EM1-M: Lecture 4 - The Theory of Environmental Externalities PDF

## EM1-M: LECTURE 4 ### THE THEORY OF ENVIRONMENTAL EXTERNALITIES **INTSTRUCTOR:** Ma. Joan R. Souribio [email protected] ### The Theory of Environmental Externalities - Externalities: an effect of a market transaction that impacts the utility, positively or negatively, of those outside t...

## EM1-M: LECTURE 4 ### THE THEORY OF ENVIRONMENTAL EXTERNALITIES **INTSTRUCTOR:** Ma. Joan R. Souribio [email protected] ### The Theory of Environmental Externalities - Externalities: an effect of a market transaction that impacts the utility, positively or negatively, of those outside the transaction. - **Negative Externality:** negative impacts of a market transaction affecting those not involved in the transaction. - Ex: Pollution - If markets operate without regulation, the production decisions of companies will not account for the social and ecological damages of pollution. Consumers also typically will not limit their purchases because of pollution caused by the goods and services that they purchase. - **Positive Externality:** the positive impacts of a market transaction that affect those not involved in the transaction. - Ex: A landowner who buys and plants trees. - In addition to benefits to the owner, the trees provide benefits to those who appreciate the scenery and to society as a whole because they absorb carbon dioxide and provide habitat for wildlife. ### The Theory of Environmental Externalities - In a basic economic analysis of markets, demand and supply curves represent the costs and benefits of a transaction. - **Marginal Cost:** is the cost of producing or consuming one more unit of a good or service. - **Marginal Benefit:** is the benefit of producing or consuming one more unit of a good or service. - **Equilibrium Price:** is the market price where the quantity supplied equals the quantity demanded. #### The Market for Automobiles - Supply (Private Marginal Costs) - **Internalizing external costs/ externalities** using approaches such as taxation to incorporate external costs into market decisions. - **External cost(s)** is a cost, not necessarily monetary, that is not reflected in a market transaction. ### Internalizing Environmental Costs - **Pigovian tax:** is a tax imposed on activities that generate negative externalities. The goal of the tax is to correct market inefficiencies by making the price of the harmful activity reflect its true social cost. - The current specific excise tax rate is PHP 60 per pack of 20 cigarettes in 2023 and is set to increase by 4% annually thereafter. - Tax rate: 6.00 Philippine pesos per liter for beverages sweetened with caloric or non-caloric sweeteners (except high-fructose corn syrup) and 12.00 Philippine pesos per liter for beverages sweetened with high-fructose corn syrup. ### Internalizing Environmental Costs - **Polluter Pays Principle:** is the view that those responsible for pollution should pay for the associated external costs, such as health costs and damage to wildlife habitats. - The Pollution Adjudication Board (PAB) of the Department of Environment and Natural Resources (DENR) has fined 219 business establishments in Boracay a total of P43 million for violation of certain environmental laws. - Of the 209 establishments fined, 110 were found to have violated Section 1, Rule 19 of RA 8749 which requires a permit to operate all sources of air pollution from the EMB. Their imposed fines totaled P1.5 million. - Another 72 establishments were fined a total of P2 million for operating facilities that discharge regulated water pollutants without a valid discharge permit, which is required under Section 27(c) of RA 9275. - Five establishments were fined a sum of P39 million for discharging untreated wastewater and exceedance of effluent standards under the clean water law. - For violating some provisions of both RAs 8749 and 9275, 22 establishments were fined a total of P900,000. ### Internalizing Environmental Costs - Rather than looking at the final consumer product, economists generally recommend applying Pigovian taxes as far upstream in the production process as possible. - **Upstream Tax:** is a tax implemented as near as possible to the point of natural resource extraction. - **Upstream** refers to the material inputs needed for production, while **downstream** is the opposite end, where products get produced and distributed. - **Example:** - In the petroleum industry, locating underground or underwater oil reserves characterizes the upstream process. Additionally, the upstream process in petroleum involves bringing oil and gas to the surface. In contrast, the downstream production process involves processing the materials collected during the upstream stage into a finished product. The downstream stage further includes the actual sale of that product to other businesses, governments or private individuals. ### Internalizing Environmental Costs - Another issue related to our externality analysis is to explore how the tax burden is distributed between producers and consumers. - **Price Elasticity of Supply:** is the amount by which the quantity supplied increases or decreases with a price change. - **Price Elasticity of Demand:** is a measurement of the change in the consumption of a product in relation to a change in its price. ### Welfare Analysis of Externalities - In some circumstances, the government believes that the free market equilibrium price is too high. If there is political pressure to act, a government can impose a maximum price, or **price ceiling**, on a market. - **Welfare economics** is the study of how the allocation of resources and goods affects social welfare. - Welfare analysis can be used to evaluate the impacts of a price ceiling. Consider the price ceilings imposed on the natural gas markets. The purpose, or objective, of this policy was to help consumers. We will see that the policy does help some consumers and also hurts producers. - A **price ceiling** is imposed to provide relief to consumers from high prices. - In food and agriculture, these policies are most often used in low-income nations, where political power is concentrated in urban consumers. If food prices increase, there can be demonstrations and riots to put pressure on the government to impose price ceilings. - A **price ceiling** is a maximum price policy to help consumers. ### Optimal Pollution - Our analysis of negative externalities reveals an idea that may seem paradoxical-the concept of **optimal pollution**. Note that even after imposing an externality tax, society is still left with pollution damages. - **Optimal Level of Pollution** refers to the point where the marginal cost of reducing pollution (abatement cost) equals the marginal benefit of reducing that pollution (the benefits to society, such as improved health and environmental quality). - The only way to achieve zero pollution is to have zero production. If we want to produce virtually any manufactured good, some pollution will result. We as a society must decide what level of pollution we are willing to accept. Of course, we can strive to reduce this level over time, especially through pollution-reducing technology, but as long as we have production we will have to determine an “optimal” pollution level. ### Property Rights and the Environment - The idea of a Pigovian tax, which forces polluters to pay for the cost of their social and environmental damages, is intuitively appealing. Implicit in the imposition of a Pigovian tax is the idea that society has a legitimate right to be compensated for any pollution damages. - Suppose a farmer drains a wetland on his property to create a field suitable for growing crops. His downstream neighbor complains that without the wetland to absorb heavy rainfall, her land now floods, damaging her crops. Should the first farmer be obliged to pay the second the value of any crop damages? Or does he have the right to do what he wants on his own land? ### Property Rights and the Environment - **Coase Theorem** is a legal and economic theory developed by economist Ronald Coase regarding property rights, which suggests that if property rights are well-defined and transaction costs are low or negligible, private parties can negotiate and resolve externalities (like pollution) on their own, leading to an efficient allocation of resources, regardless of who initially holds the rights. It offers a potentially useful way to think about how to best resolve conflicts between competing businesses or other economic uses of limited resources. It is applied when there are conflicting property rights. It states that under ideal economic conditions, where there is a conflict of property rights, the involved parties can bargain or negotiate terms that will accurately reflect the full costs and underlying values of the property rights at issue, resulting in the most efficient outcome. - **Transaction Cost:** are costs associated with a market transaction or negotiation, such as legal and administrative costs to transfer property or to bring disputing parties together. ### Property Rights and the Environment - If a business that produces machines in a factory is subject to a noise complaint initiated by neighboring households who can hear the loud noises of machines being made, the Coase Theorem would lead to two possible settlements. - The business may choose to offer financial compensation to the affected parties in order to be allowed to continue producing the noise or the business might refrain from producing the noise if the neighbors can be induced to pay the business to do so, in order to compensate the business for additional costs. - Lose revenue associated with stopping the noise. - If the market value produced by the activity that is making the noise exceeds the market value of the damage that the noise causes to the neighbors, then the efficient market outcome to the dispute is that the business will continue making machines. The business can continue to produce the noise and compensate the neighbors out of the revenue generated. - If the value of the business's output of making machines is less than the cost imposed on the neighbors by the noise, then the efficient outcome is that the business will stop making machines and the neighbors would compensate the business for doing so. In the real world, however, neighbors would not pay a business to stop making machines because the cost of doing so is higher than the value they place on the absence of the noise. ### Property Rights and the Environment - In recognizing these real-world difficulties with applying the Coase Theorem, some economists view the theorem not as a prescription for how disputes ought to be resolved, but as an explanation for why so many apparently inefficient outcomes to economic disputes can be found in the real world. - **Limitation of the Coase Theorem:** - **Free market environmentalism:** is the view that a more complete system of property rights and expanded use of market mechanisms is the best approach to solving issues of resource use and pollution control without government regulation. ### Property Rights and the Environment - Suppose that we assign the factory the right to pollute. The communities can then offer compensation for reducing pollution. But which community will pay what share? Unless all 50 can agree, it might prove impossible to make a specific offer to the company. No single community, 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" the factory-and thus gain pollution control benefits for free. - **Free-rider Effect:** is the incentive for people to avoid paying for a resource when the benefits they obtain from the resource are unaffected by whether they pay; results in the undersupply of public goods. ### Property Rights and the Environment - A similar problem arises if the communities are given the "right to be free from pollution" and the factory must compensate them for any pollution emitted. Who will determine which community gets how much compensation? Because all are situated on the same river, any single community can exercise a kind of veto power. - Suppose that 49 communities have hammered out an agreement with the company on permissible pollution levels and compensation. - **Holdout Effect:** is the ability of a single entity to hinder a multiparty agreement by making disproportionate demands. The fiftieth community can demand a much higher rate of compensation, for if it withholds consent, the entire agreement will fail, and the company will be restricted to zero pollution (i.e., forced to shut down). ### Issues of Equity and Distribution - Issues of **environmental injustice** concern both economic status and also political power. - **Environmental justice is the fair treatment and meaningful involvement of all people regardless of race, color, national origin, or income, with respect to the development, implementation, and enforcement of environmental laws, regulations, and policies**. - This was the case in Flint, Michigan, where a crisis of water contamination arose when officials decided to switch the city's water source from the Detroit Water and Sewerage Department water to the Flint River in April 2014. The explicit goal was to save millions of dollars for the municipal budget of Flint, which was on the brink of financial collapse. The corrosive Flint River water was not treated properly, causing lead from aging pipes to leach into the water supply, resulting in highly elevated levels of this heavy metal neurotoxin. Between 6,000 and 12,000 children have been exposed to drinking water with dangerously elevated levels of lead, and they may experience a range of serious health problems. Flint is a low-income community, 84 percent black, and the agonizingly slow government response to the crisis was widely considered as a prime example of environmental racism and injustice.