUTOMOBILE MARKET WITH POLLUTION TAX

Equilib rium without tax

e’

e

Supply with taxPrice

Quantity of automobiles

P1

P2

Q 2 Q 1

Equilib rium with tax

Supply without tax

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We could also include in social cost other externalities which are not strictlyenvironmental -- for example the costs of congestion as more automobiles fill the roads. Wecould use the value of time wasted in traffic jams to give a money estimate of thisexternality. Congestion will also raise the air pollution costs as cars idle in traffic. S'reflects the impact of all these unintended but significant effects associated with theproduction and use of automobiles.

Now let's consider how the introduction of externalities into supply and demandanalysis affects economic equilibrium. Of course, drawing a new curve on a graph has noeffect on real-world decisions to produce and purchase automobiles. But it affects ourunderstanding of market equilibrium. In neoclassical price theory, market equilibrium,shown here at e, is generally considered to be the most efficient solution to the problem ofhow many automobiles to produce. Once we introduce external costs into our analysis, thisconcept of efficient equilibrium is altered.

Since the market process automatically balances the benefits to consumers (reflectedin the demand curve) and the costs of production (reflected in the supply curve), it ensuresthat there will be neither surpluses nor shortages of cars -- the "right amount" will beproduced, at a price which accurately reflects the costs of production. But if we believe thatsignificant extra costs -- environmental externalities -- have been left out of the marketprocess, the equilibrium reached through the market can no longer be considered efficient.From this point of view, the wrong quantity of cars is being produced, at a price which doesnot accurately reflect true costs.

If significant externalities exist, how can this inefficient market equilibrium becorrected? There are several ways of internalizing the externalities. One example wouldbe a tax on automobiles. We could call this a pollution tax, whose object is not primarilyto raise revenue for the government (though that will be one result), but to bring home to thepurchaser of automobiles the real environmental costs of his/her actions.

Figure 3-2 shows the impact of such a tax on the market for automobiles. At the newequilibrium e', the price rises to P2, and the quantity consumed decreases to Q2. From thepoint of view of economic efficiency, these effects are good. Consumers may complainabout higher prices, but these prices reflect the real costs to society of automobile use. There are fewer cars sold, which reduces pollution. We are now closer to a truly efficientequilibrium, or social optimum, than we were at the unmodified market equilibrium e.

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2 CAFE stands for Corporate Average Fuel Efficiency. These are the average standards which majorautomobile manufacturers are required to meet.

3 For a discussion of different economic policies for environmental regulation, see Baumol and Oates1993, and Tietenberg 2000.

It may strike you that there are some other issues to be considered. What if the taxis too high? or too low? Will the tax be the same for compact cars and gas guzzlers? Mightit not be better to measure and tax automobile emissions directly, rather than place a tax onautomobile sales? How about taxing gasoline instead? Automobiles and gasoline arecomplementary goods, meaning that they tend to be used together. Thus we couldinternalize the effects of automobile pollution either by taxing cars themselves, or by taxinggas, or by taxing emissions. (Which would you favor and why?)

Regardless of the exact mechanism we use, the idea of internalizing environmentalcosts through some kind of tax is one which is well supported by economic theory. The sizeof the tax must be determined by some process of environmental valuation, the topic ofChapter 6. If we are satisfied with this valuation process, a tax may sometimes be the besttool to accomplish the goal of environmental protection.

There are other policies, however, which may sometimes be preferred to a pollutiontax. Government regulation, such as tailpipe emission standards or the CAFE2 standardsrequiring certain levels of average fuel efficiency, have a similar effect. They reduce totalfuel consumption and total pollution. By requiring more efficient and less pollutingengines, they also tend to drive up the purchase price of automobiles (although greater fuelefficiency will reduce operating costs). Do you think this would be a better or worsemechanism than a tax on cars? a tax on gasoline?3

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THE EXTERNAL COSTS OF MOTOR VEHICLE USE

What are the external, or social, costs of motor vehicle use in the United States? While someexternal costs are internalized through gasoline taxes, these taxes are not sufficient to cover allexternal costs. Instead, these costs are paid in terms of higher health care costs, decreasedenvironmental quality, and higher personal taxes.

Annually in the U.S., motor vehicles emit about 50 million tons of carbon monoxide, 7 milliontons of nitrogen oxides, as well as other toxins including formaldehyde and benzene. Annually, motorvehicle accidents in the U.S. kill over 40,000 people and injure over 3 million. Additional externalcosts include the destruction of natural habitats from building roads and parking lots, the disposal ofvehicles and parts, costs associated with national security in securing petroleum supplies, and noisepollution.

A 20-volume study (Delucchi, 1997) is perhaps the most ambitious attempt to monetize theexternal costs of motor vehicle use. The report estimates costs associated with such impacts as airpollution, crop losses, reduced visibility, national security, and noise pollution. Some of these costsare paid by the public sector while others are external social losses.

Total annual monetary and non-monetary externality costs were estimated as $99 billionunder the low-estimate assumptions and $879 billion using the high-estimate assumptions. Annualpublic sector costs for motor vehicle infrastructure and services were estimated as $132 billion and$241 billion. Total public sector and social costs are $231 billion or $1,120 billion per yeardepending on the set of assumptions.

A comparable analysis (Cobb, 1998) found the public sector and social costs of motor vehicleuse in the U.S. to be at least $184 billion per year. Additional costs for free parking subsidies andcross-subsidies caused by congestion amount to another $50 to $100 billion per year.

Cobb suggests an additional gasoline tax of $1.60 per gallon to internalize social costsalthough some costs could not be addressed with a gas tax. Delucchi also notes that a range of policyapproaches would be needed to fully internalize all the costs associated with motor vehicle use. Forexample, internalizing air pollution externalities should be based on a vehicle’s emissions level ratherthan gasoline consumption.

Any attempt to internalize the externalities associated with motor vehicle use would beimperfect due to scientific and economic uncertainty. However, failure to internalize these costssends a signal to consumers that the external costs are effectively zero. While a full internalizationof costs may not be practical, the research by Delucchi and Cobb suggests that economic efficiencycould be increased through policies to internalize the public sector and social costs of motor vehicleuse.

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Selected Public Sector and Social Costs of Motor Vehicle Use, 1991(Billions of 1991 dollars)

Cost Category Low Estimate High Estimate

Public Sector Costs

Highways and parking $109.7 $196.7

Pollution regulation and control $3.2 $8.1

Highway patrol and safety $7.4 $8.4

National security costs associated with Persian Gulf oil $0.6 $7.0

Other public sector costs $11.2 $27.7

Externality Costs

Imposed travel delays $33.9 $135.5

Accident costs - pain, death, lost productivity, damages $23.3 $169.0

Air pollution - human mortality and morbidity $24.3 $450.0

Air pollution - loss of visibility $5.1 $36.9

Air pollution - damage to crops, materials, and forests $2.7 $13.9

Global warming $0.5 $9.2

Noise pollution $0.5 $15.0

Water pollution $2.8 $7.2

Other externality costs $6.4 $42.6

Total public sector and externality costs $231.0 $1,120.2

Sources

Cobb, Clifford W. 1998. The Roads Aren’t Free: Estimating the Full Social Costs of Driving and the Effects of Accurate Pricing. SanFrancisco, CA: Redefining Progress. Resource Incentives Program Working paper No. 3.

Delucchi, Mark A. 1997. The Annualized Social Cost of Motor Vehicle Use in the U.S., 1990-1991: Summary of Theory, Data,Methods, and Results, Report #1 in the Series: The Annualized Social Cost of Motor Vehicle Use in the United States, based on 1990-1991 Data. Report number UCD-ITS-RR-96-3(1), Institute of Transportation Studies, University of California, Davis.

ICF Incorporated. 1997. Opportunities to Improve Air Quality through Transportation Pricing Programs. Report prepared for the Officeof Mobile Sources, U.S. Environmental Protection Agency.

U.S. Department of Transportation. 1999. Transportation Statistics Annual Report 1999. Report number BTS99-03.

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2. POSITIVE EXTERNALITIES

Just as it is in society's interest to internalize the social costs of pollution, it is alsosocially beneficial to internalize the social benefits of activities that generate positiveexternalities. For example, many suburban and rural towns have instituted open landpreservation programs. Using tax incentives or public purchases they seek to maintain orincrease the amount of open and rural land. Why do they do this?

A private landowner may have his/her own reasons for keeping land open or usingit as farmland. But there are significant external benefits from such uses. Others who livein the town enjoy the sight of natural areas and farmland close to their homes. A beautifulsetting may significantly increase surrounding property values while an industrial orresidential development nearby would lower them. The external benefits are not limited toresidents of the town. Passers-by, hikers, bicyclists, and out-of-state tourists may all gainsatisfaction, or utility, from the pleasant scenery.

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4 In development rights purchase programs, a town or state buys the rights to development on private land. The landowner retains ownership of the land, but cannot use it for industrial or residential development. Forfurther discussion of this issue see Hodge, 1995.

FIGURE 3-3A POSITIVE EXTERNALITY

Quantity of rural land (acres)Qs

Marginal Private Benefits

Marginal Social Benefits

Marginal Private Costs

Marginal CostsMarginal Benefits

<Qp

Private Optimum

Social Optimum

An economic analysis of the situation is shown in Figure 3-3. Marginal socialbenefits are higher than marginal private benefits because they include gains to neighborsand passers-by as well as to private land-owners. The market demand curve for rural usesof land will reflect the private, but not the social benefits, leading to an equilibrium at theprivate optimum. At the social optimum, including the benefits to non-owners, there isa larger quantity of open and rural land than at the private market equilibrium.

From an economic point of view, these policies aimed at reaching the social optimumare subsidies to the provision of open land. It is in the social interest to encouragelandowners, through tax rebates or purchase of development rights4, to keep land in anundisturbed state.

By lowering the costs (through tax rebate) or offering a payment (through purchaseof development rights), public authorities encourage landowners to maintain open and ruralland (Figure 3-4). The principle is similar to the use of a tax to discourage economicactivities which create negative externalities -- except that in this case we want to encourageeconomic uses of land which have socially beneficial side-effects.

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5Since the supply and demand schedules show the marginal benefits and costs for each individual unitproduced, the areas under these curves in effect sum up the total benefits and costs for all units produced.

FIGURE 3-4A SUBSIDY FOR OPEN AND RURAL LAND USE

Quantity of rural land (acres)Qs

Marginal Private Benefits

Marginal Social BenefitsMarginal Private Costs

Marginal CostsMarginal Benefits

Qe

Private Optimum

Social Optimum

Marginal Private Costswith subsidy

SUBSIDY

New PrivateOptimum withsubsidy

3. WELFARE ANALYSIS OF EXTERNALITIES

We can use a form of economic theory called welfare analysis to show why it issocially preferable to internalize externalities. This is shown in Figure 3-5. The idea hereis that areas on a supply and demand graph can be used to measure total benefits and costs.5The area under the demand curve shows total benefit; the area under the supply curve showstotal cost. For each unit purchased, the demand curve shows the value of that unit toconsumers.

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FIGURE 3-5

WELFARE ANALYSIS OF THE AUTOMOBILE MARKET

A: CONSUMER SURPLUS

B: PRODUCER SURPLUS

C: TOTAL COSTS

D: NET SOCIAL LOSS FROM OVERPRODUCTION

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The total value of Q0 units purchased is shown by areas A + B + C. The total costof producing these units is area C. A + B is the net social benefit from the productionand consumption of Q0 units -- in other words, the amount by which total benefit exceedstotal cost. Part A of this net social benefit goes to consumers as consumer surplus -- itrepresents the difference between the benefits they get from consumption of automobiles,as shown by the demand curve, and the price they pay, as shown by the horizontal line atP0. Part B goes to producers as producer surplus -- the difference between their costsof production shown by the supply curve and the price P0 which they receive.

The reason economists call market equilibrium efficient is that it maximizes netsocial benefit. If we were to produce less than Q0 units, or more than Q0, there mightstill be some net benefit, but it would be less than at Q0. At Q1, for example, the netbenefit is only part of the area A + B. At Q2, we get the full net benefit A + B, but wealso experience some net social loss, shown here by area D. The overall social benefit isthen A + B - D, a lower amount than at Q0. Thus Q0, as we have argued, is in somesense the "right" amount to produce.

But this is without externalities. If we introduce external costs (Figure 3-6), thecombination of private and external costs gives a social cost curve S' which lies abovethe ordinary supply curve. The market equilibrium Q0 no longer maximizes net socialbenefit. With the new higher total social cost curve, net social benefit is only A' + B'. The area D' is net social loss, so that the overall net social benefit is A' + B' - D'. Wewould do better to lower production to Q1, avoiding the net social loss D'. And of coursethis is exactly what we seek to accomplish with a pollution tax.

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FIGURE 3-6: WELFARE ANALYSIS OF THE AUTOMOBILE MARKET

WITH POLLUTION COSTS

A’: CONSUMER SURPLUS WITH EXTERNAL COSTS

B’: PRODUCER SURPLUS WITH EXTERNAL COSTS

C: TOTAL PRIVATE COSTS

C’ + D’: TOTAL COSTS OF POLLUTION

D’: NET SOCIAL LOSS

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Notice that in this example the total cost of pollution at point Q0 can be seen asthe area C' + D'. But of this total cost, only D' is considered net social loss. Accordingto this analysis, some pollution costs are justifiable -- provided that they are outweighedby social benefits from production. It is only when the combined costs of productionand of pollution (C + C’ + D’) rise above the benefits shown by the demand curve thatwe are producing “too much” pollution.

This analysis leads to a concept that some people might find paradoxical: thedoctrine of optimal pollution. At our socially optimal equilibrium Q1, we still havesome pollution costs (the part of C' to the left of Q1). According to our analysis, this isthe "optimal" amount of pollution, given current production costs and technologies. But,you might object, isn't the optimal amount of pollution zero? How can we say that anyamount of pollution is "optimal"?

The economist's answer would be that the only way to achieve zero pollution is tohave zero production. If we want to produce virtually any manufactured good, there willbe some pollution resulting. We as a society must decide on what level of pollution weare willing to accept -- so the idea of "optimal pollution" is not so ridiculous after all. Ofcourse, we can strive to reduce this level over time, especially through better pollution-reducing technology. But since zero pollution is an impossible goal, there will alwaysbe some "optimal" pollution level.

Some people remain uneasy with the concept of optimal pollution. Note, forexample, that if demand for automobiles increases, the demand curve will shift to theright, and the "optimal" pollution level will increase. This suggests that as globaldemand for automobiles rises steadily, ever-rising levels of pollution will in some sensebe acceptable. Does society have a right to increase pollution just because we want moregoods? This analysis would seem to imply that the answer is yes.

The issue is by no means a purely academic one. During the last thirty years,improvements in automotive technology have reduced pollution per car as well as totalautomotive pollution in the United States. But with ever more cars on the road, totalpollution levels for at least some major pollutants may soon start to rise again, after aperiod of decline (see Figure 3-7). Carbon dioxide emissions from the U.S.transportation sector have been on the rise since the early 1980's. Certainly on a globalscale, the potential for increased automobile pollution as demand rises is enormous. This is certainly not a trend most people would feel is "optimal".

4. PROPERTY RIGHTS AND THE COASE THEOREM

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The theory of externalities also raises another fundamental issue, that of rights. Do I have a right to drive my automobile even though it pollutes? Do others have a rightto be protected from the impact of tailpipe emissions? When we talk about prices,values, and costs, our discussion is really about underlying rights. It is the allocation ofthese rights which is at issue -- patterns of resource allocation are determined by theunderlying assignment of rights.

Let's consider a simple case where the issue can be defined in terms of propertyrights. A factory operating in a rural area emits pollutants from its stacks. Thepollutants damage the crops of the neighboring farm. This is clearly an example of anexternality. It might be remedied by the imposition of a tax on the factory equal to thevalue of the damage caused to the farmer's crops. This method of responding toexternalities is known as a Pigovian tax, after Arthur Pigou, a well-known Britisheconomist who published his Economics of Welfare in 1920. This has come to beknown as the polluter pays principle, which sounds like a reasonable solution to manypeople.

However, the Pigovian approach has been subjected to criticism by othereconomic theorists. Suppose we take a different, less clear-cut case. A farmer drains aswamp on his property to create a field suitable for growing crops. His downstreamneighbor complains that without the swamp to absorb heavy rainfalls, his land nowfloods -- damaging his crops. Should the first farmer be obliged to pay the second thevalue of crop damages? Or does he have the right to do what wants on his own land?

We can see that this is an issue not just of externalities but also of the nature ofproperty rights. Does the ownership of land include a right to drain swamps on thatland? Or is this right separate, subject to control by the community or other propertyowners?

We could resolve the problem in two ways. Suppose we say that the first farmer(we'll call him Albert) does have the right to drain the swamp. But let's also suppose thatthe net value of crops grown on the former swampland would be only $200, while the netvalue of crops damaged on the second farmers's land would be $600. It will then bepossible for the two farmers to reach an agreement. The second farmer (call her Betty)can offer an amount between $200 and $600 -- say $400 -- to Albert in return for anagreement not to drain the swamp. Betty will not be happy about this, but she's betteroff giving up $400 than losing her $600 crop. Albert will also be better off taking the$400 than making a mere $200 growing crops on drained land. In effect, Bettypurchases the right to say how the swampland will be used (without having to purchasethe land itself).

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6 Coase, 1960, reprinted in Stavins 2000.

We can also assign the relevant right to Betty, by passing a law stating that no-onecan drain swampland without the agreement of any affected parties downstream. In thatcase, Albert would have to reach an agreement with Betty before he could drain theswamp. With the crop values we have assumed, the same result will occur -- the swampwill not be drained, because the value of doing so to Albert ($200) is not enough tocompensate Betty for her loss. Betty will demand at least $600 to grant her permission,and this price is too high for Albert.

But now suppose a new gourmet crop item becomes popular, a crop which growswell on former swampland and will bring Albert $1000 in revenues. A deal is nowpossible -- Albert can pay Betty $800 for the right to drain the swamp, earn $1000 for thenew crop, netting $200 profit for himself and leaving Betty also $200 better off.

The principle at issue in this simple example has come to be known as the Coasetheorem, after Ronald Coase, a Nobel-prize winning economist who discussed similarexamples of property rights and externalities in his famous article "The Problem ofSocial Cost"6 The Coase theorem states that if property rights are well defined, andthere are no transactions costs, an efficient allocation of resources will result even ifthere are externalities. Transactions costs are the costs of conducting negotiations -- inthe case of Albert and Betty, these costs should be low or zero since they just have to talkthe issue over to see if they can reach an agreement.

Through negotiations, the two parties will balance the external costs against theeconomic benefits of a given action (in this case, draining the swamp). In the exampleabove, the external costs were $600. It is not worth incurring these costs for aneconomic benefit of $200, but it is worth it for an economic benefit of $1000. Regardless of which farmer is assigned the property right, this "efficient" result willoccur through negotiation.

The principle of the Coase theorem can also be expressed in terms of a right topollute. This sounds strange, but it is exactly the principle embodied in, for example,the U.S. Clean Air Act of 1990. This act creates a system of permits to emit suchpollutants as Sulfur Oxides and Nitrogen Oxides; these permits can be traded amongpolluting industries. Individual firms can acquire rights to increase their own pollution -- provide they purchase them from other firms which reduce pollution by an equalamount. By controlling the total number of permits issued, the government cangradually reduce overall pollution.

It is also possible for public interest groups to buy up pollution permits and retirethem, permanently reducing pollution totals. In effect, this system turns pollution, and

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pollution reduction, into marketable goods. From the economist's point of view, it hasthe advantage of efficiency, and can be seen as a practical application of the “right topollute” principle.

We can illustrate the Coase theorem graphically, by showing the marginalbenefits and marginal costs of an economic activity which generates an externality. Suppose, for example, a factory emits effluent into a river, polluting the water supply of adownstream community. The factory is currently emitting 100 units of effluent. If thefactory were forced to reduce effluent to zero, they would have to abandon a valuableproduction line. Thus we can say that there are marginal benefits to the factory fromemitting pollution, as well as marginal costs to the community as a result of the damageto the water supply. We may well be able to get a reasonable quantitative estimate ofthese external costs by estimating the costs of water treatment. Both marginal costs andmarginal benefits are shown in Figure 3.8.

What is the optimal solution? The emission of 100 units of pollution clearlyimposes high marginal costs on the community, while bringing the company lowermarginal benefits. This is "too much" pollution. But suppose emissions were limited to60 units. Marginal benefits to the company would then be equal to marginal costs to thecommunity. A further limitation to, say, 20 units, would result in high additional lossesto the company while bringing only low additional benefits to the community. Theefficient or "optimal" solution, therefore, is at a level of pollution of 60 units. At thislevel the extra benefit to the company from production just balances the extra costimposed on the community through pollution.

This solution can be achieved by assigning the pollution rights either to thecompany or to the community. Suppose the community has the right to say how muchpollution can be emitted. Should they demand zero pollution? If they do, the companycan offer them up to $200 per unit for pollution permits to allow 60 units of pollution. The company can afford to pay this much since their marginal benefits from producing60 units exceed $200 up to the 60th unit. It will also be to the community's advantage toaccept this offer, granting permits for 60 units of pollution at $200 each. The first 60units of pollution impose less than $200 per unit of costs on the community.

We can actually measure the total cost of pollution at this level as the area C onthe graph, or $6,000. But the amount paid by the company to the community will be B +C or 60 x $200 = $12,000. The community can then pay $6,000 to treat the water andstill come out $6000 ahead. The company gains A + B + C = $21,000 in benefits, pays$12,000, and has a net profit of $9,000 (area A).

We can also assign the right to pollute to the company. Would they then emitthe full 100 units of pollution? If they did so their gain would be areas A + B + C + D =

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$25,000. But they can do better by negotiating with the community. The communitywill be willing to pay them up to $200 per unit, or areas D + E = $8,000, to cut back theirpollution to only 60 units. This saves the community D + E + F = $10,667 inenvironmental damage or water treatment costs. They still suffer environmental costsequal to C, or $6000. The company's net gain will now be A + B + C + D + E =$29,000, better for them than the maximum pollution option. This approach may seemunfair to the community, but it leads to the same equilibrium solution -- 60 units ofpollution emitted -- as when the community held the right to control pollution levels.

This more formal demonstration of the Coase theorem shows that the efficientsolution is reached regardless of the assignment of the property right governing pollution. Provided that right is clearly defined, the party who values it most highly will acquire it,with the result that the external costs of pollution and the economic benefits ofproduction are balanced through the marketplace.

Note, however, that the assignment of the right makes a big difference indistribution of gains and losses between the two parties (see Table 3-1). The net socialbenefit from production is the same in both cases; it is area A + B = $15,000. But inone case this benefit is divided between the community and the company. In the othercase, the community has a net loss of $14,000 and the company a net gain of $29,000(for an overall social net benefit of $29,000 - $14,000 = $15,000).

We can say that the value of the right to pollute, or to control pollution, is $20,000in this case. By redistributing that right, we make one party $20,000 better off and theother $20,000 worse off. The different assignments of rights are equivalent in terms ofefficiency, since the final result balances marginal benefits and marginal costs, but theyclearly differ in terms of equity, or social justice.

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Units of Effluent Emitted

FIGURE 3-8APPLICATION OF THE COASE THEOREM

TABLE 3-1

DIFFERENT ASSIGNMENTS OF POLLUTION RIGHTS

IF COMMUNITY HOLDSRIGHTS

IF COMPANY HOLDSRIGHTS

Net Gain/Loss to Community $12,000 payment -$8,000 payment

-$6,000 environ. cost -$6,000 environ. cost

$6,000 -$14,000

Net Gain/Loss to Company $21,000 benefits $21,000 benefits

-$12,000 payment $8,000 payment

$9,000 $29,000

Net Social Gain $15,000 $15,000

5. LIMITATIONS OF THE COASE THEOREM

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According to the Coase Theorem, the clear assignment of property rights appears topromise efficient solutions to problems involving externalities. In theory, if we couldclearly assign property rights to all environmental externalities, further governmentintervention would not be required. Individuals and business firms would negotiate allpollution control and other environmental issues among themselves once it was clear whohad the "right to pollute", or the "right to be free from pollution". Through this process,fully efficient solutions to the problem of externalities would be achieved.

This is the basis for the approach which has come to be known as free marketenvironmentalism. In effect, by setting up a system of property rights in the environment,this approach seeks to bring the environment into the marketplace, allowing the free marketto handle issues of resource use and pollution regulation.

As we will see in dealing with specific examples in future chapters, this approach hassignificant potential, especially in areas like water rights. It may result in the creation ofnew markets, such as a market in tradable permits for airborne pollutants. But it also hascrucial limitations. What are some of the problems with using market mechanisms to solveenvironmental problems?

One important limitation derives from the assumption of no transactions costs whichwas stated in the Coase theorem. In the examples we have used, there are only two partiesto the negotiation. What happens if, for example, fifty downstream communities areaffected by pollution from a factory's effluent? The process of negotiating effluent limitswill be very cumbersome, and perhaps impossible.

Suppose we assign the factory the right to pollute. The communities can then offercompensation for reducing pollution. But which community will pay what share? Unlessall fifty can agree, it will be impossible to make a specific offer to the company. No singlecommunity, or group of communities, is likely to step forward to pay the whole bill. In fact,there is likely to be a tendency to hang back, waiting for other communities to "buy off" thefactory -- and thus gain pollution control benefits for free. This barrier to successfulnegotiations is known as the free rider effect.

A similar problem arises if the communities are given the "right to be free frompollution", and the factory must compensate them for any pollution emitted. Who willdetermine which community gets how much compensation? Since all are situated on thesame river, any single community can exercise a kind of veto power. Suppose 49communities have hammered out an agreement with the company on permissible pollutionlevels and compensation. The 50th community can demand a much higher rate ofcompensation, for if they withhold their consent the whole agreement will fail and the

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7 For further discussion of private property rights and the environment, see Schmid, 1995.

8For some practical examples of the differential impact of environmental pollution on rich and poorcommunities, see Bullard, 1994.

company will be restricted to zero pollution (i.e. forced to shut down). This parallel to thefree rider effect is known as the holdout effect.

When there are large numbers of parties affected, the Coase theorem generally cannotbe applied. In this case, some form of government intervention is required, such asregulation or a Pigovian tax. The state or Federal government could set a standard forwater-borne effluent, or a tax per unit of effluent. This would not be a pure market solution(although a tax does have its impact through market processes) because government officialsmust decide on the strictness of regulation or the level of tax. This is what economists calla process of public choice rather than the private choice which is characteristic of themarket solutions.7

There are other lines of criticism of the Coase theorem, concerning its effects onequity. Suppose that in our original example the community suffering from pollution is alow-income community. Even if the water pollution is causing serious health impacts,which could be valued at many millions of dollars, the community may simply be unable to"buy off" the polluter. In this case, the market solution is clearly not independent of theassignment of property rights. Pollution levels will be significantly higher if the right topollute is assigned to the company.

It is also possible that, even if the right is assigned to the community, poorcommunities will accept location of toxic waste dumps and other polluting facilities out ofa desperate need for compensatory funds.8 While this is apparently consistent with theCoase theorem – it is a voluntary transaction – many people would feel that communitiesshould not be forced to trade the health of their residents for needed funds. An importantcriticism of free market environmentalism is that under a pure market system poorercommunities and individuals will generally bear the heaviest burden of environmental costs.

A similar example would be preservation of open space. Wealthy communities canafford to buy up open space for preservation, while poor communities cannot. Ifcommunities are allowed to use zoning to preserve wetlands and natural areas, poorcommunities too will be able to protect their environment -- since passing a zoningregulation costs them no money other than enforcement costs.

Another point to note in considering the limitations of the Coase theorem principleis the issue of environmental impacts on non-human life forms and ecological systems. Our

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examples so far have assumed that environmental damage affects specific individuals orbusinesses. What about environmental damage that affects no individual directly, but thatthreatens plant or animal species with extinction? What if a certain pesticide is harmlessto humans but lethal to birds? Who will step into the marketplace to defend the preservationof non-human species? No individual or business firm is likely to do so, except on arelatively small scale.

Consider, for example, the activities of a group like the Nature Conservancy, whichbuys up ecologically valuable tracts of land in order to preserve them. Here is an exampleof an organization which is prepared to pay to save the environment. But their purchasescan only reach a tiny proportion of the natural areas threatened with destruction throughdevelopment, intensive farming, and other economic activities. In the "dollar vote"marketplace, purely ecological interests will almost always lose out to economic interests.

We should also note that property rights and regulating capabilities are limited to thecurrent generation. What about the rights of the next generation? Many environmental issueshave long-term implications. Rights to non-renewable resources can be assigned today, butthose resources will be used up by some time in the future. This important issue of resourceallocation over time is the subject of Chapter 4.

In some cases, property rights are simply inappropriate tools to deal withenvironmental problems. It may be impossible, for example, to establish property rights tothe atmosphere, or to the open ocean. When we confront problems such as global warming,ocean pollution, the decline of fish stocks, or endangered species, we find that the systemof private property rights, which has evolved as a basis for economic systems, cannot befully extended to ecosystems. It may be possible to use market transactions such as tradablepermits for air emissions or fishing rights, but these only apply to a limited subset ofecosystem functions. In cases like these, some other techniques of economic analysis willbe helpful in considering the interaction between human economic activity and aspects ofthe broader ecosystem. We will consider some of these analyses in Chapter 5.

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PROPERTY RIGHTS AND ENVIRONMENTAL REGULATION

Under the principle of eminent domain, governments are permitted to appropriate privateproperty for public purposes. However, the Fifth Amendment of the U.S. Constitution requires thatthe property owner be fairly compensated. Specifically, the Fifth Amendment concludes with thestatement - “nor shall private property be taken for public use, without just compensation.”

An action by a government that deprives someone of their property rights is referred to as a“takings”. In cases where the property owner is deprived of all their property rights, the U.S.Constitution clearly orders full compensation. For example, if a state government decides to builda highway through a parcel of private property, the landowner must be paid the fair market value ofthe property.

A more ambiguous situation arises when actions by a government limit the uses of propertyand, consequently, reduce the value of property. Instances of government regulations reducing thevalue of private property are often called “regulatory takings”. For example, suppose a new law iscreated which regulates timber harvesting and reduces the value of private forests. Are thelandowners entitled to compensation under the Fifth Amendment?

The most notable case concerning a regulatory takings is the Lucas v. South Carolina CoastalCouncil case. David Lucas, a real estate developer, purchased two oceanfront lots in 1986 andplanned to construct vacation homes. However, in 1988 the South Carolina state legislature enactedthe Beachfront Management Act, which prohibited Lucas from building any permanent structures onthe property. Lucas filed suit claiming that the legislation had deprived him of all “economicallyviable use" of his property.

A trial court ruled in Lucas’ favor, concluding that the legislation had rendered his property“valueless”, and awarded him $1.2 million in damages. However, the South Carolina Supreme Courtreversed this decision. They ruled that further construction in the area posed a significant threat toa public resource and in cases where a regulation is intended to prevent "harmful or noxious uses" ofproperty private no compensation is required.

The case was appealed to the U.S. Supreme Court. While the Supreme Court overturned theState Court ruling, it delineated a distinction between total and partial takings. Compensation isnecessary only in cases of total takings - when a regulation deprives a property owner of “alleconomically beneficial uses.” If a regulation merely reduces a property’s value, then compensationis not required.

In essence, this ruling represented a victory for environmentalists because cases of totaltakings are rare. Partial takings as a result of government regulations, on the other hand, are common.A requirement of compensation for partial takings would have created a legal and technical morass

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that would effectively render many environmental laws ineffective. Still, partial takings can resultin significant costs to individuals and the debate continues over equity when private costs arenecessary to achieve the public good.

Sources

Ausness, Richard C. 1995. “Regulatory Takings and Wetland Protection in the Post-Lucas Era”, Landand Water Law Review, vol. 30(2):349-?.

Johnson, Stephen M. 1994. “Defining the Property Interest: A Vital Issue in Wetlands TakingsAnalysis After Lucas”, Journal of Energy, Natural Resources & Environmental Law, vol. 14(1):41-?.

Hollingsworth, Lorraine. 1994. “Lucas v. South Carolina Coastal Commission: A New Approach ToThe Takings Issue”, Natural Resources Journal, vol. 34(2):479-?.

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SUMMARY

Many economic activities have significant external effects – impacts on peoplewho are not directly involved in the activity. Pollution from automobile use is anexample. The costs of these external impacts are usually not reflected in the marketprice, leading to an excessive production of goods with negative externalities.

One approach to pollution control is to internalize external costs by a tax or otherinstrument which requires producers and consumers of the polluting good to take thesecosts into account. In general, the use of such a tax will raise the price and reduce thequantity produced of the good, thereby also reducing pollution. In so doing, it shifts themarket equilibrium towards a socially more desirable result. In theory, a tax whichexactly reflects external costs could achieve a social optimum – but it is often difficult toestablish a proper valuation for externalities.

Not all externalities are negative. Positive externalities result when economicactivities bring benefits to others not directly involved in the transaction. Preservation ofopen land benefits those live nearby directly, often raising their property values. Inaddition, it brings greater satisfaction to hikers, tourists, and passers-by. When apositive externality exists, there is an economic case for a subsidy to increase the marketprovision of the good.

The analysis of externalities implies that it is generally not appropriate to seek toreduce pollution to zero. Rather, the social costs of pollution-creating goods should bebalanced against their social benefits. This usually means reducing, not eliminating,pollution. Another way of putting this is to say that there is some optimal level ofpollution. This formulation arouses opposition from some who point out that “optimal”pollution levels may become unacceptable with increased demand and greater productionof pollution-creating goods.

An alternative to the use of a tax is the assignment of property rights toexternalities. If there is a clear legal right either to emit a certain amount of pollution, orto prevent others from emitting pollution, a market in “rights to pollute” can develop. However, this solution depends on the ability of firms and individuals to trade thesepollution rights with relatively low transactions costs. Where large numbers of peopleare affected, or where the environmental damages are not easy to define in monetaryterms, this approach is not effective. It also raises significant questions of equity, sinceunder a market system the poor will generally bear a heavier burden of pollution.

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KEY CONCEPTS

Coase theoremcomplementary goodsconsumer surpluseconomic efficiencyenvironmental externalitiesenvironmental valuationequityexternal benefitexternal costfree market environmentalismfree rider effectgovernment regulationholdout effectinternalizing externalitiesmarginal benefitmarginal costmarket demand schedulemarket equilibriummarket supply schedulesocial benefitnet social benefitnet social lossoptimal pollutionPigovian taxpolluter pays principlepollution taxprivate choice private optimumproducer surplusproperty rightspublic choiceright to pollutesocial benefitssocial costssocial optimumsubsidiestotal cost of pollution transaction costs

utilitywelfare analysis

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REFERENCES

Baumol, William J. and Wallace E. Oates, “The Use of Standards and prices forProtection of the Environment,” Chapter 18 in Anil Markandya and Julie Richardsoneds., Environmental Economics: A Reader. New York, St. Martin’s Press, 1993.

Daniel W. Bromley ed., Handbook of Environmental Economics. Cambridge,Massachusetts and Oxford, U.K.: Basil Blackwell, 1995.

Bullard, Robert D. Dumping in Dixie: Race, Class, and Environmental Quality. Boulder, Colorado: Westview Press, 1994.

Coase, Ronald, 1960. "The Problem of Social Cost," Journal of Law and Economics,Volume 3. Reprinted in Stavins ed. 2000.

Cobb, Clifford W. The Roads Aren’t Free: Estimating the Full Social Costs of Drivingand the Effects of Accurate Pricing. San Francisco, California: Redefining Progress. Resource Incentives Program Working Paper No. 3, 1998.

Hodge, Ian. “Public Policies for Land Conservation,” Chapter 5 in Bromley ed.1995.

Robert N. Stavins ed., Economics of the Environment: Selected Readings, 4th Ed. NewYork: W.W. Norton, 2000.

Schmid, A. Allan. “The Environment and Property Rights Issues,” Chapter 3 inBromley ed. 1995.

Tietenberg, Tom H. “Economic Instruments for Environmental Regulation,” Chapter 16in Stavins ed. 2000.

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DISCUSSION QUESTIONS

1. "Solving the problems of environmental economics is simple. It is just a matterof internalizing the externalities." What is your reaction to this statement? Doesthe theory of externalities apply to most or all environmental issues? What aresome of the practical problems involved in internalizing externalities? Can youthink of some examples where the principle works well, and some where it ismore problematical?

2. A pollution tax is one policy instrument for internalizing externalities. Discussthe economic policy implications of a tax on automobiles, a tax on gasoline, or atax on tailpipe emission levels as measured at an auto inspection. Which wouldbe the most efficient? Which do you think would be most effective in reducingpollution levels? How do these taxes compare as policy instruments to ameasure such as the requirement for oxygenated (lower-polluting) fuelsintroduced by the Environmental Protection Agency in 1995? Bear in mind thatoxygenated fuels are more expensive than standard fuels.

3. Does it make sense to speak of "the right to pollute"? How can anyone have aright to pollute? What do you think of the concept of "optimal pollution"? Canwe really combine the economic concept of efficiency with the idea of protectingthe environment? What are the strengths and the weaknesses of such anapproach?

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EXERCISES

1. Consider the following supply and demand schedule for steel:

Price per ton ($) 20 40 60 80 100 120 140 160 180QD (million tons) 200 180 160 140 120 100 80 60 40QS (million tons) 20 60 100 140 180 220 260 300 340

Pollution from steel production is estimated to create an external cost of $60 perton.

Show the external cost, market equilibrium and social optimum on a graph.What kinds of policies might help to achieve the social optimum? What would be theeffects of these policies on the behavior of consumers and producers? What would be theeffect on market equilibrium price and quantity?

2. A chemical factory is situated next to a farm. Airborne emissions from the chemicalfactory damage crops on the farm. The marginal benefits of emissions to the factory,and the marginal costs of damage to the farmer, are as follows:

Quantity of 100 200 300 400 500 600 700 800 900Emissions

Marginal Benefit 320 280 240 200 160 120 80 40 0to factory ($000)

Marginal Cost 110 130 150 170 190 210 230 250 270to farmer ($000)

From an economic point of view, what is the best solution to this environmentalconflict of interest? How might this solution be achieved? How should considerationsof efficiency and equity be balanced in this case?