Efficient Level of Environmental Use

live without their biological environment. Maintaining biodiversity is, there-fore, a priority. For this reason, determining the economic value of the ‘ser-vices’ provided by the environment constitutes an important area of research.

possible. However, such efficiency can only be achieved if all the factors affecting social welfare become price signals. The producer (seller) is faced with all production costs, and their marginal willingness to accept is defined by such costs together. At the same time, the consumer (buyer) is faced with all the costs related to consumption, which define their marginal willingness to pay. Finally, the willingness of many sellers and many buyers creates a dynamic balance between supply and demand, thus establishing the quantity of goods being exchanged in the market and the transaction price.

In the previous example of electricity put on the market in the exchange be-tween the power station and the consumer, several costs of electricity gener-ation appear as part of the supply function, such as the price of energy carriers and the wages of the employees of the power station, but—unless there is government intervention, e.g. a tax on Sulphur dioxide emissions—the loss of the forest holding caused by the Sulphur dioxide emissions of the power station is not included therein. Thus, it will not be part of the willingness to accept, i.e. the supply function. The existence of acid rains—which are caused by Sulphur dioxide emissions—will probably not affect electricity consumers’ willingness to pay and, thus, the demand function. In this way, there will be a cost related to the exchange of a good in the market that is not included either in the supply or in the demand function, which means that the equilibrium quantity and price will be determined without taking into ac-count this cost.

The following figure shows the social loss, thus caused by externalities and the efficiency drop in market allocation. The independent variable (Q) is usu-ally the physical quantity of a given good, while the dependent variable (P) is the price. Neither the demand function (D) nor the supply function (S) includes the cost incurred by the third party, i.e. the externality. The diagram also includes the hypothetical supply function S’, whose difference from S is T, which is the size of the externality. This function would include the cost of sulfur dioxide emissions, either as the cost of the desulfurization equip-ment or as the compensation paid to the forest holding. (Let us imagine, for example, that the company that owns the power station acquires the forest holding, and the management of the holding company realizes that they incur losses due to their own activities. Then, probably, they will find a solution to maximize the profits of both companies; thus the supply of the power station may change.)

The welfare loss caused by externalities can thus be seen in the diagram. The quantity that changes hands will be Q’, instead of Q*, and the price to be paid

will be only P*, instead of the P⁺ equilibrium price. The negative external-ity—i.e. one that causes damage to the third party—generates overproduc-tion: we produce and use more electricity than what would maximize social benefits.

The impact of negative externalities on the market of a product

The bigger externalities linked to the market of a given product are, the greater the social loss resulting from misallocation. Externalities, however, may also be positive: in this case, the third party does not incur a loss but benefits from the effects not taken into account in the market. Environmental pollution is usually a negative externality.

That is why we mentioned in the introduction to this chapter that environ-mental pollution was not only harmful to nature and to nature-lovers but to everyone. Even if there may be people who are not annoyed by forests dying as a result of acid rains, everyone is affected by inefficient market allocation and the fact that, due to the misuse of resources, economic performance will be lower than its potential. The damage caused by the externality is randomly distributed among the members of society, generally reducing welfare.

Increasing pollution can lead to increasing damages, but reducing damage is costly. If we do not want to spend money on avoiding or reducing pollution, the damage caused by it may rocket. A totally pollution-free world can only be a theoretical idea because the costs of achieving zero emissions would probably be infinite. How much pollution is allowed, then?

As we have seen in the previous diagram, welfare loss is described as the difference between Q’ and Q* (Q’-Q*) and not between 0 and Q* (0-Q*).

This means that if environmental pollution is also taken into consideration, the optimal level of emissions will be Q’, instead of zero.

Environmental economics and, particularly, its main branch based on welfare economics consider that the solution to the problem lies in the optimal level of environmental pollution.

Setting aside the situation in which externalities are ignored, there are two ways to achieve lower environmental costs: either by reducing market equi-librium quantity from Q* to Q’ (by generating and consuming less electric-ity), or by disconnecting the generated quantity and the pollutant emissions (i.e. generating the same amount of electricity with less sulfur dioxide emis-sions through a technological change).

In the next model, the MEC (marginal external cost) function will be used for measuring the damage caused by pollutants. This function measures the damage caused by sulfur dioxide emissions—in the form of acid rains—in the tree stock of the forest holding. If we want to achieve the optimal level of environmental pollution by reducing the produced quantity, its cost will be the lost profit of the output – if we sell less electricity, we will get less revenue (although our costs will also be lower), thus, altogether, what we will lose is our profit that could have been generated by the withheld quan-tity. The profit loss caused by decreasing economic activity is measured by the MNPB (marginal net private benefit) function. The independent variable of the functions (horizontal axis) is the physical size of the activity (Q), i.e.

the quantity of the electricity that we produce and consume, while the de-pendent variable (vertical axis) is the economic value (P), i.e. the price in euros, for example.

Withholding the output (its initial level is Q*) is a good solution as long as the net benefit (MNPB) that we lose due to the reduction is less than the loss incurred by the third party (MEC). The production volume ensuring the effi-cient level of environmental pollution (Q’) will be the produced quantity (Q)

where MNPB = MEC. Reducing the production further than Q’ does not gen-erate social benefit because, moving from Q1 towards 0, the values of MNPB are consistently higher than the values of MEC (this is true for all Qs between 0 and Q’).

Attaining the efficient level of externalities by reducing pro-duction

Let us now examine the other option, where the market equilibrium quantity does not change, but the associated pollution is reduced by using an addi-tional environmental technology (in the case of the power station, for exam-ple, by adding desulfurization equipment to the existing technology and pur-chasing coal with significantly lower sulfur content at a slightly higher price).

Reducing pollutant emissions in this way, evidently, comes with a cost. In environmental economics, this is measured by the MAC (marginal abatement cost or, more generally, the marginal cost of the abatement of externalities) function.

It is advisable to reduce pollution from level Q* to Q’, as long as the values of MAC are consistently below the values of MEC. The efficient level of pollution is defined by the equality MAC = MEC. Emissions below Q’ are not efficient because the cost of attaining them is higher than the amount of damage that emissions would cause.

P

MEC – marginal cost of the externality

MNPB – marginal utility of the good

Q (good) Q*

Q’

T

Attaining the efficient level of externalities by reducing pollution

Therefore, the optimal level of pollutant emissions is either the size of eco-nomic activity (Q [product]) where the marginal net private benefit (MNPB) of the activity is equal to its marginal environmental cost (MEC), or the level of pollution (Q [pollution]) where the marginal abatement cost (MAC) of the pollution is equal to its marginal environmental cost (MEC).

Although we know, in theory, where the socially efficient (optimal) level of pollution would be, it is not established automatically because of externali-ties. Therefore, government intervention is needed, which will set an addi-tional rule forcing or encouraging polluters to take measures to approach the efficient level.