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Economics of Pollution

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Economics of Pollution

We can all agree that humanity can't survive in a heavily polluted environment, and we can't live comfortably without polluting a little bit. So, do we need a Captain Planet to help us find a balance? How do we figure out a market equilibrium where the pollution quantity satisfies our consumption needs while not causing too much suffering? How do we balance the costs and benefits of pollution? What about the trade-off between our current consumption and the well-being of future generations? If you want to learn more about all of the above, keep scrolling!

Economics of pollution meaning

What do we mean by the economics of pollution? Well, economics is all about the trade-off between costs and benefits. It's no exception when it comes to the topic of pollution - with one important caveat. There is the problem of externalities. In fact, pollution is a classic example of an external cost. When a factory emits pollution into the air or a river, it doesn't have to bear the cost of that pollution. So if pollution is left unchecked, as in the case of a completely free market, there will be too much of it.

The Economics of Pollution Key Concept

As always, the key concept in the economics of pollution is the marginal cost and marginal benefit. But since we are dealing with an externality problem in the case of pollution, we need to distinguish the marginal social cost from the marginal private cost and the marginal social benefit from the marginal private benefit. With these, we can figure out the socially optimal quantity of pollution.

To learn more check our article on - Externalities!

Economics of Pollution: Examples

Some argue that pollution is a necessary evil of development; it makes some people better off and others worse off. Anyone trying to articulate how we arrive at a socially optimal pollution price and quantity must demonstrate how we arrive at a point where the marginal benefit from an additional unit of pollution equals the marginal cost.

Marginal Social Cost of Pollution

In a case where externalities exist, the true marginal cost that we consider is the marginal social cost.

The marginal social cost of pollution is the additional cost that society as a whole has to bear each time an additional quantity of pollution is released.

Indoor cooking with charcoal stoves harms our lungs; any extra ton of carbon monoxide released in our households increases negative effects like lung disease. When we decide to cook with charcoal, we would consider the private cost - both the cost of buying the charcoal and also the health damage to us. But this pollution would also affect our neighbors if we live close enough. The marginal health damage to the neighbors is a marginal external cost. The marginal social cost in this case is the sum of the marginal private cost to us plus the marginal external cost to our neighbors.

Another example is a polluting factory that dumps its wastewater into a nearby river. In the factory's production decisions, it only considers the private marginal cost of producing one more unit of product - using more energy, materials, and workers. It doesn't consider the marginal external cost of dumping more wastewater into the river, which would cause more harm to the people who live downstream along the river and those who would like to use the river. The marginal social cost of producing one more unit of product here is the marginal private cost to the factory plus the marginal external cost of more water pollution.

Marginal Social Benefit of Pollution

Economists also look at the additional gains that society as a whole makes from polluting activities.

The marginal social benefit of pollution is the additional benefit that society as a whole can derive from an additional quantity of pollution.

These benefits may seem superficial, however, when the economic agents' expenditure of resources to avoid pollution is greater than the costs of pollution itself, then the marginal benefit to society may have been lost because these resources could have been utilized differently. An example might help clear things up.

A factory is polluting the air with certain gas emissions. If emissions of this particular gas are very difficult to tackle, then the resource expense on reduction of such emissions would be substantial. Imagine now that the government instead allowed the factory to emit additional X amount of tonnes of emissions of this particular gas, but would impose an obligation for the factory to invest these resources into a technology that would reduce the emissions of all other gases by Y amount into the atmosphere. As long as Y>X, this scenario would result in a marginal social benefit to society from the overall pollution reduction.

Socially optimal quantity of pollution

Nowadays, governments are pushing for responsible economic growth that achieves a socially optimal pollution quantity within manageable social costs. However, achieving that socially optimal pollution quantity is easier said than done; a free market economy operating with minimal government intervention can only deliver a free market equilibrium.

The socially optimal quantity of pollution is the quantity of pollution that society would choose when all costs and benefits are taken into consideration. It is the quantity where the marginal social cost of pollution equals the marginal social benefit of pollution.

Let's illustrate this with the example of a polluting factory in Figure 1 below. There is a factory that makes jeans which produces a lot of water pollution. The factory dumps this wastewater into a river. The water pollution is an external cost that the factory does not consider. In its production decision, the factory considers its marginal private cost (MPC) and marginal private benefit (MPB). To maximize profit, it produces up to the point where MPC equals MPB at Qf - this is the free-market equilibrium when the external cost is not taken into account.

We are assuming that there is no external benefit in manufacturing jeans, so the marginal social benefit (MSB) curve is the same as the MPB curve. Because water pollution is an external cost, the MSC curve is higher than the MPC curve. The socially optimal quantity of pollution occurs when these two curves intersect at Qs. We can see that when there is an external cost, the socially optimal quantity is less than the free-market equilibrium.

economics of pollution Socially optimal quantity of pollution studymsarterFigure 1. Socially optimal quantity of pollution, StudySmarter Originals

Pollution as an external cost

Free market resource allocators act in their best interest to maximize their profits. These actors expect society to deal with the negative effects of their activities, and society blames political actors for allowing excessive pollution without environmental tools that protect public interests.

A classic example is the oil spill in the Gulf of Mexico, where British Petroleum (BP) cut corners and procured cheap off-shore drilling equipment that helped the company maximize profit over a longer time horizon. Unfortunately, this profitability drive led to huge external and social costs. BP couldn't compensate coastal communities when a catastrophic oil spill upended livelihoods along the coast of Louisiana, U.S.A.

Millions of sea animals died or remain contaminated to this day. The seafood industry supply curve shifted to the left as fish quantity dwindled and prices skyrocketed. The Louisiana fish industry is still dealing with negative effects that economists call negative externalities. On the other hand, China enjoyed unexpected external benefits due to positive externalities as the seafood market reached out to Chinese suppliers to fulfill the desired quantity.

A disruptive war can have costs and benefits on markets.

The conflict between Russia and Ukraine delivered negative and positive externalities when the United States and its allies imposed sanctions on Russian oil.

This conflict disrupted the oil industry and pollution in two ways:

  1. The oil supply curve shifted to the left, as the quantity supplied diminished, and prices rose substantially. Economic actors responded by increasing gas prices at the pump; American drivers had to abandon private cars and use public transport in some cities. You can argue that this economic outcome had some environmental benefits since driving fewer cars reduced the overall pollution quantity and lowered the social costs.
  2. Russia offered considerable discounts to countries willing to buy its oil as it needed the money to sustain its economy. China and India sidestepped the sanctions and continued trading with Russia with the view that this economic outcome was a positive externality unleashing cost benefits from every extra oil barrel they bought from Russia. You can also submit that if China and India continue accessing such cheap crude oil, they will drive more, manufacture more, and increase their pollution quantity and environmental and therefore social costs.1

Economics of pollution control: private solutions to externalities

We can all agree that the most effective way to resolve externalities is through government interventions that define environmental tools, penalties, and incentives that encourage economic actors to engage in activities that minimize social costs. However, the Coase theorem states that under some conditions, the free market would be able to solve the externality problem.

Coase Theorem

The Coase theorem argues that in a free-market economy with clearly defined property rights and low transaction costs, individuals and firms can efficiently allocate resources and resolve externalities without involving the government or political actors.

Parties can resolve these issues if they:

  • clearly define their legal rights
  • properly enumerate transaction costs incurred by each party.

These transaction costs can be legal fees on issues involving lawyers and bank charges and licensing expenses incurred to notarize the concessions.

Imagine a community that planted trees to help reduce pollution in an area. Suddenly, these same trees are at the heart of a local dispute involving two neighbors. The tree owners need those trees to act as a carbon monoxide absorption mechanism. But unfortunately, one of the neighbors argues that some trees are too close to his property and can easily fall on his house, destroy the property or kill the occupants.

Both parties have a legitimate argument for or against the trees, but the law is not enough to determine whose rights are more important. The tree owners have a right to grow anything on their property, and the next-door neighbor has a right to protect his house occupants from tree limbs that may come down with hurricane or tornado force winds.

You can apply the Coase theorem to help break the stalemate since these parties can reach a private deal that clearly outlines each party's legal rights and costs each may incur to accommodate the other.

For example, the tree owners can keep their trees and agree to reimburse the neighbor when tree limbs damage his house. Also, the neighbor can consent to incur any expenses involving trimming branches, cutting down trees, and replanting the tree in another location.

Agreements of this kind help parties settle with a well stipulated compensation mechanism regardless of individual rights.

If the benefits enjoyed from keeping the trees outweigh the costs of repairing a damaged house, then the trees will stay, and neighbors will have some peace. Conversely, neighbors will coexist strife-free if cutting down trees and replanting them away from properties offers benefits that outweigh the property damage compensation.

The Coase theorem helps parties tackle externalities without resorting to inefficient outcomes since both actors will come out better off, with negligible costs. When economic actors reach a deal that irons out external cost, they are said to have internalized the externalities. We consider such an outcome efficient even if it did not involve any act of government intervention.

However, this kind of outcome is not always achievable in most cases because the transaction costs may differ.

One neighbor may argue that the cost of replanting, growing, and maintaining the tree overtime was much higher than anticipated. The other party may argue that carrying the cost of repairing a damaged rooftop is unreasonable and suggest that neighbor needs to get their property insured and stop worrying about tree damage. These arguments would increase the transaction costs and tank the deal.

Economics of Pollution - Key takeaways

  • The marginal social cost of pollution is the additional cost that society bears when an additional quantity of pollution is released.
  • The marginal social benefit of pollution is the additional gains to society from an additional quantity of pollution.
  • The socially optimal quantity of pollution is where the marginal social cost of pollution equals the marginal social benefit of pollution.
  • Pollution as an external cost: the free market will produce a higher quantity of pollution than the socially optimal level when the external cost of pollution is not taken into account.
  • Government interventions shape environmental tools, penalties, and incentives that discourage excessive pollution and minimize social costs.
  • The Coase theorem, argues that private individuals can efficiently allocate resources and resolve externalities without involving the government.

Sources:

1. Weizhen Tan - India is snapping up cheap Russian oil and China could be next (2022, March 28, CNBC)

Frequently Asked Questions about Economics of Pollution

Economics is all about the trade-off between costs and benefits. When it comes to pollution, the socially optimal level is where the marginal social benefit of pollution equals the marginal social cost of pollution.

Figuring out the socially optimal level of production for a polluting factory.

The marginal social cost of pollution is the additional cost that society as a whole has to bear each time an additional quantity of pollution is released. 

The marginal social cost (MSC) of pollution, the marginal social benefit (MSB) of pollution, and the socially optimal quantity of pollution.

Pollution is an external cost, so if it is not considered by economic actors, the free market will produce too much of it.

Final Economics of Pollution Quiz

Question

How would you classify pollution? A negative or positive externality?

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Answer

Negative Externality

Show question

Question

Why does pollution pose a problem to the free market?

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Answer

Pollution is a classic example of an external cost. When left unchecked, the market will generate too much pollution.

Show question

Question

What is an external cost when people use charcoal stoves to cook?

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Answer

the health damage that it causes to the neighbors

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Question

What are the social costs when you use charcoal to cook?

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Answer

The private cost of buying the charcoal and suffering negative health effects yourself plus the external cost such as the health effect that it has on your neighbors.

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Question

What does a factory consider when it dumps wastewater into a river?

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Answer

It only considers the private marginal cost of producing one more unit of product - using more energy, materials, and workers. It doesn't consider the marginal external cost of dumping more wastewater into the river, which would cause more harm to the people who live downstream along the river and those who would like to use the river

Show question

Question

The optimal amount of pollution is achieved when ______

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Answer

MSB = MSC

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Question

Give some examples of pollution-related external costs.

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Answer

1.  Poor crop yield -- contaminated land.

2.  Poor labor productivity -- sick employees.

3.  High health expenditure -- respiratory infections.

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Question

What is the marginal social benefit of allowing a factory to emit a ton of carbon dioxide?

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Answer

The resource that it can save from having to spend on pollution mitigation and thus can invest in other areas

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Question

What do you know about Coase Theorem? 

Show answer

Answer

The Coase theorem argues that in a free-market economy with clearly defined property rights and low transaction costs, individuals and firms can efficiently allocate resources and resolve externalities without involving the government or political actors.

Show question

Question

What do you know about a socially optimal pollution quantity? 

Show answer

Answer

The socially optimal level of pollution is when the marginal social cost of pollution equals the marginal social benefit of pollution.

Show question

Question

What is the marginal social cost of pollution?

Show answer

Answer

The additional cost that society as a whole has to bear each time an additional pollution quantity is released.

Show question

Question

What is the marginal social benefit of pollution?

Show answer

Answer

The marginal social benefit of pollution is the additional benefit that society as a whole can derive from an additional quantity of pollution.

Show question

Question

What are transaction costs, in relation to the external costs of pollution?

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Answer

The costs that firms or individuals incur when negotiating or settling a dispute. 

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Question

What does MSB stand for?

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Answer

Marginal Social Benefit

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Question

What does MPB stand for?

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Answer

Marginal private benefit

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What does MSC stand for?

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Answer

Marginal social cost

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Question

What does MPC stand for?

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Answer

Marginal private costs

Show question

Question

In the following definition identify the incorrect segment out of the highlighted options.

The marginal social cost of pollution is the additional cost that a firm as a whole has to bear each time an additional quantity of pollution is released.  

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Answer

a firm

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Question

In the following definition identify the incorrect segment out of the highlighted options.

The marginal social benefit of pollution is the additional benefit that society as a whole can derive from any quantity of pollution.

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Answer

any

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Question

In the following definition identify the incorrect segment out of the highlighted options.


Pollution as an external cost: the free market will produce a lower quantity of pollution than the socially optimal level when the external cost of pollution is not taken into account.

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Answer

lower

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Question

If coase theorem were used in practice, then a medical device firm that needs to cut down rainforest for land will:

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Answer

Pay a portion of the lost rain forests benefits.

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Question

Why does coase theorem only work in practice?

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Answer

High transaction cost and imperfect information.

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Question

If a firm is providing larger social benefits than the cost of pollution it makes, should the firm be forced to pay for pollution?

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Answer

Yes, in a perfect economy all costs and benefits are accounted for.

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Question

Why doesn't the government measure pollution for businesses?

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Answer

Because it would require government workers to perform frequent geological surveys on every inch of the country. Also, the supreme court said "no".

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Question

Why doesn't the government enforce all its environmental regulations?

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Answer

Enforcement costs are very high, they must first measure the damage, then prove through courts the polluter's wrongdoing.

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Question

What presidential candidate received backlash over their employment at a firm whose function is to help businesses skirt environmental regulations and consequences?

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Answer

Pete Buttigieg at Mckinsey

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Question

Pollution is widely accepted as an unwanted outcome, why isn't it adequately addressed in the United States?

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Answer

Unequal distribution of political influence.

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Question

What are SLAPP suits?

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Answer

SLAPP suits are legal procedures and fees used to intimidate not to mess in someone's business. (Strategic lawsuits against public participation)

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Question

In an ideal perfectly competitive market, would there be an inequitable amount of pollution?

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Answer

No, in an ideal economy all costs are accounted for, and any excess pollution cost would be made efficient.

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Question

How effective is a personal choice in persuading companies to be more environmentally friendly?

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Answer

Not effective, not enough consumers have the time or money to actively support and reject goods based on their environmental outcomes.

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Question

Who designed the carbon footprint idea and the concept of personal accountability?

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Answer

British Petroleum

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