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Externalities and the use of cost benefit analysis

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Details: Sometimes market activities (production, buying and selling) have unintended positive or negative effects outside the market's scope. This is called an externality. Suppose that you are a policy maker concerned with correcting the effects of gases and particulates emitted by and local power plant. What tools would you use? What would be the benefits of the action? What would be the costs? How would you decide what was the best level of emission reduction? Why do you think your approach would be better than others?

Cost and Benefit analysis can be used to justify eliminating pollution. There are two levels of analysis. The society must decide on the optimal level of pollution. For example, if a factory were creating $100,000 per year in damages due to pollution it would not make sense to pay $500,000 to eliminate it. It would be best to pay the damages of of $100, 000 and continue to pollute. Second, if pollution should be eliminated, the society must decide how to eliminate the pollution: regulation (uniform abatement policy), tax on pollution, or selling permits to pollute. To understand the analysis, it is best to consider marginal benefit and the marginal cost of any new program or activity. Your response should address of the two levels of analysis,. Justify your choice for the method to control and reduce pollution.

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Since you aren't given the marginal costs of any given method of pollution reduction, there isn't a single right answer to this question. Your instructor wants to make sure you understand how such a decision would be made. You will need to make some assumptions in order to choose one method over another. It doesn't matter which method you choose as long as your reasoning is sound.

Most people agree that there are some circumstances where the market fails and some sort of regulation is necessary. Market failures result in externalities: benefits and costs not reflected in the market price. In this case, you are dealing with a negative externality that causes the production costs to be lower than they really should be. The government needs to intervene to bring the cost up to its true value to society.

First we should establish that zero pollution is not a feasible position. We tend to think of pollution as a modern phenomenon, but whenever people congregate in large numbers, pollution results. It occurred in ancient civilizations just as it does today, although on a much smaller scale. So, we cannot expect any industry to be entirely pollution-free. The earth has many systems that eliminate pollution, and the important thing is not to allow them to become overwhelmed, which will disrupt global cycles (as we are with greenhouse gases) and not to create pollution so quickly that it builds up to harmful levels before the earth can remove it. In addition we must consider that the costs of cleaning the environment are often passed on to consumers through higher prices.

Thus, ...

Solution Summary

Correcting externalities and the use of cost benefit analysis.