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The economists’ approach to
Presenter: Brian Danley

What problems are created when
negative externalities exist in production
and how can economics be used to
approach these problems?
Recall: what is the goal of the firm?
But what about companies that care?
How should quantitative environmental
goals be set?
 How to balance between socially
beneficial production and socially
harmful pollution?
 After we determine the right balance
how to acheive that solution? (cost
minimization)

Teaser trailer: ”internalize” the
externality.
The Economics Model
Emission
(utsläpp) function: z= k(q^n) Damage
function: = A(u)
Static effects. The firm’s cost curve is private, but
we can also calculate social costs in money as well.
Some kind of technology exists to reduce emissions
but it is costly.
Firms in a competetive goods market. (what does that
mean for profit maximization?)
A market optimum and a social
optimum
The standard supply and
demand diagram.
What are these curves, in
mathematical terms?
Is this market producing an efficient
amount of the good?
A market with a negative externality.
Add in a new supply function (MSC= S + EC).
Consumer and
producer surplus
analysis.
Important! Negative externalities are modeled as costs and positive
externalities are modeled as benefits for this kind of analysis.
One possibility: direct state
production
A government authority can take over
production.
 Normally this is done for more than
strictly economic reasons. (healthcare)
 Problems?

We want a private market for many things,
don’t we?
Anyone care for a smoke?

Specific regulation: ”command and control”
 EX: Everyone must reduce emissions by X
amount.
 Your preferences don’t matter.
○ Problems: goal setting, monitoring costs, EFFICIENCY in cost allocation
(information)

Property rights (äganderätter) solution,
Coase invariance theorm
 Depends on self interest of participants.
○ Requirements: rights are clearly and fully defined
over the entire issue (no issues left out), rights are
100% transferrable, assigning the rights does not
change the relative positions of power among the
actors (income effect is negligable), the costs of
organizing the trade and executing the trade are
negligable (transaction costs are zero).
Issues with the property rights
solution
free riding (individual utilities are private information)
 monitoring will likely be easier and less costly, but it may be
an issue still
 MAIN PROBLEM: transaction costs (benefits of polluting are
often concentrated while the costs are widely spread)
 In a way, doesn’t society already own the right to not have
a polluted environment?

Pigovian Tax (put a price on it)
What is really wrong with a restriction
like ”everyone must reduce emissions
by amount X?”
 If the damage function is the same for all
emissions sources, and there are 2 firms
with different cost functions for reducing
emissions, how would a ”price” on
emissions affect the choices of each
firm?

The nuts and bolts
MCr for firm 1 is: MCr = A(z)
 MCr for firm 2 is: MCr = A(z^2)
 With the same price on emissions (tax)
the emission of each firm will be
different.

 Which firm will emit less?

Graphical reasoning, then the math.
Marketable Permits, Transferrable
Emission Rights (överlåtbara utsläppsrättigheter)
What if we decide not to put a regulation
on price, but instead on quantity of
emissions? Firms can trade these rights
or permits between themselves. How
will the outcome be different?
 The graphical reasoning.
 Which solution would firms prefer?

Comparison of
taxes and
permits.
If the benefits of pollution reduction are
uncertain.
 If the costs of emission reduction are
uncertain.
 If there is some kind of ecological
threshold for the pollution.

Things to keep in mind…
It is hard to accurately figure out how the
social cost curve is affected by
environmental factors.
 The more market power firms have, the
more careful you should be about this
intution.
 Need flexability and ability to react to
changes and possible errors in
computation.

Go forth and do likewise…
Figure out how to make it in the rational self
interest of people, companies, or organizations
to care about the effects of their actions.