Consider the standard demand and supply diagram with pollution
(click on the thumbnail to the right for a bigger image). An
unregulated market leads to equilibrium price and quantity determined at the
intersection of the supply, or marginal private cost (MPC), curve and the
demand curve: P1, Q1.
Consumers and producers enjoy the gains from this equilibrium. The consumer surplus is the difference between willingness to pay (height of the demand curve) and price: area a + b + c + d. You enjoy consumer surplus every time you buy something and get a "good deal."
The producer surplus is the difference between the revenue earned on each unit (P1) and its marginal cost of production: area f + g + h (note that f includes the tiny triangle below P1 and above the MSC curve). Producer surplus is equivalent to profit without the fixed cost (e.g., monthly lease payments that don't change with output).
Unfortunately, production of Q generates some harmful side (i.e., external) effects
such as fewer healthy days, fewer recreation opportunities, etc:
marginal external cost = MEC. If these costs are constant then the full
costs to society of production of Q is the marginal social cost curve:
MSC = MPC + MEC. The external costs of Q1 are equal to area c + d + e +
f + g + h. (Nothing in the conclusions changes if the MEC is increasing in Q0.
Environmental regulation is designed to get firms to "internalize
the externality" by considering the external costs of production. If
firms face a constant pollution tax on each unit of output so that they face
production costs equivalent to the MSC curve then the new market
equilibrium will be P2, Q2. The regulated product market will have a
higher price and lower quantity.
At the new equilibrium, consumer surplus is area a and producer surplus is h. Government revenue is area b + c + f. The deadweight loss (DWL) of the tax is d + g (poof!). However, the avoided external cost is equal to d + e + g. Therefore, the net benefit of the environmental regulation is d + e + g - d - g = e > 0 (MEC - DWL). A benefit-cost analysis would indicate that the pollution tax is an efficient policy.
Now imagine that the environmental policy is command and control (and assume that abatement costs of command and control are the minimum abatement costs): firms are required to use a clean technology. In this case the producer surplus becomes area b and area c + f + h is simply the higher production costs associated with pollution abatement: the increased capital and labor devoted to pollution reduction.
Jobs are lost as output decreases from Q1 to Q2 but jobs are gained with activities associated with pollution control. If the pollution control activities are more labor intensive than production of the good, then jobs might be created as a result of environmental regulation. Yet, these jobs represent an additional cost of production and the benefit-cost analysis conclusion is as before. Counting abatement costs c + f + h as beneficial jobs without recognizing the offsetting loss of producer surplus (i.e., profit) to the polluting firm is to confuse costs and benefits.
Comments are welcome.
