Chapter 6 Externalities in Action: Environmental and Health Externalities Jonathan Gruber Public...

Chapter 6 Externalities in

Action:Environmental and Health Externalities

Jonathan GruberPublic Finance and Public Policy

Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Introduction

This lesson will review, in detail, some real life externalities related to the environment and health.

Along the way, it also reviews some recent empirical evidence.

Introduction

The four major areas reviewed are: Acid rain Global warming Smoking Other behaviors

ACID RAIN

When sulfur dioxide (SO2) and nitrogen oxides (NOX) are released into the atmosphere, they form sulfuric and nitric acids, respectively.

These acids may fall back to earth hundreds of miles away from their original source, known as acid rain.

Majority of acid rain in North America caused by SO2, the majority of which comes from coal-fired power plants concentrated in the Ohio River Valley.

The Damage of Acid Rain

Acid rain is a negative production externality. It causes damage by: Making lakes more acidic. Eroding forests. Causing damage to property ($5

billion/year). Reducing visibility. Leading to adverse health outcomes.

History of Acid Rain Regulation

Regulation of acid rain 1970 Clean Air Act 1990 amendments and emissions

trading


1970 Clean Air Act set maximum standards for various substances, including SO2.

It set New Source Performance Standards (NSPS) for any new power plant, forcing the plant to either reduce emissions or install scrubbers.


Thus, the 1970s Clean Air Act relied on regulation, not corrective taxation or tradable permits.

It also created a loophole by excluding older plants from the NSPS. Utilities had a greater incentive to run older, dirtier plants.

This is one of the hazards of “partial policy reform.”


1990 Clean Air Act Amendments mandated a reduction of more than 50% of the level of SO2 nationwide, and included all plants.

It offered an SO2 allowance system that granted plants permits to emit SO2 in limited quantities, based on their historical fuel utilization.


Plants were allowed to buy, sell, or save their allowances.

The allowances involved very few restrictions– trading could occur anywhere within the United States, with no approval or review, and the frequency and mechanism of trading were unlimited.


The 1990 amendments and emissions trading drew opposition from two very diverse groups: Those opposed on economic grounds, like

utilities and coal miners. An industry study predicted the full cost of the

regulations to be up to $7.4 billion, with a loss of up to 4 million jobs.

It was also opposed by environmentalists. They opposed the 1990 amendments on the

grounds that they created a “market for vice and virtue.”


Estimates suggest that emissions trading significantly lowered the costs of the 1990 amendments. Over the 1995-2007 period, costs were lowered from

$35 billion to $15 billion. Thus, trading has worked to greatly improve the

efficiency of regulation. Even environmentalists are now more sympathetic

to emissions trading, because it reduces economic opposition. “In less than a decade, emissions trading has gone

from being a pariah among policymakers to being a star.” -- Daniel Ellerman, expert on acid rain regulations

Estimating the Adverse Health Estimating the Adverse Health Effects of ParticulatesEffects of Particulates

Although there is a large empirical literature relating pollution to health outcomes, most studies are not all that convincing. Relate adult mortality in an area to the

level of particulates. Areas with more particulates may differ

in many other ways from areas with less particulates in ways that affect mortality, such as job safety.

Empirical

Empirical

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Recent empirical work by Chay and Greenstone (2003) is much more convincing.

The Clean Air Act of 1970 created a quasi-experiment. Counties were classified as “attainment” or

“non-attainment” based on whether their pollution levels were below a threshold.

“Non-attainment” counties were subject to state regulations, while “attainment” counties just below the threshold were not subject to these regulations.

Empirical

Empirical

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Clearly, if we examined the 3,000-plus counties in the United States, the non-attainment counties look a lot different than the attainment counties.

But if we examine counties very close to the arbitrary threshold, those attainment and non-attainment counties are much more similar.

Figure 1Figure 1 shows the effects of regulation on pollution levels.

Empirical

Empirical

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Figure 1 Effect of regulation on pollution levels

Nonattainment Annual Mean Regulation Threshold Attainment Nonattainment Annual Mean Regulation Threshold Attainment

1969 1970 1971 1972 1973 1974

50

60

70

80

90

100

110

Trends in Mean TSPs Concentrations, by 1972 Nonattainment Status

Mean of Average Daily Readings (Micrograms per

Cubic Meter)

TSP stands for “total suspended particulates” and is a measure of

pollution emissions.

Nonattainment Annual Mean Regulation Threshold Attainment

There was no obvious trend for either group, however.

While attainment counties had lower emissions.

The Clean Air Act created a regulation threshold for non-

attainment counties.While emissions for the attainment “control” counties

showed no obvious trend.The Clean Air Act became effective in 1971, which creates “treatment” and “control” groups.

We can examine pollution levels before the law change …

Non-attainment counties had higher emissions than the

threshold before 1972.

After the Clean Air Act, emissions for the non-attainment

counties trended down.

And after the law change.

This law change creates a convincing “difference-in-

differences” approach.


Chay and Greenstone go on to examine the infant mortality rate in the different counties over time. The infant mortality rate is the share of

newborns who die before their first birthday. They find that infant mortality declined

substantially from the regulation-induced emissions. Each 10% decline in emissions led to a 5% decline in the infant mortality rate. They find that 1,300 fewer infants died in 1972

as a result of the Clean Air Act.

Empirical

Empirical

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Has the Clean Air Act Been a Success?

The overall success of the Clean Air Act is much harder to determine. The regulations were costly. In its first 15 years,

the Clean Air Act cost: 600,000 jobs. $75 billion in output.

They did result in benefits, too. Health improvements, such as reductions in infant

mortality. Burtraw, et al. (1997) estimate that the health

benefits alone exceed the cost of reduction by a factor of seven, once the lower-cost trading regime was implemented.

GLOBAL WARMING

The earth is heated by solar radiation that passes through our atmosphere and warms the earth’s surface.

A large portion of the heat is trapped by certain gasses in the earth’s atmosphere, which reflect the heat back toward the earth again.

This is known as the greenhouse effect.

GLOBAL WARMING

The concentration of greenhouse gasses like carbon dioxide and methane has increased due to human activity.

Using fossil fuels like coal, oil, and natural gas produce carbon dioxide and contribute to this effect.

GLOBAL WARMING

The surface temperatures have increased by more than 1 degree Fahrenheit in the past 30 years.

Projections for the next 100 years suggest an unprecedented increase by as much as 6-10 degrees.

This could have very bad consequences for the environment.

Figure 2Figure 2 shows carbon dioxide emissions by country.

Table 2

Top 25 Fossil Fuel CO2 Emitters in 2000

0

200

400

600

800

1000

1200

1400

1600

UN

ITE

D S

TA

TE

S

CH

INA

RU

SS

IAN

FE

D.

JAP

AN

IND

IA

GE

RM

AN

Y

UN

ITE

D K

ING

DO

M

CA

NA

DA

ITA

LY

SO

UT

H K

OR

EA

ME

XIC

O

SA

UD

I A

RA

BIA

FR

AN

CE

AU

ST

RA

LIA

UK

RA

INE

SO

UT

H A

FR

ICA

IRA

N

BR

AZ

IL

PO

LAN

D

SP

AIN

IND

ON

ES

IA

TU

RK

EY

TA

IWA

N

TH

AIL

AN

D

NO

RT

H K

OR

EAM

illi

on

s o

f M

etri

c T

on

s o

f C

arb

on

The U.S. is currently responsible for nearly 25% of the planet’s

carbon dioxide emissions.

Japan contributes only 5% of annual emissions.

Developing counties like China and India emit large quantities of

greenhouse gasses.

GLOBAL WARMING

Global warming is truly a global problem. Carbon emissions in Boston and Bangkok have the same effect on the global environment.

The stock, not the flow, of carbon dioxide cause the warming. Thus, it takes a long time to undo the damage.

Global warming is a thus a complicated externality involving many nations and many generations of emitters.

The Kyoto Treaty

The goal of the Kyoto treaty in 1997 was to reduce the emissions of greenhouse gasses to 5% below their 1990 levels.

United States and Russia have not signed on; many other of the 38 industrialized nations have, however.

The Kyoto Treaty

For the United States, the Kyoto treaty would: Mean reducing emissions in 2010 by

roughly 30% With a present discounted cost of

$1,100,000,000,000. That’s 1.1 trillion. The United States would bear 90% of the

total world cost, even though it contributes only 25% of annual greenhouse gas emissions.

Can Trading Make Kyoto More Cost-Effective?

Kyoto treaty introduced international emissions trading. Under the Kyoto treaty, the industrialized signatories

are allowed to trade emissions rights among themselves, as long as the total emissions goals are met.

There are tremendous differences across developed nations in terms of meeting these goals, for two reasons: Slow growth in some countries: Relatively easy for a

country like Russia to meet its goal. Estimates suggest that emissions trading (say, from Russia to United States) could lower the cost of the treaty by 75%.

Environmentally conscious growth: Other countries, like Japan, tend to use more gas and nuclear-powered production.

Figure 3Figure 3 shows the benefits of international emissions trading.

Figure 3 The benefits of trading

Yet the treaty calls for the U.S. to reduce

emissions a lot.

Carbon Reduction (millions of metric tons)

Price of carbon reduction

0 630

It is fairly expensive for the U.S. to reduce

its emissions.SUS SR

$210

$20

440190

It is easier for Russia and others to reduce

their emissions.

And the requirements are lower, too.The total cost to the

U.S. is 440x$210.

The overall cost, with no emissions trading,

is $96 billion.

ST

$50

With emissions trading, the supply curve is

summed horizontally.

The cost of worldwide emission reduction is $50

per ton with ST.

590

The total cost to Russia and others is

190x$20.The U.S. buys 400 permits (440-40).

The overall cost, with emissions trading, is

$32 billion.

40

Can Trading Make Kyoto More Cost-Effective?

By distributing the reduction from the high-cost United States to the low-cost other nations, the total price is significantly lowered.

It is lowered by about a factor of four.

Developing country participation

The Kyoto treaty does not including developing nations, yet they will produce more than half the world’s emissions by 2030.

Cost to developing countries for complying with the treaty is 10 times smaller than for developed countries because developing nations do not need to “retrofit” their industrial base.

Including these counties lowers the cost of reducing emissions by another factor of four.

Developing country participation

Including both developing counties and tradable permits lowers the cost to 1/16th of the cost without those flexibilities.

Resistance among developing counties, however. Solution to including developing nations will likely involve significant international transfers.

THE ECONOMICS OF SMOKING

As Figure 4Figure 4 shows, the number of cigarettes smoked has declined substantially in the United States over time.

Figure 4


Yet, as Figure 5Figure 5 shows, smoking still causes more than 440,000 deaths each year, four times as much as AIDS, motor vehicle accidents, homicide, and suicide combined.

By 2030, 10 million persons will die annually from smoking-related disease, and it will be the leading cause of death throughout the world.

Figure 5


What is the role for government intervention in the case of a decision like smoking? We will go through several arguments: Smoking is bad for you. Smoking is addictive. It generates negative externalities to the

health system, workplace, and fire departments.

It generates positive externalities to the Social Security and Medicare system.

It creates negative externalities to other family members through secondhand smoke.


Smoking is bad for you. In standard utility-maximization, any

damage individuals do to themselves from dangerous activities results from a rational tradeoff of benefits against potential costs.


Smoking is addictive. “Rational addicts” understand that each cigarette

that they smoke today increases their addiction. Smokers consider not only the cost of today’s pack

of cigarettes, but the cost of all additional future packs that will now be purchased because their addiction is deepened.

Smokers also understand that smoking doesn’t just reduce health through the current cigarette, but all future cigarettes that will be consumed because of the addiction.

With this model, smoking remains a rational choice.

The Externalities of Smoking

Smoking generates negative externalities due to higher health costs.

Smoking-related disease increases U.S. medical care costs by $75 billion annually, 5% of the total.

If insurance companies can make actuarial adjustments, they simply charge smokers higher rates. Such adjustments internalize the medical

cost externality from smoking. In a simple model, there are no health externalities because smokers pay for the high medical costs through higher premiums.


Actuarial adjustments are often not the case with employer health insurance, however. In this case, the externality is financial, not physical.

This is an externality because the social marginal benefit from an individual’s cigarette consumption is below the private marginal benefit–the individual’s coworkers have to pay higher premiums.

In addition to higher health costs to the private sector, individuals who receive government insurance exert a negative externality onto taxpayers.

The same is true of the uninsured (smokers and non-smokers alike)–they exert negative externalities onto medical providers, who pass along the costs to consumers.

The Economics of Smoking

Smoking generates negative externalities due to lower workplace productivity and more frequent absences.

Firms may be able to adjust wages to compensate for this type of problem. If workers’ wages adjust to compensate

for their lower expected productivity, then the externality is internalized, akin to the adjustments in health premiums.


Smoking generates negative externalities due to fires, mostly due to falling asleep with a burning cigarette.

To the extent the smoker only damages himself and his own property, there is not an externality. But if the fire spreads to other properties, there is an externality.

Also costs to fire departments and insurance companies that may not be fully internalized.


Smoking generates positive externalities to taxpayers due to the early deaths of smokers and lower payouts for some social insurance programs. Often contribute payroll tax for Social

Security and Medicare during working life, but smokers may not be alive to collect benefits when they are elderly.

This is known as the “death benefit.”


Smoking generates negative externalities (mostly to other family members) through secondhand smoke. Considerable medical uncertainty about

the damages done from this. Moreover, if the smoker maximizes family

utility rather than individual utility, he rationally trades off the benefits to himself versus the harm to his family.

Evidence suggest family utility maximization is incomplete, however.


Taken together, the external costs of smoking are roughly 40¢ per pack of cigarettes in 2003 dollars.

Estimates of external costs of secondhand smoke vary widely, from 1¢ to $1.16 per pack.

The average federal plus state cigarette tax is over $1 per pack.

Should We Care Only About Externalities, or Do “Internalities”

Matter Also? Traditional economics approach cares

only about externalities that smokers impose on others.

Model ignores some key features of the smoking decision that may motivate government intervention. Youth smoking decisions Inability of adults to quit


Matter Also? Youth smoking decisions: 75% of adults

who smoke began smoking before their 19th birthday.

Sometime between when we are born and become adults, we start making rational decisions, but it is not clear when this happens.

Thus, youths may be unable to make rational tradeoffs between current benefits of smoking and future costs.

Should We Care Only About Externalities, or

Do “Internalities” Matter Also? Suggestive that teens who smoke may

not account for the long-run implications of addiction; they are overly optimistic.

Among high school seniors who smoked more than 1 pack per day: Among those who said they would not be

smoking 5 years later, 74% still were. Among those who said they would be

smoking 5 years later, 72% still were.


Matter Also? Many adults who smoke would like to

quit, but are unable to do so. 80% of adults who smoke express a

desire to quit, but many fewer actually succeed.

Over 80% of smokers try to quit in a typical year, and the average smoker tries every 8.5 months.

54% of serious attempts to quit fail within one week.

Should We Care Only About Externalities or Do “Internalities”

Matter Also? Smokers may face a self-control

problem, an inability to carry out optimal strategies for consumption.

Economic theory assumes that individuals not only can maximize their utility, but carry out these optimal plans.

Psychology contradicts this assumption: individuals are often unable to carry out long-term plans when there are short-term costs of doing so.


Matter Also? Examples include:

Smoking Retirement savings Diet and/or exercise.


Matter Also? Evidence for self-control problems

includes laboratory experiments and real-life institutional features. In experiments, individuals reveal they

are willing to be patient in the future, but impatient in the present.

For example, in one experiment, individuals preferred a check for $100 today versus one for $200 in the future.

Yet the same people preferred a check for $200 eight years from now versus a check for $100 six years from now.


Matter Also? The real-life evidence comes from the

demand for commitment devices, used to fight off their bad instincts. Smokers regularly set up systems to

restrain themselves, such as betting with others or telling people about their decision.

“Christmas clubs” that are low-interest, forced saving.

Expensive memberships at health clubs to commit themselves to exercise.

Implications for government policy

The lack of self-control and irrationalities have implications for government policy.

For smokers who make mistakes (rather than deliberate choices), the damage from smoking could be viewed as an internality–the damage people do to themselves through adverse behavior.

The internality justifies government intervention in the same way an externality does.

The market failure is the cost imposed on a person’s long-run well-being generated by his or her short-run impatience or irrationality.


Recall that the external costs of smoking were roughly 40¢ per pack.

The internal costs are much larger: Smoker lives about 6 fewer years than a

nonsmoker. A year of life is valued by economists at

about $200,000. With this estimate, the internal costs of

smoking are about $35 per pack, roughly 100 times larger than the external costs.


Government has several policy tools for addressing “internalities” Information/outreach campaigns–these

have reduced the smoking rate a lot over the last 30 years.

Reducing access to cigarettes for teenagers.

Taxation–elasticity of demand for cigarettes is around -0.5, and higher for youth smokers.

The Economics of Other Addictive Behaviors

Other health behaviors can be analyzed, too. Alcohol consumption Illicit drugs Obesity

The Economics of Other Addictive Behaviors: Drinking

Alcohol consumption is an interesting alternative to smoking. Major externality associated with alcohol

is drunk driving, with over 17,000 persons per year killed and 500,000 injured.

The external cost is roughly $120 billion. Drunk drivers may lose their license, go

to jail, or see insurance premiums rise, but are unlikely to bear the full costs of their action.

Drinking

It is possible that alcohol consumption leads to domestic violence, in which it creates another externality.

The Center for Disease Control reports that “Alcohol use is frequently associated with violence between intimate partners.” There are serious questions about

causality, however. http://www.cdc.gov/ncipc/factsheets/ipv

facts.htm

Drinking

Alcohol taxes vary between 9 to 24¢ per ounce of ethanol, while the external costs are calculated to be around 80¢ per ounce.

“Internalities” from alcohol consumption are certainly much smaller. Small quantities of alcohol may be good

for long-run health. Only small share of drinkers do damage

to themselves.

Drinking

Role for government in drinking is more difficult, because negative externalities arise from small share of drinking that results in drunk driving.

In principle, optimal policy would target drunk driving, with steeper fines and penalties. But hard to realistically raise the fines high enough.

On the other hand, taxing alcohol consumption is a very blunt instrument. It lowers drinking too much among those who aren’t going to drive drunk.

Illicit Drugs

Government heavily regulates illicit drugs, such as marijuana, cocaine, ecstasy, and heroin; often they are illegal to consume.

For some drugs, essentially no more externalities than with cigarettes.

Illicit Drugs

Milton Friedman wrote: “The harm to us from the addiction of

others arises almost wholly from the fact that drugs are illegal. A recent committee of the American Bar Association estimated that addicts commit one-third to one-half of all street crime in the U.S. Legalize drugs, and street crime will drop dramatically.”

Nonetheless, the government appears to have concluded that individuals are not making the right long-term decisions for themselves with respect to illegal drugs.

Obesity

The prevalence of obesity has risen dramatically in the United States. The fraction of adults classified as obese

has risen from 12% in 1960 to 28% in 1999.

External and internal costs of obesity may exceed either alcohol or cigarettes.

Using tax policy is difficult, however, because of the complicated relationship between food consumption and health.

Recap of Externalities in Action: Environmental and

Health Externalities Acid rain Global warming The economics of smoking The economics of other addictive

behaviors

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