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Chapter 4 Pollution Problems: Must We Foul Our Own Nests? McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. Key Concepts Cost-benefit analysis Supply and demand as marginal costs and benefits Externalities and opportunity costs Marginal social costs Marginal social benefits Externalities in consumption Externalities in production Market failures Pollution rights markets Environment and Its Services Environment Environment services Air Water Land Are used during the production process Consequences of using the environment Depletion of exhaustible resources Irresponsible usage of replaceable resources Waste disposal What Is Pollution? The Environment and Its Services Exhaustible resources Replaceable resources Waste disposal Recycling Wastes and the Concept of Pollution 4-4 Pollution occurs when recycling process es fail to prevent wastes from accumulat ing in the environment Common Forms of Pollution Air Pollution Water pollution Level of dissolved oxygen Materials and matter Land pollution 4-5 Carbon monoxide Sulfur dioxides Nitrogen oxides Hydrocarbons Particulates Dumping of wastes Tearing up Earth’s surface Markets and Resource Allocation Supply and demand schedule intersection determines market equilibrium Market-determined equilibrium reflects the socially optimal allocation of resources Maximum social well-being is achieved whenever marginal social benefit equals marginal social cost We now fit cost-benefit thinking into the supply and demand model Market: the Demand Side Demand curve Shows the maximum quantity of a good or service that can be bought at any given price Shows the maximum price consumers will be willing to pay for each successive unit of a good or service Demand curve is downward sloping: Suppose the first pizza is sold at $10the marginal benefit of the first pizza is at least $10 The second pizza is worth less, say, $8 reflecting the declining marginal willingness to pay Market demand curve is reflecting the marginal private benefit of consumption Marginal private benefit is the benefit that accrues to the direct consumers of a good or service resulting from a one-unit increase in consumption Marginal Social Benefit Normally consuming goods or services does not affect anybody except the direct consumer However: consider vaccination for a contagious disease There is a spillover of benefits from the vaccine to third parties (that is, to the society, not only the direct consumer), or externalities in consumption Externality in consumption is a change in satisfaction, which can be either positive or negative, for someone other than the direct consumer of an item When externalities are present, the marginal private benefit does not equal marginal social benefit: Marginal social benefit = Marginal private benefit +/- Externality Demand and Marginal Private Benefit $ The demand curve is a marginal private benefit curve 14 12 10 8 6 4 D = MPB 2 1 4-9 2 3 4 5 6 Quantity of pizza Externality in Consumption $ MSB = MPB ± Externality 14 12 10 8 6 4 MSB 2 MPB 1 4-10 2 3 4 5 6 HIV vaccine Marginal Private Cost A supply curve shows the maximum quantity of a good or service that sellers are willing to offer given the price A supply curve shows the minimum price sellers are willing to accept for an additional unit of a good or service The supply curve is the producer’s marginal private cost curve Marginal private cost is the increase in total cost that producers incur when output is increased by one unit Increasing Slope of Supply Curve Supply curve is upward sloping reflecting the fact that the marginal private costs increase as the volume of production increases Increasing opportunity costs reflect the fact that as producers produce more they have to attract resources that are increasingly valuable Example: hiring workers in a student town Externality in Production In most production processes, the actual producer of a product bears all costs associated with this production so that the marginal private product and the marginal social product coincide Externalities in production occur whenever production of a good or service leads to cost changes (negative or positive) in the production of the other items Examples Smoking Landscaping Marginal social cost = Marginal private cost +/- Externality Supply and Marginal Private Cos t $ 11 10 S = MPC 9 8 7 6 5 1 4-14 2 3 4 5 6 Quantity of pizza Externality in Production MSC = MPC ± Externality $ MSC 11 10 S = MPC 9 8 7 6 5 1 4-15 2 3 4 5 6 Quantity of pizza Market Failure The market leads to the outcome where the marginal private benefit to consumers is equal to the marginal private cost of producers When externalities exist and are of significant size, the market equilibrium outcome is not a socially optimal one Market failure occurs when markets, operating on their own, do not lead to a socially optimal allocation of resources Explicit and Implicit Costs Explicit costs of production are the ones incurred by the producer to buy or hire the resources required to produce Actual cost outlays Implicit costs of production are the ones incurred by the producer for the use of self-owned, selfemployed resources required to produce Household members’ labor Marginal Social vs Marginal Private Cost A firm dumping its waste into the river produces negative externalities by increasing the social cost of production The market outcome in this case is not socially optimal since the private supply curve is not the social supply curve In case of negative externalities, too much production occurs Market Equilibrium without Externalities $ 14 12 S = MPC 10 8 7 6 4 D = MPB 2 1 4-19 2 3 3.5 4 5 6 Quantity of pizza Marginal Private Cost vs Marginal Social Cost The true cost of producing electric power is the cost that would exist were the river not polluted by the paper producers However, the power producer have to clean the water so from their perspective the cost of producing power has to include the cost of cleaning water The market gets it wrong again since it underestimates the true costs of production by ignoring the externality so that too little power is produced Why Polluters Pollute 4-21 Property rights in the environment eit her nonexistent or not enforced Much of environment’s services share d by entire population Consumer Surplus and the Demand Curve –A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good. –Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyer’s willingness to pay and the price paid. The Demand Curve for Used Textbooks Price of bo ok Aleisha $59 Potential b uyers Brad 45 Claudia 35 Aleisha Brad $59 Claudia 35 Darren Edwina 25 45 10 Darren 25 Edwina 10 D 0 Willingness to pay 1 2 3 4 5 Quantity of books A consumer’s willingnes s to pay for a good is the maximum price at which he or she would buy that good. Willingness to Pay and Consumer Surplus –Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good. –The term consumer surplus is often used to refer to both individual and total consumer surplus. Consumer Surplus in the Used Textbook Market Price of boo k Aleisha’s consumer surplu s: $59-$30=$29 $59 Aleisha Brad’s consumer surplu s: $45-$30=$15 45 Brad Claudia’s consumer s urplus: $35-$30=$5 35 Claudia 30 Price = $30 25 Darren 10 The total consumer surpl us is given by the entire shaded area - the sum of the individual consumer surpluses of Aleisha, Bra d, and Claudia - equal to $29 + $15 + $5 = $49. Edwina D 0 1 2 3 4 5 Quantity of books Consumer Surplus in the Used Textbook Market Consumer Surplus The total consumer surplus generated by purchases of a good at a given price is e qual to the area below the d emand curve but above tha t price. Price of co mputers Consumer surplus Price = $1,500 $1,500 D 0 1 million Quantity of computers How Changing Prices Affect Consumer Surplus –A fall in the price of a good increases consumer surplus through two channels: • A gain to consumers who would have bought at the original price and • A gain to consumers who are persuaded to buy by the lower price. Consumer Surplus and a Fall in the Price of Used Textboo ks Price of b ook $59 Aleisha Increase in Aleish a’s consumer surp lus Increase in Brad’s co nsumer surplus 45 Brad Claudia 35 Increase in Claude’s consumer surplus 30 Original price = $30 Darren 25 20 New price = $20 10 Darren’s consum er surplus Edwina D 0 1 2 3 4 5 Quantity of books A Fall in the Market Price Increases Consumer Surplus Price of comp uters Increase in consumer surplus to original buy ers $5,000 Consumer surplu s gained by new buyers 1,500 D 0 200,000 1 million Quantity of computers Producer Surplus and the Supply Curve –A potential seller’s cost is the lowest price at which he or she is willing to sell a good. –Individual producer surplus is the net gain to a seller from selling a good. It is equal to the difference between the price received and the seller’s cost. –Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good. The Supply Curve for Used Textbooks Price of bo ok $45 Engelbert Donna 35 25 Carlos 15 Betty Andrew 5 0 Potential sellers S 1 2 3 4 5 Quantity of books Cost Andrew $5 Donna 15 Carlos 25 Betty 35 Engelbert 45 Producer Surplus in the Used Textbook Market Price of book S $45 Engelbert 35 Donna Price = $30 30 25 0 Betty’s pro ducer surp Andrew’s prlus oducer surpl us Betty 15 5 Carlos’s producer surplus Carlos Andrew 1 2 3 4 5 Quantity of books Producer Surplus Price of wheat (per bushel) S $5 The total producer surp lus from sales of a goo d at a given price is the area above the supply curve but below that pri ce. Price = $5 Producer surp lus 0 1 million Quantity of wheat (bushels) A Rise in the Price Increases Producer Surplus Price of wheat (per bus hel) Increase in produ cer surplus to orig inal sellers Producer surp lus gained by new sellers S $7 5 0 1 million 1.5 million Quantity of wheat (bushels) Putting It Together: Total Surplus • The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. • The concepts of consumer surplus and producer surplus can help us understand why markets are an effective way to organize economic activity. Total Surplus Price of book S Equilibrium pr ice Consumer surpl us $30 E Producer surplu s D 0 1,000 Equilibrium quantity Quantity of books Pollution and Resource Allocation Price $ Loss of well-being to society B 11 MSC S = MPC C 10 A 9 D = MPB = MSB r0 4-38 r1 Reams per day Externalities and the Market Outcome When a negative externality in production exists, the outcomes in the markets do not reflect an allocation of resources that maximizes social well-being Market incentives in case there are externalities lead to suboptimal production levels For the polluter, production costs are artificially reduced so they overproduce For the power producers, production costs are artificially increased so they underproduce How Much Pollution Control is Appropriate? We need to apply cost and benefit analysis to answer this question Measurement of both costs and benefits of pollution control measures is difficult As pollution control increases, marginal costs of it increase while the marginal benefits of it decline The level of pollution control that yields the maximum net social benefit is the one at which the marginal social benefit equals marginal social cost Why Polluters Pollute 4-41 Property rights in the environment eit her nonexistent or not enforced Much of environment’s services share d by entire population The Appropriate Level of Polluti on Control (1) (2) (3) (4) (5) (6) (7) Pollution Control or Eliminated Stench Total Social Cost of Control ($000) Marginal Social Cost of Control ($000) Per-Person Marginal Benefit of Control Marginal Social Benefit of Control ($000) Total Social Benefit of Control ($000) Net Social Benefit of Control ($000) 1st 10% 10 10 10.00 100 100 90 2nd 10% 20 10 8.00 80 180 160 3rd 10% 30 10 6.00 60 240 210 4th 10% 40 10 4.00 40 280 240 5th 10% 50 10 2.00 20 300 250 6th 10% 60 10 1.60 16 316 256 7th 10% 70 10 1.20 12 328 258 8th 10% 80 10 .80 8 336 256 9th 10% 90 10 .40 4 340 250 10th 10% 100 10 .20 2 342 242 4-42 Direct Controls Assumes regulatory bodies know what social optimum is Assumes regulatory bodies can allocate pollution reducing costs efficiently Fail to provide polluters with economic incentives not to pollute so enforcement can be a problem Indirect Controls Economic incentives are there Incentives to overproduce are reduced for the polluter Determining the benefits of cleaning the waste is difficult Enforcement is not easy Taxes are a political matter Pollution Rights Markets A market that exists when firms are allowed to buy and sell government-issued licenses granting the holder the right to create a certain amount of pollution Economic incentives are there Any desired level of pollution can be achieved by the market rather than administrative means What Can Be Done About Pollution? Creation of Pollution Rights Markets 4-46 Pollution rights license Pollution rights market Clean Air Act of 1990