Gruber4e ch06

Public Finance and Public Policy Jonathan
CopyrightGruber
2012 Fourth
WorthEdition
Publishers
Copyright 2012 Worth Publishers
1 of 44
Externalities in Action: Environmental

and Health Externalities
6.1 Acid Rain

6.2 Global Warming
6.3 The Economics of Smoking
6.4 The Economics of Other Addictive
Behaviors
6.5 Conclusion
P R E PAR E D B Y
Dan Sacks
Public Finance and Public Policy Jonathan Gruber Fourth Edition Copyright 2012 Worth Publishers
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6.1
C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S
The Damage of Acid Rain
Acid rain is a classic negative production

externality.
Acid rain: Rain that is unusually acidic due
to contamination by emissions of sulfur
dioxide (SO2) and nitrogen oxide (NOx).
Two-thirds of SO2 emissions come from coalfired power plants, mostly located in the
Ohio River Valley.
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6.1
The Damage of Acid Rain
Acid rain causes damage in a variety of ways :

Increased acidity of lakes and streams
Forest erosion
Damage to property
Reduced visibility
Adverse health outcomes
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6.1
History of Acid Rain Regulation
To combat acid rain, Congress passed the

1970 Clean Air Act.
1970 Clean Air Act: Landmark federal
legislation that first regulated acid rain
causing emissions by setting maximum
standards for atmospheric concentrations of
various substances, including SO2.
Regulations only affected new plants,
however, encouraging use of older, dirtier
plants.
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6.1
Estimating the Adverse Health Effects of Particulates
How does acid rain (or SO2) affect health?

The typical approach taken in this literature
is to relate adult mortality in a geographical
area to the level of particulates (such as
SO2) in the air.
The results are suspect: Areas with more
particulates may differ from areas with
fewer particulates in many other ways, not
just in the amount of particulates in the air.
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6.1
Estimating the Adverse Health Effects of Particulates
Chay and Greenstone (2003) studied this

question.
Used an excellent quasi-experiment by
examining the infant mortality rate, using
the regulatory changes induced by the
Clean Air Act of 1970.
Some areas (attainment) did not have
to reduce SO2 levels.
Others (non-attainment) were required
to do so.
Infant mortality declined substantially in
non-attainment areas, relative to
attainment ones.
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6.1
SO2 Levels in Attainment and Non-Attainment Areas
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6.1
Clean air acts reduced SO2 emissions but

encouraged use of older plants.
The 1990 amendments and emissions
trading attempted to rectify this.
SO2 allowance system: The feature of
the 1990 amendments to the Clean Air
Act that granted plants permits to emit
SO2 in limited quantities and allowed
them to trade those permits.
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6.1
Has the Clean Air Act Been a Success?

Led to dramatic improvements in infant
health, among other things.
But may have cost 600,000 jobs and $75
billion in polluting industries.
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6.2
Global Warming
Global warming is a serious environmental

externality.
Gas emissions lead to increased global
temperature because of the greenhouse
effect.
o Greenhouse effect: The process by
which gases in the Earths atmosphere
reflect heat from the sun back to the
Earth.
Global temperatures are increasingly more
rapidly than any time in the last 1000
years.
Temperatures are projected to rise even
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6.2
CO2 Output: 25 Largest Contributors
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6.2
APPLICATION: The Montreal Protocol
International cooperation will be necessary to

address global warming.
Montreal Protocol of 1987, which banned
the use of chlorofluorocarbons (CFCs), an
early example.
As with global warming, this was a
potentially enormous long-run problem.
The CFC problem was showing itself
immediately and urgently: By the 1980s, a
25-million-square-kilometer hole had
opened in the ozone layer over Antarctica!
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6.2
APPLICATION: The Montreal Protocol
The Montreal Protocol was adopted, aimed

for complete phaseout of specified
chemicals (mostly CFCs and halons)
according to specified schedules.
The result is that scientists predict the hole
in the ozone layer will begin to recover and
return to normal around 2050.
It may take some type of exciting event to
spur action on global warming, which will
not be solved for centuries after emissions
are greatly reduced.
If the world waits for a crisis to spur us into
action, it may be too late.
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6.2
The Kyoto Treaty
In 1997, Kyoto hosted international

negotiations to govern carbon emissions.
38 industrialized nations agreed to combat
global warming by reducing their emissions
of greenhouse gases to 7% below 1990
levels by the 2012.
Written into a treaty that has since been
ratified by 35 of the 38 signatory countries,
and went into effect in early 2005.
Not ratified by the United States.
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6.2
Can Trading Make Kyoto More Cost-Effective?
The Kyoto treaty allowed for international

emissions trading.
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.
Allows efficient countries to reduce their
emissions on behalf of less-efficient ones
(for a price).
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6.2
Price of
reduction
per metric
ton of
carbon
$210
SUS
S
R
2
0
0
19
0
440
Carbon reduction
(millions of metric
tons)
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6.2
Price of
reduction
per metric
ton of
carbon
SUS
S
RS
T
$5
0
0 40
59
0
63
0
Carbon reduction
(millions of metric
tons)
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6.2
Participation of Developing Countries
The Kyoto treaty did not involve developing

nations.
But by 2030, developing nations will
produce more than half of the worlds
emissions.
Much cheaper to use fuel efficiently as you
develop an industrial base than it is to
retrofit an existing industrial base.
By some estimates, an international trading
system that included developing nations
would reduce the cost of the Kyoto treaty by
a factor of four.
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6.2
Participation of Developing Countries
Developing nations want no part of this

argument.
The problem that the world faces today is
the result of environmentally insensitive
growth by the set of developed nations.
Why should they be forced to be
environmentally conscious and clean up the
mess that the United States and other
nations have left behind?
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6.2
What Does the Future Hold?
Developments since the Kyoto treaty of

1997 do not bode well for short-term
agreements:
o United States rejection of the Kyoto
treaty
o Difficulty of persuading developing
nations to agree to reductions
Recent evidence suggests that the nations
of the world can come together to combat a
global environmental threat, but only when
that threat is urgent.
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6.2
APPLICATION: Congress Takes on Global Warming
In 2009, the House passed the American

Clean Energy and Security Act (ACES) to help
combat global warming.
Lower limits on the amount of emissions
allowed, and firms could comply with the
tighter targets in a number of ways:
o Emissions reductions
o Purchase emissions permits
o Purchase pollution credits to offset their
emissions
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6.2
APPLICATION: Congress Takes on Global Warming
The ACES Act drew criticism from several

sources:
Some feared increased costs of energy
production:
o Emitting firms would now either need to
buy permits, buy credits, or undertake
other expensive actions to reduce their
emissions.
Some felt that the full value of the
allowances should be rebated to consumers
and not simply given back to the polluting
industries.
Prospects in the Senate are unclear.
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6.3
The Economics of Smoking
Not all externalities are large-scale

environmental problems.
Some of the most important externalities
are local and individualized.
Many of these arise in the arena of personal
health, and one of the most interesting is
smoking.
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6.3
Per Capita Annual Cigarette Consumption,

19902010
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6.3
Leading Causes of Death, 2008
Cause of Death
Heart disease, hypertension
Smoking
Cancer
Stroke, Alzheimers disease
% of all
deaths
22.9%
18.3
16.1
8.4
Respiratory diseases, flu,

pneumonia
7.7
Accident, suicide, homicide

Diabetes, lung, liver, kidney
diseases
6.5
5.8
Other
14.2
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6.3
Does Smoking Have Externality?
Negative health consequences do not, by

themselves, mean smoking has
externalities.
Externalities require that the smoker not
bear all these costs.
Rational smokerswho know the health
risksmay internalize these costs.
But there are several reasons that the
costs might not be internalized.
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6.3
The Externalities of Smoking: Increased Health Care

Costs
Smoking increases health care costs. An

externality?
Not if people pay for their health care
themselves
Or if their insurance premiums are
actuarially adjusted
o Actuarial adjustments: Changes to
insurance premiums that insurance
companies make in order to compensate
for expected expense differences.
Yes, if their insurance premium is not
adjusted since non-smokers pay some of
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6.3
The Externalities of Smoking: Workplace

Productivity
Smokers have lower workplace productivity
because they are more likely to get sick and
to take (smoking) breaks. Externality?
Yes, if smokers and non-smokers are paid
the same amount; then smokers end up
taking profits from their employers or
wages from non-smokers
No, if smokers are paid according to their
productivity
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6.3
The Externalities of Smoking: Fires
Smokers are much more likely to start fires

than nonsmokers, mostly due to falling asleep
with burning cigarettes. Externality?
Yes, if smokers burn other peoples things
Yes, if smokers burn their own things and
fire insurance/fire department costs arent
actuarially adjusted
No, if smokers burn only their own things
and the costs are actuarially adjusted
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6.3
The Externalities of Smoking: The Death Benefit
Smokers early death might be a positive

externality.
Social Security and Medicare pay out until
death.
Early death of smokers means smokers
receive less payment, leaving more money
for non-smokers.
But dying earlier also means smokers have
fewer years to pay taxes.
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6.3
What about Secondhand Smoke?
Secondhand smoke appears to be a classic

externality.
Yet the costs of secondhand smoke are not
easily added to the list of external costs:
o There is considerable medical
uncertainty about the damage done by
secondhand smoke.
o Most of the damage from secondhand
smoke is delivered to the spouses and
children of smokers.
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6.3
Should We Care Only About Externalities, or Do

Internalities Matter Also?
Economists usually assume that smokers
follow the rational addiction model:
o They know the costs (which occur far
into the future).
o They understand the possibility of
addiction.
This model may not be a good description
of smoking.
o Youth smoking: More than 75% of
adult smokers begin smoking before
their nineteenth birthday.
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6.3
Adults Are Unable to Quit Smoking Even if They

Have a Desire to Do So
Many adults who smoke would like to quit but
are unable to do so.
Eight in ten smokers in America express a
desire to quit the habit, but many fewer
than that actually do quit.
According to one study, over 80% of
smokers try to quit in a typical year, and
the average smoker tries to quit every eight
and a half months.
54% of serious quit attempts fail within one
week.
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6.3
Adults Are Unable to Quit Smoking Even if They

Have a Desire to Do So
Many smokers suffer from self-control
problems and use commitment devices.
Self-control problem: An inability to carry
out optimal strategies for consumption.
Commitment devices: Devices that help
individuals who are aware of their selfcontrol problems fight their bad tendencies.
o Smokers who want to quit make public
promises to do so, making it
embarrassing to smoke.
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6.3
Implications for Government Policy
If smokers are not rational, then intervention

may be justified because of internalities.
Internality: The damage one does to
oneself through adverse health (or other)
behavior.
Taxation of cigarettes is a plausible,
effective mechanism to discourage
smoking.
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6.4
The Economics of Other Addictive Behaviors:

Drinking
The economics of drinking are different than
smoking.
Very large externalities:
o Damage due to drunk driving.
Smaller internalities:
o Drinking in small quantities, while it may
impair ones driving, may actually be
good for long-run health.
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6.4
EVIDENCE: The Effects of the Minimum Drinking

Age
Drinking is regulated as well as taxed: People
younger than 21 cannot drink.
How does this regulation affect peoples
health?
Carpenter and Dobkin study this question
using a regression discontinuity design, a
very clean strategy.
The RDD compares health outcomes of
people just above and just below their
birthday.
These people are likely to be quite similar,
so the RDD estimates the causal effect of
being able to drink.
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6.4
EVIDENCE: The Effects of the Minimum Drinking

Age
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6.4
Illicit Drugs
Most of the externalities associated with illicit

drugs arise because of their illegality.
Legal consumption of some illicit drugs is
likely to have much lower externalities than
consumption of alcohol.
Milton Friedman in 1972:
The harm to us from the addiction of
others arises almost wholly from the
fact that drugs are illegal. addicts
commit one-fourth to one-half of all
street crime in the U.S. Legalize drugs,
and street crime would drop
dramatically.
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6.4
APPLICATION: Public Policy Toward Obesity
Obesity has both enormous externalities and

internalities.
Addressing obesity through tax policy is
hard: While every cigarette is bad for you,
clearly some food consumption is good for
you!
Major policy focus:
o Improved information about
caloric/nutrition content
o Targeting of the substances most closely
linked to obesity, such as trans-fats
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6.4
APPLICATION: Public Policy toward Obesity
Alternative policies are under consideration:

A number of states are considering taxes on
sugary sodas.
Some states have moved directly to
charging individuals for being obese or for
not caring for their weight.
Other states and employers are providing
financial incentives for employees to enroll
in wellness programs that will help them
manage their weight.
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6.5
Conclusion
Public finance provides tools to help us

think through the regulation of many kinds
of externalities:
o Regional externalities such as acid rain
o Planet-wide externalities such as global
warming
o Even the internalities of smoking and
other health-related decisions
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6.5
Conclusion
Careful analysis of public policy options

requires:
Discriminating external costs from costs
that are absorbed through the market
mechanism
Understanding the benefits and costs of
alternative regulatory mechanisms to
address externalities
Considering whether only externalities or
also internalities should count in
regulatory decisions
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Public Finance and Public Policy Jonathan

Externalities in Action: Environmental

6.1 Acid Rain

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

The Damage of Acid Rain

Acid rain is a classic negative production

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

The Damage of Acid Rain

Acid rain causes damage in a variety of ways :

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

History of Acid Rain Regulation

To combat acid rain, Congress passed the

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Estimating the Adverse Health Effects of Particulates

How does acid rain (or SO2) affect health?

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Estimating the Adverse Health Effects of Particulates

Chay and Greenstone (2003) studied this

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

SO2 Levels in Attainment and Non-Attainment Areas

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

History of Acid Rain Regulation

Clean air acts reduced SO2 emissions but

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

History of Acid Rain Regulation

Has the Clean Air Act Been a Success?

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Global warming is a serious environmental

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

CO2 Output: 25 Largest Contributors

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

APPLICATION: The Montreal Protocol

International cooperation will be necessary to

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

APPLICATION: The Montreal Protocol

The Montreal Protocol was adopted, aimed

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

The Kyoto Treaty

In 1997, Kyoto hosted international

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Can Trading Make Kyoto More Cost-Effective?

The Kyoto treaty allowed for international

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Can Trading Make Kyoto More Cost-Effective?

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Can Trading Make Kyoto More Cost-Effective?

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Participation of Developing Countries

The Kyoto treaty did not involve developing

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

Participation of Developing Countries

Developing nations want no part of this

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

What Does the Future Hold?

Developments since the Kyoto treaty of

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

APPLICATION: Congress Takes on Global Warming

In 2009, the House passed the American

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

APPLICATION: Congress Takes on Global Warming

The ACES Act drew criticism from several

C HAPTE R 6 E XTE R NALI TI E S I N ACTI O N : E N V I R O N M E N TAL AN D H EALTH E XTE R NALI TI E S

The Economics of Smoking