736 section 14 Market Failure and the Role of Government
Production, Consumption, and Externalities
Nobody imposes external costs like pollution out of malice. Pollution, traffic conges-
tion, and other negative externalities are side effects of activities, like electricity gener-
ation, manufacturing, or driving, that are otherwise desirable. We’ve just learned how
government regulators can move the market to the socially optimal quantity when the
side effects can be directly controlled. But as we cautioned earlier, in some cases it’s
not possible to directly control the side effects, only the activities that cause them can
be influenced. As we’ll see shortly, government policies in these situations must in-
stead be geared to changing the levels of production and consumption that create ex-
ternalities, which in turn changes the levels of the externalities themselves.
This approach, although slightly more complicated, has several advantages. First,
for activities that generate external costs,it gives us a clear understanding of how the
desirable activity is affected by policies designed to manage its side effects. Second, it
helps us think about a question that is different but related to the problem of exter-
nal costs: what should be done when an activity generates external benefits.It’s impor-
tant to realize that not all externalities are negative. There are, in fact, many positive
externalities that we encounter every day; for example, a neighbor’s bird-feeder has
the side effect of maintaining the local wild bird population for everyone’s enjoy-
ment. And a beautiful flower garden in front of a neighbor’s house can be enjoyed by
many passersby.
Using the approach of targeting the activity behind the externalities, we’ll now turn
our attention to the topic of positive externalities.Private versus Social Benefits
Earlier, we pointed out that getting a flu shot has benefits to people beyond the per-
son getting the shot. Under some conditions, getting a flu vaccination reduces the ex-
pected number of otherpeople who get the flu by as much as 1.5. This prompted oneCap and Trade
The tradable emissions permit systems for both
acid rain in the United States and greenhouse
gases in the European Union are examples of
cap and trade programs:the government sets a
cap (a total amount of pollution that can be
emitted), issues tradable emissions permits,
and enforces a yearly rule that a polluter must
hold a number of permits equal to the amount
of pollution emitted. The goal is to set the cap
low enough to generate environmental benefits
and, at the same time, to give polluters flexibil-
ity in meeting environmental standards and mo-
tivate them to adopt new technologies that will
lower the cost of reducing pollution.
In 1994 the United States began a cap and
trade system for the sulfur dioxide emissions
that cause acid rain by issuing permits to power
plants based on their historical consumption ofcoal. The cap of 8.95 million tons set for 2010
was about half the level of sulfur dioxide emis-
sions in 1980. Economists who have analyzed
the sulfur dioxide cap and trade system point to
another reason for its success: it would have
been a lot more expensive—80% more to be
exact—to reduce emissions by this much using
a non-market-based regulatory policy.
The European Union cap and trade scheme is
the world’s only mandatory trading scheme for
greenhouse gases and covers all 27 member
nations of the European Union. Available data
indicate that within the system, 3,093 metric
tons of emissions were transacted in 2008 and
6,326 metric tons in 2009, an astonishing in-
crease of 105%. Although it is still too early to
evaluate the system’s performance, at the time
of this writing the U.S. Senate was impressedfyi
enough with the preliminary results to consider
proposing an American cap and trade system
for greenhouse gases.
Despite all this good news, however, cap and
trade systems are not silver bullets for the world’s
pollution problems. Although they are appropriate
for pollution that’s geographically dispersed, like
sulfur dioxide and greenhouse gases, they don’t
work for pollution that’s localized, like mercury or
lead contamination. In addition, the amount of
overall reduction in pollution depends on the level
of the cap. Under industry pressure, regulators
run the risk of issuing too many permits, effec-
tively eliminating the cap. Finally, there must be
vigilant monitoring of compliance if the system is
to work. Without oversight of how much a polluter
is actually emitting, there is no way to know for
sure that the rules are being followed.