1.

Analytical Tools (a review of micro principles)

2. Externalities, Public Goods, and Common Property Problems
A. Externality: a spillover effect associated with the production
or consumption that extends to a third party outside the
market.
B. Public Goods: a commodity that is non-rival in consumption
and yields benefits that are non excludable.
a. Free Rider Problem: people will hope to pay less for a
public good with the hopes that someone else will pay
more. (For private goods this is theft)
C. Externality Problem V. Public Good Problem
a. Depends on how one looks at the market. For
example, clean air is a public good and electricity
produces pollution which is an externality.
D. Property Rights: the set of valid claims to a good or resource
that permits its use and the transfer of its ownership
through sale.
a. Coase Theorem: This theorem states that proper
assignment of property rights to any good, even if
externalities are present, will allow bargaining
between the affected parties such that an efficient
solution van be obtained, no matter which party is
assigned those rights. (Must assume that transactions
are costless and damages are accessible and
measurable.)
b. Property rights are critically important to the sound
functioning of the market system. Who owns the air?
Who owns the water? Do recreational users have the
right to clean air/water or do firms have the right to
pollute the air/water?
c. Common property resources: those for which property
rights are shared by some group of individuals. (i.e.
ocean fishing)
i. Fall between pure public goods and pure private
goods.
ii. Public access without any control leads to
resource exploitation, which in turn generates a
negative externality.
d. From an economic perspective, the general solution to
externalities, including those affecting the
environment, is to internalize the externality, that is,
to force the market participants to absorb the external
 costs or benefits.
i. Assignment of property rights. If recreation
users own resource, then the firm can internalize
the externality by paying them to pollute. If the
firms own the resource, recreational users can
compensate the firm not to pollute as much.
ii. Impose policies that change the effective price of
a product by the amount of the associated
external cost or benefit. For example, a refinery
may suffer a tax that raises the price per barrel
of oil by an amount equal to cost of the
externality.
iii. Establish a market and price for pollution and
charge firms accordingly.
3. Pollution Abatement
A. Command and Control/standards
a. Gov’t mandates how things must be done.
B. Standards
a. Engineering and technology based.
b. Performance
c. Hybrid of previous 2
i. Either technology is introduced that everyone
must employ or standards are set that
everyone must meet through whatever
technology necessary.
ii. Employing these standards is easy but
monitoring there compliance is costly.
C. Market Mechanisms – uses incentive-based policy tools to
motivate abatement through market fources.
a. product charges (tax on output) – the government
can tax a product that has pollution as an output. In
order for the government to set an efficient tax, they
must know the private marginal costs as well as the
marginal damages.
i. It is easier to determine marginal social
benefit.
ii. Firms have a reason to strategically
misrepresent their costs.
iii. The goal is not to increase tax revenue, it is to
get the firm to internalize the externality.
b. emissions charges (tax on emissions)
i. Instead of taxing the goods produced, the gov’t
 can tax the emissions. (the bads)
a) This automatically results in the most
cost efficient method of reducing a given
quantity of pollution.
c. subsidies –give an incentive to improve technology
to pollute less.
i. Instead of taxing the firm, the gov’t may give a
reqard/subsidy to firms that reduce emissions.
ii. Pay money for reduced emissions.
iii. Pay for technology for pollution reducing
technology so the firm doesn’t have to.
d. deposit/refund system, environmental bonding – a
bond is deposited and then returned if certain
conditions are met.
e. emissions permit trading
i. Auctioning environmental permits may avoid
problems.
a) Less problematic for new entities to enter
markets.
ii. Permits are treated by firms as taxes.
a) Depends on how auctions are set up.
b) Auctions have “winner curse”
c) Need to be aware of how many are
available as this effects price.
iii. If gov’t sets the optimal number of permits,
non-emitters will not want to participate.
iv. Gov’t must continually monitor that emittors
have the proper number of permits.
v. Taxes and permits treat all pollutants the same.
vi. Inflation should always be included in permit
prices.
vii. Choose permits when you want to be certain of
emissions. Choose taxes when you want to be
certain of costs. In reality benefits are known
and costs are not.
E. Marginal social benefit of abatement: benefit derived from
the reduction in one more unit of pollution.
a. Includes the cost incurred by emitters.

4. Benefit-Cost Analysis – Initially banned from use for

determining pollution standards. In public policy, MB and MC are
largely unknown – these values are purely estimates.

A. Techniques for Benefit Estimation

a. Health Damages Approach -- damage function method –
the researcher specifies a model of the relationship between an
environmental contaminant and some type of observed damage.
Once the function is specified, the analys uses the model to
estimate the damage reduction from any policy-induced decline
in the contaminant. (measured in non-monetary units). Limited
in that it only estimates one aspect of incremental benefits, this
procedure would need to be repeated for every different type of
damage for complete accuracy. Also, this procedure is only a first
step approach in that it is not capable of simultaneously
monetizing the benefits it quantifies.
a) Examine individual behavior
a. mitigating behavior (averting expenditure model) – what
do you do you do to avoid the costs imposed by
pollution?
b. travel cost method – how much would people be willing
to pay to get there. i.e. National parks.
c. hedonic price method – A price is the sum of its parts.
Breaking goods down to their basic elements to estimate
their prices.
b) Contingent valuation
a. Dose Response Function: how a health related problem
responds to a reduction in a contaminant.
i. i.e. less asmtha or coughing as a result of improved
air quality. Each unit improvement in air quality
improves asthma and coughing. Survey people to
determine what such improvements are worth.
(can look at what they spent on them as well.)
b. Survey method: ask people what they are willing to pay.
c. Before the fact: “how much would you be willing to pay IF
pollution is abated?”
d. Can be used to value resources that people don’t use: i.e.
paying for endangered specie protection.
e. Survey must be properly designed.
i. Must clearly state design of program so that the
individual can make a sound valuation.
ii. Must have a mechanism for eliciting value.
1. Free rider problem
2. WTP and WTA
 iii. Must be able to determine the characteristics of the
respondent – make sure that sample is
representative of population as a whole.
f. Political Referendum method

B. Techniques for Cost Estimation

a. Survey approach - above
b. Engineering approach – uses information of what
technology is available and calculates the cost based on the
most efficient approach.
c. Combined approach – Combine the above two.

C. Problems with Benefit-Cost Analysis

a) Strategic Bias: Respondents to surveys’ do not need to put
their money where there mouth is.
a. They may lie about how much they are willing to pay
because their response has no immediate cost.
b) Information Bias: people may have no experience or
understanding of the contingency.
c) Hypothetical Bias: people may not treat the issue seriously.
a. i.e. They may give a response just to say something
with no actual representation of their true WTP or WTA
d) Choosing the correct discount rate
a. High social discount – may react when interest falls
and do something you may regret.
b. Are the future generations rights to be respected now?
c. People argue that a value lower than the risk free rate
should be used to discount decisions that will affect
people in the future.
i. The future will be richer and have more
resources.
d. Treat future problems differently than current ones.
Time horizon matters a great deal.
i. Lower rate/ longer horizon = greater weight than
something given a higher discount rate.
1. i.e. global warming has a lower discount
rate than 3rd world hunger.
e) Risk and uncertainty
a. With the environment, the future is in large part
uncertain.
i. Uncertainty about future technological changes
in abatement.