Choosing the Most Efficient Remedy for Externalities

selecting the most efficient method of minimizing externalities can be a complicated process. To illustrate, we will compare the costs of two approaches to controlling pollution, government standards versus property rights

Suppose five firms are emitting sulfur dioxide, a pollutant that causes acid rain. The reduction of the unwanted emissions can be thought of as an economic good whose production involves a cost.  We can assume that the marginal cost of reducing sulfur dioxide emissions will rise as more and more units are eliminated. We can also assume that such costs will differ from firm to firm. Table 7.1 incorporates these assumptions. Firm A, for example, must pay $100 to eliminate the first unit of sulfur dioxide and $200 to eliminate the second. Firm B must pay $200 for the first unit and $600 for the second. Although the information in the table is hypothetical, it reflects the structure of real-world pollution clean-up costs.  The technological fact of increasing marginal costs faces firms when they clean up the air as well as when they produce goods and services.

Suppose the Environmental Protection Agency (EPA) decides that the maximum acceptable level of sulfur dioxide is ten units.  To achieve that level, the EPA prohibits firms from emitting more than two units of sulfur dioxide each. 

Remember that the EPA can control the number of tickets it sells.  To limit pollution to the maximum acceptable level of ten units, all it needs to do is sell no more than ten tickets. Either way, whether by pollution standards or rights, the level of pollution is kept down to ten units, but the pollution rights method allows firms that want to avoid the cost of a cleanup to bid for tickets.

The potential market for such rights can be illustrated by conventional supply and demand curves. The supply curve is determined by EPA policymakers, who limit the number of tickets to ten. Because in this example the supply is fixed, the supply curve must be vertical (perfectly inelastic). Whatever the price, the number of pollution rights remains the same. The demand curve is derived from the costs firms must bear to clean up their emissions. The higher the cost of the cleanup, the more

At a price of $1,500 per ticket, firm A will buy one and only one ticket. At that price, it is cheaper for the firm to clean up its first four units (the cost of the cleanup is $100 + $200 + $400 + $800). Only the fifth unit, which would cost $1,600 to clean up, makes the purchase of a $1,500 ticket worthwhile. Similarly, firm B will buy three tickets, firm C none, firm D two, and firm E four.

The cost of any cleanup must be measured by the value of the resources that go into it. The value of the resources is approximated by the firm’s expenditures on the cleanup—not by their expenditures on pollution tickets.  (The tickets do not represent real resources, but a transfer of purchasing power from the firms to the government.)  Accordingly, the economic cost of reducing pollution to ten units is $9,300; $1,500 for firm A. $800 for B, $3,000 each for C and D, and $1,000 for E

The idea of selling rights to pollute may not sound attractive, but it makes sense economically.  When the government sets standards, it is giving away rights to pollute. In our example, telling each firm that it must reduce its sulfur dioxide emissions by three units is effectively giving them each permission to dump two units into the atmosphere.  One might ask whether the government should be giving away rights to the atmosphere, which has many other uses besides the absorption of pollution. Though some pollution may be necessary to continued production, that is no argument for giving away pollution rights. Land is needed in may production processes, but the Forest Service does not give away the rights to public lands. When pollution rights are sold, on the other hand, potential users can express the relative values they place on the right to pollute.2 In that way, rights can be assigned to their most valuable and productive uses.