B.  The Theory of Environmental Externalities

• Externality - benefit or cost that affects someone who is not directly involved in the production or consumption of a good or service

• Negative externality - negative impacts of a market transaction affecting those not involved in the transaction

Ex. - Pollution

• Positive externality - positive impacts of a market transaction affecting those not involved in the transaction

Ex. - Planting trees

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1.  Negative externalities

a.  No externalities

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b.  External cost

• A cost, not necessarily monetary, that is not reflected in a market tranaction

• Ex. - External cost of automobiles

• Social marginal cost - considers both private production costs and externalities

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c.  Internalizing environmental costs

• Pigouvian tax - per-unit tax set equal to the external damage caused by an activity

• Polluter pays principle - those responsible should pay for external costs

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• Considerations

(1)  Damage must be estimated - may not be worthwhile if damage is small

(2)  Administrative costs may outweigh tax revenue if damage is small

(3)  Upstream tax - tax implemented as near as possible to the point of natural resource extraction

• Tax will be reflected in final sales price of downstream products

(4)  Price elasticity of supply and demand will affect whether consumer or producer bears the burden of the tax

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(5)  Tax may have disproportionate impact on low-income households

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2.  Positive externalities

• External benefit generated - a benefit, not necessarily monetary, that is not reflected in a market tranaction

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• Use a subsidy to achieve optimal result

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3.  Welfare analysis

• Look at consumer and producer surplus

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a.  Consumer and producer surplus with no externalities

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b.  Impact of negative externalities

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c.  Impact of Pigouvian tax

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d.  Optimal pollution

• Level of pollution that maximizes net social benefits

• Different than zero - any production will generate some pollution

• Ecological economists would use factors other than economics to determine optimal overall level of pollution

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4.  Property rights and the environment

• Allocation of property rights could help solve environmental problems without government intervention

• Free market environmentalism - a more complete system of property rights and expanded use of market mechanisms is the best approach to solving issue of resource use and pollution control

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a.  Coase Theorem

• If property rights are well defined and there are no transactions costs, an efficient allocation of resources will result even if externalities exist

• Negotiations between parties will lead to optimal result

Ex. -

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(1)  Graphical analysis

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(2)  Limitations

• Assumes no transactions costs - higher when more parties are involved

• Free-rider effect - incentive for people to avoid paying for a resource when the benefits obtained are unaffected by whether they pay

• Holdout effect - ability of a single entity to hinder a multiparty agreement by making disproportionate demands

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b.  Equity and distribution

• Poor communities may not be able to pay if rights assigned to polluter

• Poor communities may accept payments to raise revenue

• Poorer communities generally bear the heaviest burden of environmental costs

•   Environmental justice (EPA definition) - "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."

• EPA Factsheet on environmental justice

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c.  Other limitations

(1)  Difficult to apply to nonhuman life forms

(2)  Future generations not considered

(3)  Can't be fully extended to some ecosystems (atmosphere, open ocean)

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