Exploring Externalities

15. Suppose that you are the head of a pollution-control agency and you desire to cut the pollution in Starry River by one-half. The polluters, the amount they pollute, and their marginal costs of reducing wastes are given in the following table. Your staff has proposed three options. With Option A, you require each firm to reduce wastes by one-half. With Option B, you require each firm to reduce wastes by 300 tons. With Option C, you put a tax on the discharge of $5.50 per ton.

What is the cost to society (how much in resources is required) to clean up the river by one-half under each option? What is the cost to business under each option? Which will economists be most likely to propose? Which will the Chamber of Commerce support?

16. The analysis of the last question was the way economists once approached the problem of pollution, and this analysis suggested that a pollution tax was a good idea. There are two problems with this solution. First, as you can see from the results, the companies consider a pollution tax the most expensive option and, hence. will fight it. As a result, it is very difficult to enact pollution taxes. Second, the efforts that companies spend fighting the tax calls into question the assumption that taxes are simply a transfer that does not use resources. The notion of rent seeking suggests that people spend resources trying to obtain transfers or avoid paying them, and hence assuming transfers as "free" is dangerous.

There is, however, another policy option, one that has proven easier to enact. We can create a market in pollution rights. Again, suppose that we want to cut pollution by one-half. The total amount of pollution is 2400, so we will allow 1200. We grant each company a right to pollute 300 tons. If they want to pollute more, they can do so by buying pollution rights from another company. For example, Hercules Int. finds it cheap to clean up, so if the price of pollution rights exceeds $3.00, it would make more money by selling its rights to someone else and cleaning up all of its pollution.

What will the equilibrium price of pollution rights be if everyone acts to maximize profits? Who will buy and who will sell pollution rights? What will the cost of this policy look like to the companies? What will it look like to society as a whole?

(The phrase "cap and trade" is often used for markets for pollution rights. If government sells pollution rights to the highest bidder, cap and trade is equivalent to a pollution tax. If government gives away pollution rights, it encourages rent seeking as various firms lobby for rules that favor them.)

17. Economists believe that only humans matter, at least when they are discussing economic efficiency. Suppose that a waste product is harmful to animals but does not harm humans. Can it be pollution? Should we consider effects on animals and plants independent of effects on humans? Some people believe that plants and animals, as coinhabitors of the planet, have the same rights as humans. Do you agree or disagree? (Comment: Here is another way to get at this issue. Quite a few years ago, a child was born with a defective heart. In an attempt to save the child, the doctors at the hospital transferred a heart of a baby baboon into the human infant. At the time, there was considerable controversy about whether this was good medical practice, but we will ignore this question. There was also a group of people who said it was morally wrong to kill the baboon to save the human. They argued that the baboon had as much right to life as the human did. Do you agree or disagree? Why?) If you think that animal preferences should matter, how would you have to adjust the notion of economic efficiency?

18. If you decide to walk around in most communities in the United States without clothing, you will be arrested. Can you justify this? Suppose a community made it illegal for ugly people to walk around town. How would this be different from making it illegal for people to appear in public nude?

19. Externalities are everywhere, but we do not always take them seriously. Which of the following do you think we should consider as legitimate externalities? Why?

a) My neighbor burns his trash and it stinks.
b) My neighbor has loud parties at 3:00 am.
c) My neighbor breaks his leg and I am pained by knowing that he is in misery.
d) My neighbor buys a new car and I am jealous because now he looks more successful than me.
e) My neighbor keeps his dog in a tiny cage and I feel sorry for the poor animal.
f) My neighbor gets a promotion and I am unhappy because he is happy.
g) My neighbor has painted his bedroom walls purple and black and just the knowledge that such a hideous room is next door causes me pain.

20. Zeke and Zach live in an arid region. Zeke grows crops while Zack raises cattle. They both need water, and there is water underground. Suppose that this water is worth $40,000 to Zeke and $30,000 to Zach. Assume there are no transactions costs. What will happen if Zeke owns the water? What will happen if Zach owns the water? In terms of the distribution of wealth, does it matter owns the water? In terms of what gets produced, does it matter who owns the water?

Now suppose that Sal and Sam are neighbors. Sal fishes and Sam farms. Sam's use of pesticides benefits her by $10,000 but the runoff, which cannot be avoided, costs Sal $8000. Assume there are no transactions costs. What will happen if Sam has the right to use the pesticide? What happens if Sal has the right to clean water? What idea is this example trying to illustrate?

Given that transactions costs are never zero, what is the point of examples of this sort?

(This question illustrates in a very simple way an insight from Ronald Coase, that in the absence of transactions costs, externalities would not result in economic inefficiency. When you understand the implications of what Coase was saying, go back to the two previous questions and see if you can explain why some externalities result in laws prohibiting certain actions, and some externalities are usually ignored.)

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