Private and public costs of pollution. The concept of externalities.Socially accepted levels of externalities. The basics of environmental policy.

Part three

George HorváthBuilding Q, room A235.george@eik.bme.hu

Sustainability in a globalised world

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Market actors are growth oriented on both micro- and macro levels.

• Adam Smith claims that an invisible hand is guiding all actors towards an unintended outcome – which should be optimal

• David W. Pearce says that this invisible hand is working, but is sick– Environmental factors are making it fail

Pareto-optimum:the maximum of welfare

• In market trade, every actor is acting according to their respective selfish ends

• Ultimately we will arrive at an „allocationally efficient state”– a.k.a. Pareto-optimum

• Samuelson and Nordhaus say that if we consider a perfectly competitive system:– all prices of goods = marginal costs– all prices of capital = cumulative costs of marginal product– … therefore no overspill (external) effects can occur– This system remains stable because of mutual selfishness:

nobody can get to a better position without putting somebody else in a worse position

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

Pareto-model vs. the Environment

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• The Pareto-model deviates from reality when it comes to the environment

• A. V. Kneese: this deviation is much larger than could be accepted as „natural”

• Environmental problems are so irrelevant to the Pareto-model like some problems that arose with relation to the 1929-1933 economic crisis– Until then, people were sure that prices can guide the

market movements of goods and services, which turned out to be a bad idea.

• From the 1960s the conflict between market and environment has become ever more apparent.

Market failures and externalities

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• If we do not consider externalities, our market theory breaks down

• Samuelson-Nordhaus: the greatest failure of the market is when a good is subjected to externalities

• Market imperfections: the allocation of goods in an unregulated, purely market-based system will be different from the socially optimal allocation

Reasons for the discrepancies•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• No or inadequate information about environmental effects

• Environmental actors do not consider future effects of their actions

• Unsettled property rights will influence the environmental situation

• Imperfect price system• Cultural and legal differences between

people

Externalities•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Arthur C. Pigou, 1920: Economics of Welfare– He separates private and public costs– He proposes the theory if externalities– He says externalities can be dealt with by taxes– Externalities do not occur on the market (ie.

they do not show up in prices)– The welfare of people is affected by externalities

at least as much as goods affect it– The Pareto-equilibrium is not optimal, because

externalities and actions carried out by others are not priced correctly or at all

Externalities•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• External economic effects, where production or consumption results in an unintended damage or benefit to others without any payment in return.

• Externalities are results of the behaviour of one actor on the benefit of another actor, which do not appear in market transactions. (Samuelson-Nordhaus)

• They are unintended side-effects of legal activities undertaken by people or companies on another person’s profit or welfare

An example•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Two companies are working next to one another, sharing the river: a hotel and a leather tanning factory

• The tanning factory is upstream, the hotel is downstream• The tanning factory takes water from the river, and puts

wastewater back into it• Hotel guests bathe and fish in the river• If the two companies are owned by different people, river

use will be socially inefficient• The leather tanning factory will not feel the reduction in

tourism, because it appears on a different market• It does not receive any icentive for compensation• It will not change any of its actions• Socially efficient distribution of goods will not happen

Another example•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Two different companies are working next to one another: a coal-powered shoe factory and a chocolate factory

• They are owned by two rich families• The soot from the coal-fired shoe factory spoils the

chocolate• The chocolate factory’s owner reports the owner of the

shoe factory – to no avail• The daugher of the owner of the chocolate factory and

the son of the shoe factory owner marry• Suddenly, the two companies become „a joint family

matter”, they are under common control and management

• And they live happily ever after…• …because…

… and a solution•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• With the marriage, the externality has been internalised

• It ceased to be an external problem, and has become an internal problem

• One part of the company was causing damage to the other part of the company

• Finding a solution to the problem has become a necessity – a solution could be found together!

Difference in accepted levels of externalities

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Society will perceive pollution (externalities) differently from polluters

• Private cost of production will be relatively low for the producers

• Social cost of production will be very high for society

• Producers will be affected by the cost of production only, while society will be affected by both production costs and social costs.

What this means• Producers will produce a

quantity which enable them to maximise producer’s surplus

• Taking the environment into consideration, this is inefficient

• The socially optimal quantity is much lower

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

On an environmentally unregulated market

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Too many polluting products will be made• Too much pollution will be done• Prices of polluting products will be too low• As long as costs remain external costs, there is

no single incentive for the use of cleaner technologies, or the production of cleaner products

• Re-use and re-cycling of polluting materials will not be encouraged, because releasing them to the environment is simple and cheap

The effects of externalities•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Demand of factors of production, including raw materials, human resources

• Economic actors will be provided with false informations

• Value-based judgements will be biased, thus distorting allocation of resources

• Distorted calculations will provide an incentive to carry out otherwise socially and sustainably undesirable actions and processes

• The ultimate adverse effects will be felt by both the economy and the society

Types of externalities•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Negative (undesirable)– Persons affected will suffer a loss

• Positive (desirable)– Those affected will unexpectedly benefit

• Affecting producers– The effects of the externality appear at the producer

• Affecting consumers– The effects will be felt by consumers

• These usually come in pairs!

Positive externalities?•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Think of an apple orchard– The farmer installs beehives– Because of the bees, there will be more apples,

but also honey!– He will make extra revenue

• Think of a genetic engineer– He contracts paprika producers to produce paprika– He only needs the seeds for research– The contractees get their money…– … and also the flesh of the paprika, because that is

not needed for the genetic research– They make extra revenue

Positive and negative externalities

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• When you build a motorway– Tourism increases– Pollution increases– Real estate prices increase– Increased tourism provides

extra revenue for the hospitality industry

Other types of externalities•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Reversible externalities– Resources are available to everybody, so the costs of

pollution can be reversed

• Irreversible externalities (unidirectional)– The use of the resource occurs in one direction only,

because e.g. a river

• Ecologically insignificant externalities– The assimilative mechanisms kick in, and the adverse

effects will be cancelled out, the externality disappears

• Ecologically significant externalities– The externality damages the assimilative mechanisms

themselves, the ecosystem gets permanently damaged.

Economically optimal level of externalities

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Environmental protectionists say that such an optimum cannot exist: from a strictly ecological point of view, the optimum is zero!

• In some cases this is economically true, e.g. if the externality is ecologically significant

• In practice, society is often willing to suffer a certain level of externalities for its benefits in welfare

The need for environmental legislation

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Externalities may be treated effectively by internalisation

• We have also shown that markets are incapable of self-regulation

• We need to create a new and improved „invisible hand”

• External costs should be presented as internal costs to decision-makers

• We need to create a link between private damage and social damage, private benefit and external costs

The principal aims of environmental legislation

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Thrifty use of environmental resources• Reduction and prevention of pollution at

an ecologically viable level• Optimalisation of environmental

protection tasks• Converting environmental aims to

economic and consumer goals• The tools for achieving this are

numerous

Pigouvian taxes•The separation

of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• A. C. Pigou suggested that externalities ought to be internalised by the use of taxes

• Aim: human environment becomes a market factor, just like capital and labour

• It recommends the introduction of a particular tax

• This tax is equivalent to the surplus damage done over the optimal level

Practical problems with Pigouvian taxes

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• To be able to determine the optimal level of the Pigouvian tax, we should know the exact details of the pollution

• This is nearly impossible• Producers usually know their own marginal private

benefit, but they are keen to withhold this information

• Producers don’t know the social damage done by their actions

• Informational asymmetry makes the application of the theory in practice nearly impossible

Your assignment for next time

•The separation of private and public costs of pollution

•The concept of externalities

•Socially accepted levels of externalities

•The basics of environmental policy

• Part one: Look at how Ronald Coase attempted to solve problems with externalities

• Part two: Find out more about the environmental policy in your country. Investigate how emission trading schemes work in theory and in practice.

• Hand it in like last time (PDF, electronically)