Externalities and Pollution Problem

Externalities and Pollution Problem:

1) Pollution:

Negative Externalities:

Private Marginal Cost (PMC) is different from Social Marginal Cost (SMC) because the free market economy failed to achieve the efficient resource allocation. Ex) Company emitting pollutants will not count the damages that the neighboring residents will face.

In this case the company’s PMC is lesser than SMC.


In perfectly competitive market, the market price of good equals the marginal cost (MC),

P = MC (= PMC)

Combining the above two equation, we get:


In consuming any goods, consumers feel that (both private and social) marginal benefit equals Price,


2) Optimal Environmental Management:

Up to what amount of pollutants that we can allow? How can we resolve that value? Sustainable development?

Types of Costs:

Direct Damages (Type-A cost, TCA ): diseases, pain, sickness, lowered production, etc.

Maintenance Costs (Type-B cost, TCB ): to decrease pollution level.

2462_types of costs.jpg

We intuitively know that q¯ = qˆ .

3) Efficient Management:

Imposing Effluent Fee or Pollution Tax (Pigouvian Tax):

OG¯ = Tax . If q < qˆ , it is more reasonable to increase q to pay lower cost. If q > qˆ , producer will reduce q because MCB is smaller than OG¯ .

This is designed to give producers a few incentives to maximize their (private) profits.

OG¯ = MCA (value of marginal damages) at qˆ (Arthur Pigou).

Direct Control (Emission Standard):

Quantity control is not preferred to price control Why?

4) Property Rights and Coase Theorem:

As an alternative, the government can assign a property right, that is, the exclusive control over the use of an asset or resource, without interference by others.

Why are property rights significant in dealing with externalities? Polluters do not have to compensate anyone when they released pollutants into the river. That’s why the firms based their production decision on private marginal costs that did not include the harm that pollution brought to the environment. The expenses of pollution were external to the polluters.

If the community owns a property right to clean the river, it could require firms to compensate it for the right to pollute. Now the expenses of pollution would be internalized to the firm.

In 1960 Ronald Coase developed a basic theorem demonstrating how the problem of externalities could be addressed by assigning property rights.7 He illustrates the idea with an example involving two farms. Farm A raises cattle, and the cattle occasionally stray onto the land of a neighboring Farm B, which raises crops. Farm A’s cattle inflict a negative externality by damaging the crops on Farm B.

Coase deal with the issues: Must the cattle be allowed to roam on the property of Farm B? Can the owner of Farm B require the owner of Farm A to construct a fence to restrain the cattle? If therefore who should pay for the fence? Does it mater whether the property rghts are assigned to the owners of Farm A and B?

The Coase Theorem states that, regardless of how property rights are assigned with an externality, the allocation of resources will be efficient when the parties can costlessly bargain with each other. If the owner of Farm A has the right to let his cattle roam on B’s land, B’s owner will pay A’s owner to build a fence when the damage to B’s crops exceeds the costs of fence. If the cost of the fence exceeds the damage to the crops, it will not be the interest of owner B to pay for the fence, and the cattle will roam. When it is socially efficient to construct the fence, the fence will be built to eliminate the externality.

If, instead, the property rights are assigned to owner B, so that A has to compensate B for any damage. Owner A would construct a fence if the damage to B’s crops exceeds the cost of the fence. However, if the cost of the fence is greater than the damage to the crops, then owner A will compensate owner B for the damage, and once again, the cattle will roam.

Regardless of whether the property rights are assigned to the owner A or to owner B, the outcome is the same and it is socially efficient. The fence will be built when the fence costs less than the damage to the crops, and it will not be built when the fence costs more than the damage.

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