Key Terms

Key Terms

additional external cost additional costs incurred by third parties outside the production process when a unit of output is produced biodiversity the full spectrum of animal and plant genetic material command-and-control regulation laws that specify allowable quantities of pollution and that also may detail which pollution-control technologies one must use externality a market exchange that affects a third party who is outside or “external” to the exchange; sometimes called a “spillover” international externalities externalities that cross national borders and that a single nation acting alone cannot resolve market failure When the market on its own does not allocate resources efficiently in a way that balances social costs and benefits; externalities are one example of a market failure marketable permit program a permit that allows a firm to emit a certain amount of pollution; firms with more permits than pollution can sell the remaining permits to other firms negative externality a situation where a third party, outside the transaction, suffers from a market transaction by others pollution charge a tax imposed on the quantity of pollution that a firm emits; also called a pollution tax positive externality a situation where a third party, outside the transaction, benefits from a market transaction by others property rights the legal rights of ownership on which others are not allowed to infringe without paying compensation social costs costs that include both the private costs incurred by firms and also additional costs incurred by third parties outside the production process, like costs of pollution spillover see externality

Key Concepts and Summary

12.1 The Economics of Pollution

Economic production can cause environmental damage. This tradeoff arises for all countries, whether high- income or low-income, and whether their economies are market-oriented or command-oriented. An externality occurs when an exchange between a buyer and seller has an impact on a third party who is not part of the exchange. An externality, which is sometimes also called a spillover, can have a negative or a positive impact on the third party. If those parties imposing a negative externality on others had to account for the broader social cost of their behavior, they would have an incentive to reduce the production of whatever is causing the negative externality. In the case of a positive externality, the third party obtains benefits from the exchange between a buyer and a seller, but they are not paying for these benefits. If this is the case, then markets would tend to under produce output because suppliers are not aware of the additional demand from others. If the parties generating benefits to others would somehow receive compensation for these external benefits, they would have an incentive to increase production of whatever is causing the positive externality. In either case, because resources are not being allocated efficiently, the externality leads to market failure.

12.2 Command-and-Control Regulation

Command-and-control regulation sets specific limits for pollution emissions and/or specific pollution-control technologies that firms must use. Although such regulations have helped to protect the environment, they have three shortcomings: they provide no incentive for going beyond the limits they set; they offer limited flexibility on where and how to reduce pollution; and they often have politically-motivated loopholes.

12.3 Market-Oriented Environmental Tools

Examples of market-oriented environmental policies, also called cap and trade programs, include pollution