Topics Today 91608

1
Topics Today (9/16/08)

• The efficient level of pollution.
• Least-cost pollution control.
• Approaches to correct for market failure.
• The Coase Theorem
• Command-and-Control (CAC)
• Read chapter 11 in your textbook for next time.
• Homework 1 is due today put it in my mailbox if
  you turn it in this afternoon.

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Market Failure

• Market failure occurs when private means
  contradict the social ends of an efficient
  allocation of resources.
• In the case of pollution, market failure occurs
  because
• Cleaning up pollution is costly and people are
  often not compensated for their costs.
• Ex/ Case of pharmeceutical waste documented in
  the Wisconsin State Journal the last two days
  (9/15, 9/16).
• There are incentives to free-ride.

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The Efficient Level of Pollution

• What is the efficient allocation of pollution?
• Should we attempt to have no pollution in
  society?
• The pursuit of efficiency is the pursuit of the
  biggest economic pie, conditional on the
  existing distribution of income.
• An efficient allocation need not be fair.

4
Alternative Views on Efficiency

• Pareto Efficiency occurs when it is not possible
  to reallocate resources without making at least
  one person worse off.
• Kaldor-Hicks Efficiency occurs when the gainers
  from a reallocation could compensate the losers
  such that nobody is worse off.
• Key difference between Pareto and Kaldor-Hicks
  efficiency gt whether compensation takes place.
• A general characteristic of both types of
  efficiency the net social benefit of using a
  resource is maximized.

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The Efficient Level of Pollution
A
B
A
B
Pie 2
Pie 3

• The pies represent the net social gain from
  three different pollution control options, with
  two types of individuals, A and B.
• Pies 2 and 3 are more efficient than Pie 1
  because they generate higher net social benefits.

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The Efficient Level of Pollution
A
B
A
B
Pie 2
Pie 3

• Pie 2 satisfies Pareto efficiency.
• Pie 3 satisfies Kaldor-Hicks efficiency.
• Note that an efficient outcome is not
  necessarily fair.

7
The Efficient Level of Pollution

• Ex/ Consider a fishing company and an upstream
  paper mill who dumps pollution into the river.
• The fishing company wants a clean stream because
  they catch more fish if the water is unpolluted.
• The paper mill wants to produce paper, but in
  order to do so, must dump pollution into the
  river.

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The Efficient Level of Pollution

• Marginal pollution damages (MPD) the damage to
  an agent from the last unit of pollution.
• Marginal abatement cost (MAC) the cost to a
  polluter from cleaning-up the last unit of
  pollution.

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The Efficient Level of Pollution
10
The Efficient Level of Pollution
11
The Efficient Level of Pollution
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The Efficient Level of Pollution

MPD
P
MAC
Q
?Pollution Reduced
Q1
The efficient level of pollution occurs where the
marginal abatement costs equate marginal
pollution damage gt at Q
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Least-Cost Pollution Control (Cost-Effective
Pollution Control)

• Suppose the government doesnt know MPD but wants
  to reduce pollution to a predetermined point, Q.
• A solution to market failure is termed a
  least-cost or cost effective solution if it
  reduces pollution Q at minimum cost.
• Q is set by the government and may or may not be
  the socially efficient level of pollution (Q).

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Least Cost Pollution Control

• An almost universal empirical finding is that MAC
  curves vary across firms.
• Consider two firms that emit pollutants into a
  river (point-source).

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Least Cost Pollution Control

MACJones
MACSmith
? Pollution Reduction
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Least-Cost Pollution Control

• What is the least-cost allocation of 10 units of
  pollution reduction?
• Jones reduces 3 units.
• Cost100200300
• Cost600
• Smith reduces 7 units.
• Cost75125375
• Cost1575.
• Total cost 2175.

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Least Cost Pollution Control
Pollution abatement at least cost implies that
MAC is the same for all firms This implies that
firms with lower abatement costs cut back more

MACJones
MACSmith
MACAggregate
MAC
Q
Q
? Pollution Reduction
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Summary of Efficient and Least-Cost Pollution
Control

• Efficient pollution reduction occurs where
  MACMPD.
• Least-cost pollution reduction occurs where
  MAC1MAC2MAC3.
• Is Least-cost pollution reduction necessary for
  economic efficiency?
• Even when the chosen level of pollution reduction
  is not efficient, it can be least-cost.

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Solutions to Market Failure The Coase Theorem

• The Coase Theorem (Ronald Coase 1960)
• Premise Two parties have an incentive to
  negotiate an economically efficient and mutually
  advantageous solution to a dispute.
• Required One party is given unilateral property
  rights to the asset in question.
• Key Point The outcome will be the same no matter
  who has the initial property right.

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Solutions to Market Failure The Coase Theorem

• Suppose the paper mill has the property right to
  use the river for waste disposal.
• The fishing company would pay the mill to reduce
  5 units of pollution (units 10 through 6).
• As shown earlier, this is the efficient level of
  pollution.

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Solutions to Market Failure The Coase Theorem

• Suppose the fishing company has the property
  right to use the river for fishing.
• The mill would pay the fishing company for the
  right to pollute 5 units (units 1 through 5).
• As shown earlier, this is the efficient level of
  pollution.

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Gains from negotiation mill has property rights

Gain to fishing company ABC Gain to mill ACD
MAC to mill
B
MPD to fishing company
A
Pollution Price
C
D
Q
Q1
? Pollution Reduction
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Gains from negotiation fishing company has
property rights

Gain to fishing company EAF Gain to mill DAE
D
MAC to mill
MPD to fishing company
A
Pollution Price
E
F
Q
Q1
? Pollution Reduction
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Solutions to Market Failure The Coase Theorem

• What would happen if there were 2 fishing
  companies on the river instead of 1?
• What about 10 fishing companies?
• What about 1000 recreational fishermen?
• If the mill had the original property right, how
  would the fishing companies organize to pay the
  mill not to pollute?

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Solutions to Market Failure The Coase Theorem

• Fundamental Assumption of the Coase Theorem
  transactions costs between parties are low.
• Transaction costs are the costs that are paid to
  organize economic activity, including
  information, negotiation, writing/enforcing
  contracts, etc.
• Transaction costs are most likely to be low when
  there are few people involved in the dispute.

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Solutions to Market Failure The Coase Theorem

• The Coase Theorem also suffers from free-riding.
  When?
• Large number of parties.
• Non-excludable good.

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Solutions to Market Failure The Coase Theorem

• Advantages of Coase
• Solution is efficient, provided conditions are
  right.
• Government doesnt need to know MAC and MPD
  curves.
• Disadvantages of Coase
• Theorem breaks down with transactions costs.
• Suffers from free-riding when goods are
  non-excludable.

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When Might the Coase Theorem Apply?

• Small number of parties and local
  externalities.
• Ex/ Neighboring crop-farmer and cattle-owner
  wandering cattle destroy the farmers crops.
• Transactions costs are low because there are only
  two parties.
• The externality is local so there is no
  free-riding by other parties.

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When Might the Coase Theorem Not Apply?

• Large number of parties and global externality.
• Ex/ Air pollution from power plants.
• Transactions costs are high because there are
  millions of people who may be harmed by
  pollution.
• Incentive for people who benefit from the reduced
  pollution to free-ride.