Yesterday, I taught the basics of externalities, Pigouvian taxes and cap'n trade in my principles of micro class. To motivate it, I talk about sulfur dioxide emissions from coal fired utilities (always a thrill for students). The graph to the right depicts SO2 emissions in the U.S. from 1980 to 2008. As you can tell, SO2 emissions dropped gradually from 1980 to 1990 then fell precipitously thereafter. The reason for the precipitous fall?
Written into the Clean Air Act amendments of 1990, and phased-in in 1995 and 2000 was the SO2 tradeable emissions market: Cap'n Trade.
I then use Cap'n Trade to motivate a standard discussion of externalities: externalities are costs or benefits from market transaction that accrue to a bystander. The economic problem is quite simple, the market fails to capture the full costs or benefits of an action--the market fails to efficiently allocate resources. The economic pie is smaller than it could be if the market were working properly.
The standard negative production externality graph is to the right (a more detailed exposition can be found here): If the market is capturing all of the costs of production (private and social), then the efficient quantity of the associated good--think electricity--is Q* and the efficient price is P*. But, without incentives to internalize the external costs, the private producers will act according to the private cost curve and the market will establish an inefficient equilibrium at a higher quantity and lower price than is efficient.
Solutuions? 1) Price the externality explicitly (Pigouvian tax) so that the private producer faces the social costs of production, or 2) Cap quantities of the externality and allow the market to establish the efficient price (Cap'n Trade). In either case, the private producer will face the social cost of production and the market will establish an efficient allocation of resources.
Cue creepy music for weird dream sequence...
At this point an astute***, and usually conservative, student will point out that SO2 emissions were on the decline from 1980 to 1990, so why the need for additional regulation? Another student, usually with libertarian leanings, will jump in with, 'Additional regulation? SO2 emissions would have been even lower with government regulations to begin with. New Source Review prevented firms from updating antiquated, dirty technologies. Had firms been allowed to update to modern technologies without government regulation, more plants would have cleaner technologies and SO2 emissions would be lower without the need for a socialist Cap'n Trade System." To which I respond: Good point.
So let's take a look at the externality graph without New Source Review (right).
The students all look puzzled. 'Dr. Haab, you made a mistake. That's the same graph as before.' and I respond: 'No mistake. The technological improvements resulting from removal of New Source Review may shift the private supply curve to the right, and may reduce the emissions per unit of output, but that doesn't solve the fundamental externality problem. So even though the technological improvements may reduce per unit emissions, emissions may actually increase from the decreased costs of producing electricity (decrease per unit emissions, but increased units). Regardless, with or without the NSR regulation, there will still be emissions and those emissions will remain unpriced (inefficiently) by the market. '
While I agree that existing regulations may have reduced the incentive for innovation, their existence doesn't change the fundamental market failure--emissions are not rationed through prices. For a market to work efficiently, ALL costs and benefits of production and consumption must be internalized. In such cases, emissions will be efficiently rationed.
***Stop laughing, we do have some astute students. Some hirsute ones too, but that's not really relevant.
