 Welcome to the first technical lecture of the political economy of the environment. Today, I'm going to describe a simple model that illustrates the problem posed by environmental externalities. I will explain what economists view as the efficient level of environmental degradation, how we can arrive at that level of degradation, and why economic inequality can be bad for the environment. Assume that your neighbor heats his home with a wood-burning stove, and the smoke from a stove bothers you. It would cost your neighbor something to pollute less. Specifically, the cost of pollution reduction is given by the following equation. mc equals 2x, where x is the amount of pollution reduction in pounds per year, and mc is the marginal cost to him in dollars. The marginal cost of pollution reduction is increasing. It costs your neighbor just $2 to reduce pollution by one pound. The cost is low because he can keep his home just slightly cooler and wear a sweater. It costs your neighbor $4 to reduce pollution by another pound, or $6 in total. The marginal cost keeps increasing as your neighbor is forced to adopt more and more extreme measures to reduce pollution, like installing solar panels or wearing a hat indoors. We can graph the marginal cost as a function of the number of pounds that your neighbor reduces his pollution. The marginal cost curve has an intercept of zero and a slope of two. It looks like this. The pollution next door bothers you. The benefit of pollution reduction is given by the following equation. mb equals 60 minus x, where x is the amount of pollution reduction in pounds per year, and mb is the marginal benefit to you in dollars. The marginal benefit of pollution reduction is decreasing. The first pound of pollution reduction is worth more to you, $59 to be exact, than the 60th pound of pollution reduction, which is worth $0 to you. The marginal benefit curve has an intercept of 60 and a slope of minus one. It looks like this. Now we have a graph that illustrates both the marginal cost to your neighbor and the marginal benefit to you of pollution reduction. Note that in this example, the benefits and the costs are given in terms of pollution reduction, which we call x. However, we could analyze the costs and benefits of pollution rather than pollution reduction. Let's say that the level of pollution is equal to 60 minus any pollution reduction. So p equals 60 minus x. We can rearrange terms to see that x equals 60 minus p. The marginal benefit of pollution reduction is the same as the marginal cost of pollution. By substituting 60 minus p for x, we see that the marginal cost of pollution equals 60 minus 60 minus p, which equals p. We can graph the marginal cost of pollution like this. Similarly, by substituting 60 minus p for x, we can see that the marginal benefit of pollution equals 2 times 60 minus p, or 120 minus 2p, which we can graph like this. Analyzing this problem in terms of pollution instead of pollution reduction would give us the same answers. However, today we will analyze this problem in terms of pollution reduction to better follow the examples in your readings. The cost and benefit of pollution reduction illustrates the problem posed by environmental externalities. How much will your neighbor voluntarily reduce his pollution? The answer is not at all. Reducing pollution by even one pound costs him $2, so he won't do it if he doesn't have to do it. Of course, the problem here is that your neighbor is ignoring the environmental externality that his pollution imposes upon you. After all, reducing pollution by one pound is worth $59 to you. Your neighbor will not voluntarily reduce his pollution, but this outcome is inefficient or suboptimal. What is the efficient or optimal level of pollution? The first pound of pollution reduction is worth $59 to you and costs your neighbor $2. So reducing pollution by one pound increases social welfare by $57, as illustrated by this green line. The second pound of pollution reduction is worth $58 to you and costs your neighbor $4 more. So reducing pollution by another pound increases welfare by an additional $54, as illustrated by the second green line. Your neighbor would maximize social welfare, but not his individual welfare, by continuing to reduce his pollution until the marginal benefit to you no longer exceeded the marginal cost to him. So what is the efficient level of pollution reduction? We can find out by simple calculating when the marginal cost of pollution reduction equals marginal benefit of pollution reduction, or where 2x equals 60 minus x. By solving for x, we find that the efficient level of pollution reduction is 20 pounds per year. How much would social welfare increase if your neighbor reduces pollution by 20 pounds per year? We can simply calculate the difference between the benefit and the cost of reducing pollution. This is equal to the area of the green triangle, or one half, times $60, times 20. Reducing pollution to its efficient level would increase social welfare by $600. So how do we get your neighbor to reduce his pollution by 20 pounds? There are multiple solutions to the problems posed by environmental externalities. Perhaps the most obvious solution is government intervention. The government could simply mandate that your neighbor reduces pollution by 20 pounds. To do this though, the government would need to know both the marginal cost and marginal benefit of pollution reduction. Calculating the marginal cost and marginal benefits of pollution reduction is difficult, but not impossible. We'll discuss this later when we learn about benefit cost analysis. Another clever solution was offered 50 years ago by an economist named Ronald Koss. Koss showed that bargaining between individuals can lead to efficient levels of pollution reduction, if property rights are well enforced, and if transaction costs are absent. In our example, assume that your neighbor has the right to pollute all he wants, but that you can pay him to reduce how much he pollutes. Could you two make a deal? Yes, you could, because reducing pollution by 20 pounds benefits you more than it costs your neighbor. Your neighbor would be willing to reduce pollution if you pay him more than it costs him to do so. The cost of him is illustrated by this green triangle, which is equal to $400. You would be willing to pay much more than $400 to reduce pollution by 20 pounds. After all, the benefit to you is illustrated by this large green trapezoid, which is equal to $1,000. As long as bargaining between you and your neighbor is costless, and as long as the government enforces any agreement you make, you and your neighbor will strike a bargain in which you pay your neighbor between $400 and $1,000 to him to reduce pollution by 20 pounds. Ronald Coase went on to show that, as long as property rights are well enforced and transaction costs are zero, individual bargaining will lead to the efficient level of pollution reduction, regardless of how pollution rights are initially distributed. This theoretical result is known as the Coase theorem. To understand it, assume that your neighbor does not have the right to heat his home with a wood-burning stove, but that he can purchase pollution rights from you. Again, your two would be able to strike a deal, because allowing him to pollute some would decrease his costs by much more than it decreases your benefits. You can calculate how much you would be able to charge your neighbor to increase his pollution on your own. In the real world, bargaining between polluters and people will not lead to efficient levels of pollution, because transaction costs are not zero. Imagine how time consuming it would be for all the people who live near a coal power plant to sit down with the owner and strike an agreement on how much the plant will reduce its pollution. But that isn't the only problem with the Coase theorem. Even our example, in which there are just two people so bargaining is nearly costless, illustrates important aspects of the political economy of the environment. First, the Coase theorem suggests that your neighbor will end up polluting at the efficient level, regardless of whether he initially has the right to pollute. But whether or not he has the right to pollute will affect you. After all, if he has the right to pollute, he could charge you up to $1,000 to reduce pollution by 20 pounds. Is that fair? Second, it is crucial to recognize that within this framework, both the benefits to you and the costs to your neighbor are measured in dollars. However, it isn't necessarily true that a dollar is worth the same to you as it is to your neighbor, especially if your incomes are quite different. To drive this point home, imagine that you lose your job and become poor. What will this do to the marginal benefit of pollution reduction? Since those benefits depend on how much you be willing to pay to reduce your neighbor's pollution, your poverty will almost certainly reduce the marginal benefit of pollution reduction. You are now not willing or able to pay as much in exchange for less pollution. Assume that your marginal benefits of pollution reduction are now given by the equation mb equals 30 minus x. Graphically, it would look like this. On your own, consider how the impact of your job loss and the associated increase in incoming equality affects the efficient level of pollution. What is the efficient level of pollution now? And is that level of pollution fair? Given your answer, where would you expect polluters to site toxic plants? And again, given your answer, what would you expect to happen if income inequality increases? Thanks for listening to your first technical lecture on the political economy of the environment.