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Microeconomic measurement of the social costs of environmental regulation
ENVIRON IMPACT ASSESS REV 1985; 5:117-131
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MICROECONOMIC MEASUREMENT OF THE SOCIAL COSTS OF ENVIRONMENTAL REGULATION
WILLIAM B. TYE
This paper provides a coherent microeconomic framework for defining and measuring the social costs of environmental regulations. A fundamental identity between two alternative means of measuring social costs is established and used to illustrate how erroneous methodologies have crept into the impact assessment literature. Several interesting cases of "ripple effects" including those related to the siting of hazardous waste disposal facilities are considered using this identi~.
W I L L I A M B. TYE is a Director of Putnam, Hayes & Bartlett, Inc., Economic and Management Counsel. The group has offices in Cambridge, Massachusetts, Washington, DC, and San Francisco, California.
New initiatives have been launched recently to improve both the methodology and practice of the microeconomic measurement of social costs of environmental regulation. 1 The purpose of this paper is to provide a simple and coherent microeconomic framework for defining and measuring those costs. 2 tEfforts to compute the costs of environmental regulations by microeconomic analysis were encouraged by Executive Order 12291, 46 F.R. 13193 (19 February 1981). The present paper originated in efforts by the U.S. Environmental Protection Agency (EPA) to improve its approach to measuring the costs of compliance with EPA environmental regulations. See Hammett and Tye (1981) and Ferguson and Burrows (1982). 2This microeconomic analysis of specific regulations for specific markets or firms should not be confused with the literature on the social costs of environmental regulation from the perspective of aggregate effects on national income, productivity, economic growth, etc. For a survey of these macroeconomic studies of expenditures, see Portney (1981). For a survey of the aggregate effects of environmental regulation on productivity, see Christainsen and Havemen (1981).
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Critical issues in the measurement of the costs of environmental compliance have not been resolved in theory or practice. Although there is a considerable theoretical literature on the subject of social cost/benefit analysis, much of it was written when evaluation focused on the output effects of government actions (transportation and water resource investments, for example). Other literature has focused on the structure of optimal taxes on emissions or on measuring the costs of pollution (or the benefits of abatement), not on directly measuring the social cost of mandated compliance. Many of the environmental regulations now being considered will increase the costs of production (and product prices) in the directly affected industries. Because they work through price effects and not directly through quantity effects, some of the conceptual approaches to the measurement of environmental costs which appear to be based on extending the results of cost/benefit analysis have been incorrect. This paper shows that some of the literature on social costs of environmental compliance (measured only in the directly affected consumer good market) contains errors of adding components from inconsistent methodologies, thereby resulting in overstated or understated measurement of true social costs. This "apples and oranges" error is most likely to be found in the special case of environmental controls applied to a monopoly. The analysis is then expanded to consider situations where the analyst must consider "ripple effects" in other markets. It is necessary to account for an interesting asymmetry for substitutes and complements. Finally, the paper identifies the circumstance where analysis of the direct effects in an intermediate good market is sufficient and downstream "ripple effects" may be safely ignored. Since the primary effect of the Resource Conservation and Recovery Act (RCRA) regulations is to raise the cost of manufacturing in the directly affected industry, the discussion focuses on the effects of increased production costs. The social costs of regulations involving bans on use or production of certain products, premanufacturing notification, and other regulatory actions are not discussed, although they raise many of the same issues as this paper. Nor does the paper address administrative costs incurred by the government in enforcing regulations. CONCEPTUAL FRAMEWORK FOR THE MEASUREMENT OF SOCIAL COSTS IN T H E CETERIS PARIBUS CASE The "private costs" imposed on different parties by regulations must be distinguished from the "social costs." Measurement of the private costs (or benefits) is required to evaluate the distributional impacts of regulations and to predict how different parties will respond to environmental regulation. "Social costs" are the net costs imposed on the society as a whole, where private costs are aggregated to determine a net social cost figure. Social costs measure the minimum aggregate money compensation that would be required to make consumers
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and producers no worse off despite the fact that the regulations will generally raise prices to consumers and increase costs (and, thereby, decrease profits) to producers. Social costs, therefore, measure the willingness of those who are adversely affected to be paid for the "damages" which they incur as a result of the regulation. The social costs of environmental regulations can be defined most broadly as the value of the output of goods and services foregone by society as a result of the regulations. One approach to measuring social costs assumes that the social costs of environmental regulations will be borne by either consumers or producers in markets directly or indirectly affected by the regulation. One measure of the social costs in an individual market, therefore, is the sum of 1) the loss of "consumers' surplus" resulting from the price increases plus 2) the loss of "producers' surplus" that sellers bear because of cost increases they cannot pass on. Another approach to the measurement of the social costs of regulation is to distinguish where the loss of output takes place. Social costs result from reduced output of goods and services which ultimately will affect the public (as consumers or producers). Some of this reduced output occurs in the directly affected industry because compliance raises production costs, raises prices, and reduces quantity demanded. The remainder of social cost comes in the form of reduced output in other industries because compliance requires the use of resources that would otherwise be used for production in other industries. Thus, it is also useful to disaggregate social costs in an individual market into a second classification scheme: social costs are the sum of 1) compliance expenditures, the value of goods and services that would otherwise be produced with resources used to achieve compliance for output in the directly affected industry which continues despite the regulation, plus 2) the net loss of consumers' and producers' surplus ("deadweight loss") associated with decreases in the output of goods and services directly in the industry required to comply with the regulation. 3 These two alternative methods of measuring social costs point to a fundamental equality (Equation 1) for measuring the social costs of environmental regulations in the directly affected market: Method 1:
Lost Consumers' Surplus + Lost Producers' Surplus ---
(1)
Total Lost Surplus =
3Note that all social costs are defined here not to net out any measure of benefits, on the grounds that these benefits are realized elsewhere in the economy and are not necessarily susceptible to measurement as social costs by similar methodologies. Method 2 is a useful result in practice because many analyses of regulations begin with an evaluation of the postregulation compliance cost imposed on the directly affected industry. If compliance cost estimates have been developed using market prices which reflect opportunity costs, then social costs can be measured by correcting this estimate, as necessary, by adding the lost surplus on foregone output. This is the framework for measuring social costs specified in "Appendix B: Regulatory Impact Analysis Guidance for Cost Analysis" of EPA (1982).
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Method 2: Compliance Expenditures on Post-Regulation Output + Lost Producers' and Consumers' Surplus Resulting from Reduced Output in the Directly Affected Industry. Based on this fundamental identity, a conceptual framework for calculating the social costs of environmental regulations may now be proposed for a ceteris paribus base case, assuming that only prices in the o n e market for a final consumer good are affected and that the directly affected market is perfectly competitive. The following changes in base case assumptions are then made: 1) the output in the directly affected industry is sold by a monopolist, and 2) the output is sold in a competitive market, but sellers are buying their resource inputs for compliance in markets with upward-sloping supply curves that cause prices to rise when compliance increases demand for those inputs. Other interesting cases of "ripple effects" occur when prices of substitutes and complements are affected or when the directly affected industry sells an intermediate good that is purchased by other industries and not consumers. SINGLE COMPETITIVE MARKET FOR CONSUMER GOODS WITH ELASTIC INPUT SUPPLY
The appropriate methodology for the base case is straightforward (Garvin and Leone 1981), 'but will be developed to provide a framework for understanding the misleading results found in the literature on departures from the base case. Under the simplified conditions of the base case, total social costs can be measured entirely by changes in the directly affected market. Figure 1 illustrates the losses in surplus as measured under the assumption that environmental regulations require an upward shift in supply from S to S'. The two approaches in Equation (1) make clear that the costs may be distinguished by who bears the costs (producers or consumers) or by how they are borne in the directly affected market (compliance costs on postregulation output or lost surplus on foregone output). The total loss of consumers' surplus associated with a decrease in output from Qo to Q1 and the price increase is the sum of areas a, b, and c. The cost to producers is the loss of producers' surplus of d + e, but there is the gain of producers' surplus equal to c. Using the first method, the social cost is the sum of the lost producers' and consumers' surplus, 4 or (a + b + c) + (d + e -
c) = a + b + d + e.
(2)
4We are thus assuming the existence of the compensated demand curve or assuming that the Marshallian demand curve is a reasonable approximation (i.e., no significant income effects). We are also assuming that the resource costs reflected in the supply curve are a true measure of the social cost of these resources in the base case.
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price
s
ii D
It
Q
QO
output
FIGURE 1. Loss of producers' and consumers' surpluses resulting from RCRA regulations.
The social costs can also be restated using the second definition, the cost of compliance for output that continues to be produced in the directly affected market (b + d), plus the loss of consumers' and producers' surplus on the lost output (a + e). (Note that c is not a net social cost because it changes from consumers' to producers' surplus.) The incidence of social costs of foregone output between consumers and producers is fairly obvious, but the incidence of the social cost of compliance is complicated by the fact that area c is a transfer from consumers' to producers' surplus which helps offset compliance costs (b + d). The following are general rules about the relative importance of compliance expenditures versus the value of lost output: • Where demand is inelastic, minimal adjustments in output occur in response to regulation, and the social costs of regulation consist primarily of the value of the resources used to achieve compliance. This result is not affected by the shape of the supply curve before and after regulation. Where demand is inelastic and the other assumptions of the base case are valid, then little bias is introduced by using compliance expenditures as a proxy for total social costs since the decreases in output in the directly affected market will be minor.
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. Where supply is highly elastic and demand is also elastic, a substantial decrease in output will occur. Hence, a substantial net loss in consumers' surplus occurs, but losses in producers' surplus are minimal. , Where demand is elastic (and hence output decreases as a result of regulation) and supply is inelastic, substantial net losses in producers' surplus will occur. A review of the theoretical and applied studies of microeconomic analysis of environmental regulations indicates that few, if any, have employed the identity of the two methods in Equation (1). Most prospective microeconomic analyses of environmental regulations, which purport to be "impact studies" rather than estimates of social cost, estimate the economic costs as the per-unit compliance costs times preregulation output, thereby, overstating social costs (Ferguson and Burrows 1982). On the other hand, most aggregate studies of environmental compliance estimate social costs on the basis of compliance costs of postregulation output and ignore the social costs of the lost output.5 Some of the theoretical literature on environmental compliance on departures from the base case has confused the two approaches. 6 MONOPOLY M A R K E T FOR OUTPUT In principle, the measurement of the social costs when the affected industry consists of a single firm is no different than for a competitive market, but the output and pricing decision of the monopolist and the discrepancy between price and marginal revenue must be accounted for. Before the cost increase, the monopolist in Figure 2 charges Po and produces Q0. Afterward he produces QI and charges PI. Using Method l, the total loss of producer's surplus is a + c + e + f - d (compliance costs plus loss of monopoly profit on foregone output minus the revenue from the price increase on postregulation output). The total loss in consumers' surplus is b ÷ d, as before, resulting in total social costs of a + b + c + e + f. The net social costs of regulation using Method 2 are more ambiguous to compute. They are equal to compliance costs on continued output (area a) plus lost consumers' surplus on foregone output (area b), plus lost producer's surplus on foregone output after accounting for the effect of the decline in output on
5Pormey (1981) notes in his survey that most of the aggregate estimates of expenditures for environmental regulation thereby understate true social costs. °Of course, not all studies have applied the two methodologies in an inconsistent manner. Thomas (1980) applies the first method consistently to the steel industry, but does not attempt to disaggregate his estimated social costs into compliance costs and lost surplus on foregone output (Method 2).
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d••
Pl
P2
.-
I i
QI
/
MC' MC
|
MR
QO
FIGURE 2. Single monopoly market. price (area c), plus the social cost resulting from the discrepancy between price and marginal revenue (e + f).7 The case of the impact of environmental regulations on a monopolist is especially interesting because of the ambiguity over the gap between price and marginal revenue on the reduced output for the monopolist. There is a true social cost of foregone output, represented by e + f, that may be thought of as a social cost incurred as a result of compounding environmental compliance with monopoly (Buchanan 1969). This cost has been the subject of considerable debate and confusion. Some authors have implied that a monopolist bears all compliance costs, thus apparently leaving consumers to bear all social costs of foregone output, which is not ordinarily true (Leone and Startz 1976). More than one study has confused the two approaches by adding the loss of consumers' surplus to the compliance expenditures to estimate the total social cost. 8 7The measurement of social cost in this exercise does not take specifically into account the fact that some of the social cost is realized in the form of reduced monopoly profit. However, weighting the cost measurements to account for the distribution of costs is not ruled out. SPeskin and Seskin (1975) incorrectly define the social cost of regulation as the sum of lost consumers' surplus and compliance costs for a monopolist. Equation (1) shows that this amounts to adding part of the result of Method 1 to part of the result of Method 2.
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Some researchers have computed social costs of environmental regulation for a monopoly by assuming that the upward shift in the cost curve resulted from a socially efficient tax on pollution (or some other form of environmental regulation for which there are no net social costs of compliance). Under these circumstances, it is argued that the monopolist allegedly bears all the costs of compliance but can force the consumer to bear an "external" social cost of foregone output. 9 Equation (1) for measuring the social costs of regulation shows that the analysis of taxes on pollution does not apply to the computation of the social costs of compliance with mandated pollution abatement, where there is no assurance that compliance costs will be exactly offset by benefits from pollution abatement. (Indeed, the purpose of the analysis of social cost is to determine whether benefits exceed costs.) In the latter case, it is not true in the case of either monopoly or competitive markets that sellers bear all the costs of compliance because lost producers' surplus is ordinarily not equal to compliance costs for a monopolist. In both cases it depends on the degree to which the cost increases can be passed on (the extent to which the loss of producers' surplus resulting from cost increases is offset by a shift from consumers' to producers' surplus on postregulation output resulting from price increases). We also cannot conclude, as some have, that in either case consumers bear all the social cost of foregone output. These principles may be illustrated by a textbook example (Henderson and Quandt 1971). Assume that a monopolist has a demand curve o f p = 100 - 4q and a cost curve of c = 50 + 20q, where p is price, q is quantity, and c is cost. Price and quantity are $60 and $10, respectively, as the profit maximum prior to the environmental control. If compliance costs $8 per unit, the postregulation price and quantity become $64 and $9, and profit declines from $350 to $274. Lost producers' surplus is therefore $76. Using Method 1, the change in consumers' surplus (b + d) is $38, making total social costs equal to $114. Using this same method, lost producers' surplus may be computed as a + c + f + e - d = $76. Compliance costs (a) are $72, lost surplus on foregone output is $42, and both also sum to $114. This example clearly indicates that compliance costs do not equal the cost of environmental regulation to the monopolist, nor may the social cost of the foregone output be said to be borne by consumers.
9According to Burrows (1980): "[t]he basic difference between the two methods of abating cutting output and switching process from the point of view of the welfare effects of pollution control is that in the case of process switches the monopolistic polluter bears all the consequences of the abatement but with output cuts he does not . . . . As we have seen, when the monopolistic polluter abates by cutting output in effect an external cost is imposed on the consumers of the monopolist's product which may exceed the benefits to the pollutees . . . . We may presume, therefore, that abatement through process switching always yields a net (social) benefit [sic], otherwise the monopolist, who pays the cost and reaps the benefit, would not undertake it" [emphasis supplied]. See also Bturows (1981).
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C O M P E T I T I V E M A R K E T FOR T H E CONSUMER GOOD AND AN UPWARD-SLOPING INPUT SUPPLY CURVE So far we have assumed that prices in other markets do not change and that effects in other markets can be safely ignored. S{nce this is the approach almost always undertaken in practice, it is of interest to identify circumstances where the ceteris paribus assumption may not be valid. The first important relaxation of the base case assumptions is a case in which the producer affected by environmental regutations is selling output in a highly competitive industry, but is purchasing inputs in circumstances where the cumulative effects of the environmental regulation drive up resource costs. An especially interesting case is restricted availability of disposal sites for hazardous wastes. Under such circumstances, the private costs of compliance will exceed the social costs because of "windfall gains," or producers', surplus, that will accrue to qualified landowners. Social costs of compliance are less than the private costs to the directly affected industry when the affected industry faces an upward-sloping supply curve for resource inputs and the resulting increase in demand for resources is large relative to the size of the market. As shown in Figure 3, the regulation causes an increase in demand for this resource (a shift from DI to D2) and drives up the price from Po to Pj. The private cost of compliance is the additional resources times the new price (the area a + b + c + d + e). However, some of this cost is ecoFIGURE 3. Measurement of social cost of resources required for compliance. price
S
P1 f
c
PO D 2
i
I
i
I
Q1
QO
D
output
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nomic rent accruing to the owners of the resources. Therefore, we net out the loss of consumers' surplus for the original consumers (f + d) against the gain in producers' surplus (f + d + c) to get a gain in surplus of c. This must be netted out of the private cost computation in the directly affected industry to get a net social cost of a + b + d + e.1° Note that this is equivalent to pricing the incremental quantity at a price between Po and PI, the before and after prices. Thus an adjustment to private costs must also be made to arrive at social costs when neither the before nor after market price is a true measure of opportunity cost. One might justify intuitively the adjustment downward of private costs by the fact that market prices of inputs used for compliance do not represent true opportunity costs. Viewed another way, when a critical resource for compliance is in scarce supply relative to the magnitude of the demands of compliance, environmental regulations work to make the supply available by encouraging additional output of the resource and by squeezing out existing uses of that resource. This happens through the mechanism of a price increase which has the effect of depriving preexisting consumers of benefits by forcing them to forego use of the resource and to pay more for the resource they continue to use. However, this loss is more than offset by the gains of the owners of that resource. These gains and losses must be netted out to the private costs of compliance in the directly affected industry to get the net social cost of the resources. When the firm faces an upward-sloping supply curve for a resource, the cost that must be used is the opportunity cost shown on the supply curve, not the price of the last unit sold, when the regulation results in relatively large changes in demand. The primary complication is that preexisting uses of the resource would also have been generating consumers' and producers' surpluses which may be lost because of the requirement to shift resources to use for RCRA compliance. In the above example, the social cost could also have been computed by taking the opportunity cost of the resources in some other use as shown by the supply curve (a + b) and adding to it the lost consumers' surplus on previous uses squeezed out by the price increase (d) and the lost producers' surplus on this suppressed demand (e). In principle, the approach when buying a resource from a monopolist is identical to that shown here. The private compliance cost in the directly affected industry must be adjusted by adding the loss in consumers' surplus and subtracting
~°Note that buyers and sellers in the immediately affected industry will usually both incur losses, but in industries supplying resources needed for compliance, there may be an increase in producers' surplus and windfall gains. Netting out these gains in the computation of social costs requires use of the controversial "hypothetical compensation" test, which also underlies final comparisons of benefits and costs. Therefore, some analysts who are troubled by this practice may prefer not to net out surpluses at this point and instead retain separate measures of compliance cost in the directly affected industry, the loss of consumers' surplus in the market of the supply of inputs needed for compliance, and the gain in producers' surplus in that input industry.
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the increase in monopoly profit in the industry supplying inputs needed for compliance. H
ANALYSIS OF "RIPPLE EFFECTS" ON SUBSTITUTES AND COMPLEMENTS Price changes in the market directly affected by the environmental regulation may have "ripple effects" on prices and quantities in markets for substitutes and complements. Many evaluations of social costs of regulation ignore these ripple effects, and indeed, some analysts have even advised EPA that economic theory says that they should be ignored (Ferguson and Burrows 1982). For example, assume that automobile production costs rise due to environmental requirements, with a resulting decline in the output of autos and an increase in auto prices. If the resulting shift in the price for automobiles has no effect on the other prices, the analysis can stop with the evaluation of the lost producers' and consumers' surpluses in the market for automobiles. This conclusion holds even though demand curves in other markets may shift causing increases or decreases in quantity demanded. ~2 However, if the change in price and quantity demanded in the automobile market is sufficient to cause price changes in the market for bicycles, the area c in Figure 4 for the bicycle market represents the net loss in producers' and consumers' surpluses associated with the increased price of bicycles. The fact that area c in Figure 4 represents an additional loss of surplus may be shown as follows. First, the price increase in the market for bicycles creates an increase in producers' surplus equal to a + b for sellers of bicycles. This gain, however, is more than offset by losses in consumers' surplus, a + b + c, leaving c as the net decrease in surplus in the market for bicycles. The case of complements illustrates an interesting asymmetry in computing the effects in linked markets. If the increase in the price of automobiles caused an inward shift (from D2 to D1 in Figure 4) in the demand for a complement, say gasoline, the change of producers' surplus would still be a + b, but the gain of consumers' surplus would now be b, leaving net loss of a. The anomaly is that there is a net loss in the indirectly affected market regardless of whether it is a substitute or a complement (i.e., whether price rises or falls). This result is a consequence of the fact that the change in consumers' surplus in the indirectly linked market must be computed using the new demand
llAnderson and Settle (1977) and Gramlich (1981) show figures for the relevant areas. ~2Since the assumption employed in computing surplt/s changes in ceteris paribus (no changes in other prices), adjustments in other markets where prices do not change have already been taken into account entirely in our measurement. There is no danger that the change in consumers' surplus for automobiles somehow will be offset or increased by changes in consumers' surplus in markets for substitutes or complements, as long as prices in those markets do not change (Mishan 1976).
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price
S P1 PO
J
~
D1 D2 output
FIGURE 4. "Ripple effects" on substitutes or complements.
curve (after the price increase in the directly affected market). The price increase for the substitute is made even more onerous because new consumers have joined the old ones in the market for the substitute. But when the price of a complement falls, much of the benefit that would have otherwise been realized is negated by the price increase in the directly affected market, again leaving a net loss in the indirectly affected market. EXTENSION OF T H E ANALYSIS TO INTERMEDIATE GOODS Some analysts have extended the consumers' surplus analysis to an intermediate good by computing areas under the derived demand curve for an intermediate good used as an input into a "downstream" market for final output. Others have argued that the analysis must not take place at the level of the intermediate good but trace through the impacts on all final consumer goods as well (Bohm 1973; Stevenson 1976; Harris arid Sullivan 1979; Schmalensee 1971). The validity of applying the methodologies in Equation (1) to intermediate goods raises major methodological and empirical issues for environmental analysis. To begin with, much of the environmental regulation problem arises at the level of heavy industry which often sells inputs to final goods industries, not directly to final customers. Second, if study of the immediate effects in the directly affected industry were inadequate, the analysis task and data requirements for measuring social cost would be vastly expanded. Lastly, the apparent
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disagreement on the appropriate methodology tends to undermine confidence in and encourage disputes over the results. Fortunately, the issue appears to have been cleared up by a recent article by Stephen E. Jacobsen (1979). He shows that under very general conditions, the area under the demand curve for an intermediate good is the sum of lost producers' surplus by the buyer of the intermediate good (i.e., the losses imposed on the sellers in the downstream market) plus the consumers' surplus losses in the downstream market--as long as that downstream market is perfectly competitive. In this case, downstream effects can be safely ignored unless there is interest in ultimate distributional effects. However, for the downstream market that is a monopoly (or imperfectly competitive), Jacobsen demonstrates the rather surprising result that the area under tho upstream demand curve represents only the losses of profit to the downstream monopolist and ignores entirely the downstream effects on consumers.13 Applying Jacobsen's results, first consider the simplest case where the environmental regulation affects the costs of supplying an intermediate good produced in a highly competitive market (such as the world market for a commodity). If costs rise, the opportunity costs of foregone output because of the regulation are borne completely by losses in producers' surplus in the directly affected market because the cost increase cannot be passed on. 14 Since the price of the producer good does not change, neither does the price or demand for final consumer goods and the analysis can stop at this point. If the price of the intermediate good rises, the analysis can also be limited to the intermediate good market as long as it is selling its output to competitive industries. A more complicated case might involve changes in the price of an intermediate good sold to a monopolist. Jacobsen's results require one to trace through the downstream effects by applying the basic identity of the two methods: 1) using Method 1, compute the downatream losses in consumers' surplus resulting from the price increase and add them to the loss of consumers' and producers' surplus in the directly affected market; or 2) using Method 2, compute the downstream losses in consumers' and producers' surplus resulting from the loss of output of the intermediate good and add these to compliance costs in the directly affected market. 15 t3Schrnalensee (1976) corrected his earlier paper and pointed out that all downstream effects would be captured in the upstream analysis as long as downstream markets are competitive. He also recognized that welfare effects in upstream markets underestimate downstream effects if final markets are monopolistic. Jacobsen generalized these results and proved that the underestimation in the upstream analysis is exactly equal to the loss of consumers' surplus in the downstream market. See also Spencer and Brander (1983) and Just and Hueth (1979). ~*rhe analysis assumes that producers buy all their inputs in competitive markets and it is impossible to "pass back" the losses to sellers in these markets. When producers am able to pass their losses back upstream, the situation is entirely analogous to our downstream results. The upsteam analysis is omitted for simplicity in the presentation that follows. ~Slt is important to note that the downsU~am effects of price changes in the market for an intermediate good are not to be added to compliance costs. Once aggregate cost has been determined by Method 1, it may then be desirable to distinguish between compliance costs in the directly affected markets and lost producers' and consumers' (or more accurately, buyers') surpluses on the foregone output in the directly affected market.
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CONCLUSIONS This paper suggests the following conclusions and guidelines for applying social cost analysis: 1. Social costs are the aggregate of private costs as measured by lost consumers' and producers' surpluses, which in the ceteris paribus case involve only the directly affected market. 2. These social costs can also be computed as the costs of compliance on postregulation output plus lost consumers' and producers' surpluses on output losses in the directly affected industry (corrected for discrepancies between price and marginal cost for the monopoly case). 3. Although there are examples of confusing the two approaches in the theoretical literature, these errors have not yet found their way into practice simply because practitioners have not yet attempted to employ social cost as a tool for estimating the cost of environmental regulation. 4. The possibility of substantial "ripple effects" must be considered when prices in other markets are affected. An important case is when the price of a critical resource, such as disposal sites for hazardous wastes, is bid up as a result of compliance efforts. Postregulation estimates of social costs that do not account for this windfall gain overstate social costs in this case. In the cases of both substitutes and complements, the estimate of social costs is increased above the level in the directly affected industry alone by considering ripple effects. For intermediate goods, it does not appear to be unreasonable to ignore upstream or downstream effects unless there is concern over the incidence of costs or there is evidence of imperfect competition in the upstream or downstream markets.
This paper is based on research initiated in connection with a project undertaken for the Office of Solid Waste of the U.S. Environmental Protection Agency (EPA) by Putnam, Hayes & Bartlett, Inc. (PHB). The purpose of the project was to define methodologies for measuring the social costs resulting from Resource Conservation and Recovery Act .(RCRA) regulations. However, the views in this paper are entirely those of the author. Special thanks go to Nancy HammeR, a co-author of the original PHB study, for her inspiration to write this paper and her invaluable suggestions. Lawrence Buc, formerly with EPA, identified the need for the PHB study and encouraged its development and circulation at EPA.
REFERENCES Anderson, L G. and Settle, R. F. 1977. Benefit-Cost Analysis: A Practical Guide. Lexington, MA: Heath, Lexington Books. Bohm, P. 1973. Social Efficiency: A Concise Introduction to Welfare Economics. New York: John Wiley & Sons.
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Buchanan, J. M. 1969. External Diseconomies, Corrective Taxes, and Market Structure, American Economic Review 59(1) (March): 174-177. Burrows, P. 1980. The Economic Theory of Pollution Control. Cambridge, MA: MIT Press. Burrows, P. 1981. Controlling the Monopolistic Polluter: Nihilism or Eclecticism? Journal of Environmental Economics and Management (December):372-380. Christainsen, G. B. and Haveman, R. H. 1981. The Contribution of Environmental Regulations to the Slowdown in Productivity Growth. Journal of Environmental Economics and Management (8):318-390. Ferguson, A. and Burrows, E. C. 1982. The Social Cost of Environmental Regulation. Washington, DC: Public Interest Economics Center. Garvin, D. A. and Leone, R. A. Regulatory Cost Analysis: An Overview. Environmental Impact Assessment Review 2(1):39-62. Gramlich, E. A. 1981. Benefit-CostAnalysis of Government Programs. Englewood Cliffs, NJ: Prentice-Hall. Hammett, N. and Tye, W. B. 1981. Measurement of the Social Costs of Regulation. Working Paper No. 3 (December): Cambridge, MA: Putnam, Hayes & Bartlett. Harris, R. G. and Sullivan, L. A. 1979. Passing on the Monopoly Overcharge: A Comprehensive Policy Analysis. University of Pennsylvania Law Review (December): 269-360. Henderson, J. M. and Quandt, R. E. 1971. Microeconomic Theory. New York: McGrawHill Co. Jacobsen, Stephen E. 1979. On the Equivalence of Input and Output Market Marshallian Surplus Measures. American Economic Review 69,3:423-428. Just, R. E. and Hueth, D. L. 1979. Welfare Measures in a Multimarket Framework. American Economic Review 69,5 (December):947-954. Leone, R. A. and Startz, R. 1976. The Methodology: A Framework for Analysis. In Leone, R. A. (ed.) Environmental Controls: The Impact on Industry. Lexington, MA: D.C. Heath. Mishan, E. J. 1976. Cost-Benefit Analysis. New York: Praeger Publishers. Peskin, H. M. and Seskin, E. P. 1975. Cost Benefit Analysis and Water Pollution Policy. Washington, DC: The Urban Institute. Portney, P. R. 1981. The Macroeconomic Impacts of Federal Environmental Regulation. Natural Resources Journal (July):457-488. Schmalensee, R. 1971. Consumers' Surplus and Producers' Goods. American Economic Review (September):682--687. Schmalensee, R. 1976. Another Look at the Social Valuation of Input Price Changes. American Economic Review (March):239-243. Spencer, B. J. and Brander, J. A. 1983. Second Best Pricing of Publicly Produced Inputs: The Case of Downstream Imperfect Competition. Journal of Public Economics 20,1 (February): 113-119. Stevenson, R. E. 1976. The Pricing of Postal Services. In Trebing, H. M. (ed.) New Dimensions in Public Utility Pricing. East Lansing, MI: Michigan State University. Thomas, V. 1980. Welfare Cost of Pollution Control. Journal of Environmental Economics and Management 7:90-102. U.S. Environmental Protection Agency. 1982. Guidelines for Performing Regulatory Impact Analyses. Washington, DC: U.S. EPA.
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MICROECONOMIC MEASUREMENT OF THE SOCIAL COSTS OF ENVIRONMENTAL REGULATION
WILLIAM B. TYE
This paper provides a coherent microeconomic framework for defining and measuring the social costs of environmental regulations. A fundamental identity between two alternative means of measuring social costs is established and used to illustrate how erroneous methodologies have crept into the impact assessment literature. Several interesting cases of "ripple effects" including those related to the siting of hazardous waste disposal facilities are considered using this identi~.
W I L L I A M B. TYE is a Director of Putnam, Hayes & Bartlett, Inc., Economic and Management Counsel. The group has offices in Cambridge, Massachusetts, Washington, DC, and San Francisco, California.
New initiatives have been launched recently to improve both the methodology and practice of the microeconomic measurement of social costs of environmental regulation. 1 The purpose of this paper is to provide a simple and coherent microeconomic framework for defining and measuring those costs. 2 tEfforts to compute the costs of environmental regulations by microeconomic analysis were encouraged by Executive Order 12291, 46 F.R. 13193 (19 February 1981). The present paper originated in efforts by the U.S. Environmental Protection Agency (EPA) to improve its approach to measuring the costs of compliance with EPA environmental regulations. See Hammett and Tye (1981) and Ferguson and Burrows (1982). 2This microeconomic analysis of specific regulations for specific markets or firms should not be confused with the literature on the social costs of environmental regulation from the perspective of aggregate effects on national income, productivity, economic growth, etc. For a survey of these macroeconomic studies of expenditures, see Portney (1981). For a survey of the aggregate effects of environmental regulation on productivity, see Christainsen and Havemen (1981).
© 1985 Elsevier Science Publishing Co., Inc. 52 Vanderbilt Avenue, New York, NY 10017
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Critical issues in the measurement of the costs of environmental compliance have not been resolved in theory or practice. Although there is a considerable theoretical literature on the subject of social cost/benefit analysis, much of it was written when evaluation focused on the output effects of government actions (transportation and water resource investments, for example). Other literature has focused on the structure of optimal taxes on emissions or on measuring the costs of pollution (or the benefits of abatement), not on directly measuring the social cost of mandated compliance. Many of the environmental regulations now being considered will increase the costs of production (and product prices) in the directly affected industries. Because they work through price effects and not directly through quantity effects, some of the conceptual approaches to the measurement of environmental costs which appear to be based on extending the results of cost/benefit analysis have been incorrect. This paper shows that some of the literature on social costs of environmental compliance (measured only in the directly affected consumer good market) contains errors of adding components from inconsistent methodologies, thereby resulting in overstated or understated measurement of true social costs. This "apples and oranges" error is most likely to be found in the special case of environmental controls applied to a monopoly. The analysis is then expanded to consider situations where the analyst must consider "ripple effects" in other markets. It is necessary to account for an interesting asymmetry for substitutes and complements. Finally, the paper identifies the circumstance where analysis of the direct effects in an intermediate good market is sufficient and downstream "ripple effects" may be safely ignored. Since the primary effect of the Resource Conservation and Recovery Act (RCRA) regulations is to raise the cost of manufacturing in the directly affected industry, the discussion focuses on the effects of increased production costs. The social costs of regulations involving bans on use or production of certain products, premanufacturing notification, and other regulatory actions are not discussed, although they raise many of the same issues as this paper. Nor does the paper address administrative costs incurred by the government in enforcing regulations. CONCEPTUAL FRAMEWORK FOR THE MEASUREMENT OF SOCIAL COSTS IN T H E CETERIS PARIBUS CASE The "private costs" imposed on different parties by regulations must be distinguished from the "social costs." Measurement of the private costs (or benefits) is required to evaluate the distributional impacts of regulations and to predict how different parties will respond to environmental regulation. "Social costs" are the net costs imposed on the society as a whole, where private costs are aggregated to determine a net social cost figure. Social costs measure the minimum aggregate money compensation that would be required to make consumers
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and producers no worse off despite the fact that the regulations will generally raise prices to consumers and increase costs (and, thereby, decrease profits) to producers. Social costs, therefore, measure the willingness of those who are adversely affected to be paid for the "damages" which they incur as a result of the regulation. The social costs of environmental regulations can be defined most broadly as the value of the output of goods and services foregone by society as a result of the regulations. One approach to measuring social costs assumes that the social costs of environmental regulations will be borne by either consumers or producers in markets directly or indirectly affected by the regulation. One measure of the social costs in an individual market, therefore, is the sum of 1) the loss of "consumers' surplus" resulting from the price increases plus 2) the loss of "producers' surplus" that sellers bear because of cost increases they cannot pass on. Another approach to the measurement of the social costs of regulation is to distinguish where the loss of output takes place. Social costs result from reduced output of goods and services which ultimately will affect the public (as consumers or producers). Some of this reduced output occurs in the directly affected industry because compliance raises production costs, raises prices, and reduces quantity demanded. The remainder of social cost comes in the form of reduced output in other industries because compliance requires the use of resources that would otherwise be used for production in other industries. Thus, it is also useful to disaggregate social costs in an individual market into a second classification scheme: social costs are the sum of 1) compliance expenditures, the value of goods and services that would otherwise be produced with resources used to achieve compliance for output in the directly affected industry which continues despite the regulation, plus 2) the net loss of consumers' and producers' surplus ("deadweight loss") associated with decreases in the output of goods and services directly in the industry required to comply with the regulation. 3 These two alternative methods of measuring social costs point to a fundamental equality (Equation 1) for measuring the social costs of environmental regulations in the directly affected market: Method 1:
Lost Consumers' Surplus + Lost Producers' Surplus ---
(1)
Total Lost Surplus =
3Note that all social costs are defined here not to net out any measure of benefits, on the grounds that these benefits are realized elsewhere in the economy and are not necessarily susceptible to measurement as social costs by similar methodologies. Method 2 is a useful result in practice because many analyses of regulations begin with an evaluation of the postregulation compliance cost imposed on the directly affected industry. If compliance cost estimates have been developed using market prices which reflect opportunity costs, then social costs can be measured by correcting this estimate, as necessary, by adding the lost surplus on foregone output. This is the framework for measuring social costs specified in "Appendix B: Regulatory Impact Analysis Guidance for Cost Analysis" of EPA (1982).
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Method 2: Compliance Expenditures on Post-Regulation Output + Lost Producers' and Consumers' Surplus Resulting from Reduced Output in the Directly Affected Industry. Based on this fundamental identity, a conceptual framework for calculating the social costs of environmental regulations may now be proposed for a ceteris paribus base case, assuming that only prices in the o n e market for a final consumer good are affected and that the directly affected market is perfectly competitive. The following changes in base case assumptions are then made: 1) the output in the directly affected industry is sold by a monopolist, and 2) the output is sold in a competitive market, but sellers are buying their resource inputs for compliance in markets with upward-sloping supply curves that cause prices to rise when compliance increases demand for those inputs. Other interesting cases of "ripple effects" occur when prices of substitutes and complements are affected or when the directly affected industry sells an intermediate good that is purchased by other industries and not consumers. SINGLE COMPETITIVE MARKET FOR CONSUMER GOODS WITH ELASTIC INPUT SUPPLY
The appropriate methodology for the base case is straightforward (Garvin and Leone 1981), 'but will be developed to provide a framework for understanding the misleading results found in the literature on departures from the base case. Under the simplified conditions of the base case, total social costs can be measured entirely by changes in the directly affected market. Figure 1 illustrates the losses in surplus as measured under the assumption that environmental regulations require an upward shift in supply from S to S'. The two approaches in Equation (1) make clear that the costs may be distinguished by who bears the costs (producers or consumers) or by how they are borne in the directly affected market (compliance costs on postregulation output or lost surplus on foregone output). The total loss of consumers' surplus associated with a decrease in output from Qo to Q1 and the price increase is the sum of areas a, b, and c. The cost to producers is the loss of producers' surplus of d + e, but there is the gain of producers' surplus equal to c. Using the first method, the social cost is the sum of the lost producers' and consumers' surplus, 4 or (a + b + c) + (d + e -
c) = a + b + d + e.
(2)
4We are thus assuming the existence of the compensated demand curve or assuming that the Marshallian demand curve is a reasonable approximation (i.e., no significant income effects). We are also assuming that the resource costs reflected in the supply curve are a true measure of the social cost of these resources in the base case.
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price
s
ii D
It
Q
QO
output
FIGURE 1. Loss of producers' and consumers' surpluses resulting from RCRA regulations.
The social costs can also be restated using the second definition, the cost of compliance for output that continues to be produced in the directly affected market (b + d), plus the loss of consumers' and producers' surplus on the lost output (a + e). (Note that c is not a net social cost because it changes from consumers' to producers' surplus.) The incidence of social costs of foregone output between consumers and producers is fairly obvious, but the incidence of the social cost of compliance is complicated by the fact that area c is a transfer from consumers' to producers' surplus which helps offset compliance costs (b + d). The following are general rules about the relative importance of compliance expenditures versus the value of lost output: • Where demand is inelastic, minimal adjustments in output occur in response to regulation, and the social costs of regulation consist primarily of the value of the resources used to achieve compliance. This result is not affected by the shape of the supply curve before and after regulation. Where demand is inelastic and the other assumptions of the base case are valid, then little bias is introduced by using compliance expenditures as a proxy for total social costs since the decreases in output in the directly affected market will be minor.
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. Where supply is highly elastic and demand is also elastic, a substantial decrease in output will occur. Hence, a substantial net loss in consumers' surplus occurs, but losses in producers' surplus are minimal. , Where demand is elastic (and hence output decreases as a result of regulation) and supply is inelastic, substantial net losses in producers' surplus will occur. A review of the theoretical and applied studies of microeconomic analysis of environmental regulations indicates that few, if any, have employed the identity of the two methods in Equation (1). Most prospective microeconomic analyses of environmental regulations, which purport to be "impact studies" rather than estimates of social cost, estimate the economic costs as the per-unit compliance costs times preregulation output, thereby, overstating social costs (Ferguson and Burrows 1982). On the other hand, most aggregate studies of environmental compliance estimate social costs on the basis of compliance costs of postregulation output and ignore the social costs of the lost output.5 Some of the theoretical literature on environmental compliance on departures from the base case has confused the two approaches. 6 MONOPOLY M A R K E T FOR OUTPUT In principle, the measurement of the social costs when the affected industry consists of a single firm is no different than for a competitive market, but the output and pricing decision of the monopolist and the discrepancy between price and marginal revenue must be accounted for. Before the cost increase, the monopolist in Figure 2 charges Po and produces Q0. Afterward he produces QI and charges PI. Using Method l, the total loss of producer's surplus is a + c + e + f - d (compliance costs plus loss of monopoly profit on foregone output minus the revenue from the price increase on postregulation output). The total loss in consumers' surplus is b ÷ d, as before, resulting in total social costs of a + b + c + e + f. The net social costs of regulation using Method 2 are more ambiguous to compute. They are equal to compliance costs on continued output (area a) plus lost consumers' surplus on foregone output (area b), plus lost producer's surplus on foregone output after accounting for the effect of the decline in output on
5Pormey (1981) notes in his survey that most of the aggregate estimates of expenditures for environmental regulation thereby understate true social costs. °Of course, not all studies have applied the two methodologies in an inconsistent manner. Thomas (1980) applies the first method consistently to the steel industry, but does not attempt to disaggregate his estimated social costs into compliance costs and lost surplus on foregone output (Method 2).
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d••
Pl
P2
.-
I i
QI
/
MC' MC
|
MR
QO
FIGURE 2. Single monopoly market. price (area c), plus the social cost resulting from the discrepancy between price and marginal revenue (e + f).7 The case of the impact of environmental regulations on a monopolist is especially interesting because of the ambiguity over the gap between price and marginal revenue on the reduced output for the monopolist. There is a true social cost of foregone output, represented by e + f, that may be thought of as a social cost incurred as a result of compounding environmental compliance with monopoly (Buchanan 1969). This cost has been the subject of considerable debate and confusion. Some authors have implied that a monopolist bears all compliance costs, thus apparently leaving consumers to bear all social costs of foregone output, which is not ordinarily true (Leone and Startz 1976). More than one study has confused the two approaches by adding the loss of consumers' surplus to the compliance expenditures to estimate the total social cost. 8 7The measurement of social cost in this exercise does not take specifically into account the fact that some of the social cost is realized in the form of reduced monopoly profit. However, weighting the cost measurements to account for the distribution of costs is not ruled out. SPeskin and Seskin (1975) incorrectly define the social cost of regulation as the sum of lost consumers' surplus and compliance costs for a monopolist. Equation (1) shows that this amounts to adding part of the result of Method 1 to part of the result of Method 2.
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Some researchers have computed social costs of environmental regulation for a monopoly by assuming that the upward shift in the cost curve resulted from a socially efficient tax on pollution (or some other form of environmental regulation for which there are no net social costs of compliance). Under these circumstances, it is argued that the monopolist allegedly bears all the costs of compliance but can force the consumer to bear an "external" social cost of foregone output. 9 Equation (1) for measuring the social costs of regulation shows that the analysis of taxes on pollution does not apply to the computation of the social costs of compliance with mandated pollution abatement, where there is no assurance that compliance costs will be exactly offset by benefits from pollution abatement. (Indeed, the purpose of the analysis of social cost is to determine whether benefits exceed costs.) In the latter case, it is not true in the case of either monopoly or competitive markets that sellers bear all the costs of compliance because lost producers' surplus is ordinarily not equal to compliance costs for a monopolist. In both cases it depends on the degree to which the cost increases can be passed on (the extent to which the loss of producers' surplus resulting from cost increases is offset by a shift from consumers' to producers' surplus on postregulation output resulting from price increases). We also cannot conclude, as some have, that in either case consumers bear all the social cost of foregone output. These principles may be illustrated by a textbook example (Henderson and Quandt 1971). Assume that a monopolist has a demand curve o f p = 100 - 4q and a cost curve of c = 50 + 20q, where p is price, q is quantity, and c is cost. Price and quantity are $60 and $10, respectively, as the profit maximum prior to the environmental control. If compliance costs $8 per unit, the postregulation price and quantity become $64 and $9, and profit declines from $350 to $274. Lost producers' surplus is therefore $76. Using Method 1, the change in consumers' surplus (b + d) is $38, making total social costs equal to $114. Using this same method, lost producers' surplus may be computed as a + c + f + e - d = $76. Compliance costs (a) are $72, lost surplus on foregone output is $42, and both also sum to $114. This example clearly indicates that compliance costs do not equal the cost of environmental regulation to the monopolist, nor may the social cost of the foregone output be said to be borne by consumers.
9According to Burrows (1980): "[t]he basic difference between the two methods of abating cutting output and switching process from the point of view of the welfare effects of pollution control is that in the case of process switches the monopolistic polluter bears all the consequences of the abatement but with output cuts he does not . . . . As we have seen, when the monopolistic polluter abates by cutting output in effect an external cost is imposed on the consumers of the monopolist's product which may exceed the benefits to the pollutees . . . . We may presume, therefore, that abatement through process switching always yields a net (social) benefit [sic], otherwise the monopolist, who pays the cost and reaps the benefit, would not undertake it" [emphasis supplied]. See also Bturows (1981).
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C O M P E T I T I V E M A R K E T FOR T H E CONSUMER GOOD AND AN UPWARD-SLOPING INPUT SUPPLY CURVE So far we have assumed that prices in other markets do not change and that effects in other markets can be safely ignored. S{nce this is the approach almost always undertaken in practice, it is of interest to identify circumstances where the ceteris paribus assumption may not be valid. The first important relaxation of the base case assumptions is a case in which the producer affected by environmental regutations is selling output in a highly competitive industry, but is purchasing inputs in circumstances where the cumulative effects of the environmental regulation drive up resource costs. An especially interesting case is restricted availability of disposal sites for hazardous wastes. Under such circumstances, the private costs of compliance will exceed the social costs because of "windfall gains," or producers', surplus, that will accrue to qualified landowners. Social costs of compliance are less than the private costs to the directly affected industry when the affected industry faces an upward-sloping supply curve for resource inputs and the resulting increase in demand for resources is large relative to the size of the market. As shown in Figure 3, the regulation causes an increase in demand for this resource (a shift from DI to D2) and drives up the price from Po to Pj. The private cost of compliance is the additional resources times the new price (the area a + b + c + d + e). However, some of this cost is ecoFIGURE 3. Measurement of social cost of resources required for compliance. price
S
P1 f
c
PO D 2
i
I
i
I
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QO
D
output
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nomic rent accruing to the owners of the resources. Therefore, we net out the loss of consumers' surplus for the original consumers (f + d) against the gain in producers' surplus (f + d + c) to get a gain in surplus of c. This must be netted out of the private cost computation in the directly affected industry to get a net social cost of a + b + d + e.1° Note that this is equivalent to pricing the incremental quantity at a price between Po and PI, the before and after prices. Thus an adjustment to private costs must also be made to arrive at social costs when neither the before nor after market price is a true measure of opportunity cost. One might justify intuitively the adjustment downward of private costs by the fact that market prices of inputs used for compliance do not represent true opportunity costs. Viewed another way, when a critical resource for compliance is in scarce supply relative to the magnitude of the demands of compliance, environmental regulations work to make the supply available by encouraging additional output of the resource and by squeezing out existing uses of that resource. This happens through the mechanism of a price increase which has the effect of depriving preexisting consumers of benefits by forcing them to forego use of the resource and to pay more for the resource they continue to use. However, this loss is more than offset by the gains of the owners of that resource. These gains and losses must be netted out to the private costs of compliance in the directly affected industry to get the net social cost of the resources. When the firm faces an upward-sloping supply curve for a resource, the cost that must be used is the opportunity cost shown on the supply curve, not the price of the last unit sold, when the regulation results in relatively large changes in demand. The primary complication is that preexisting uses of the resource would also have been generating consumers' and producers' surpluses which may be lost because of the requirement to shift resources to use for RCRA compliance. In the above example, the social cost could also have been computed by taking the opportunity cost of the resources in some other use as shown by the supply curve (a + b) and adding to it the lost consumers' surplus on previous uses squeezed out by the price increase (d) and the lost producers' surplus on this suppressed demand (e). In principle, the approach when buying a resource from a monopolist is identical to that shown here. The private compliance cost in the directly affected industry must be adjusted by adding the loss in consumers' surplus and subtracting
~°Note that buyers and sellers in the immediately affected industry will usually both incur losses, but in industries supplying resources needed for compliance, there may be an increase in producers' surplus and windfall gains. Netting out these gains in the computation of social costs requires use of the controversial "hypothetical compensation" test, which also underlies final comparisons of benefits and costs. Therefore, some analysts who are troubled by this practice may prefer not to net out surpluses at this point and instead retain separate measures of compliance cost in the directly affected industry, the loss of consumers' surplus in the market of the supply of inputs needed for compliance, and the gain in producers' surplus in that input industry.
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the increase in monopoly profit in the industry supplying inputs needed for compliance. H
ANALYSIS OF "RIPPLE EFFECTS" ON SUBSTITUTES AND COMPLEMENTS Price changes in the market directly affected by the environmental regulation may have "ripple effects" on prices and quantities in markets for substitutes and complements. Many evaluations of social costs of regulation ignore these ripple effects, and indeed, some analysts have even advised EPA that economic theory says that they should be ignored (Ferguson and Burrows 1982). For example, assume that automobile production costs rise due to environmental requirements, with a resulting decline in the output of autos and an increase in auto prices. If the resulting shift in the price for automobiles has no effect on the other prices, the analysis can stop with the evaluation of the lost producers' and consumers' surpluses in the market for automobiles. This conclusion holds even though demand curves in other markets may shift causing increases or decreases in quantity demanded. ~2 However, if the change in price and quantity demanded in the automobile market is sufficient to cause price changes in the market for bicycles, the area c in Figure 4 for the bicycle market represents the net loss in producers' and consumers' surpluses associated with the increased price of bicycles. The fact that area c in Figure 4 represents an additional loss of surplus may be shown as follows. First, the price increase in the market for bicycles creates an increase in producers' surplus equal to a + b for sellers of bicycles. This gain, however, is more than offset by losses in consumers' surplus, a + b + c, leaving c as the net decrease in surplus in the market for bicycles. The case of complements illustrates an interesting asymmetry in computing the effects in linked markets. If the increase in the price of automobiles caused an inward shift (from D2 to D1 in Figure 4) in the demand for a complement, say gasoline, the change of producers' surplus would still be a + b, but the gain of consumers' surplus would now be b, leaving net loss of a. The anomaly is that there is a net loss in the indirectly affected market regardless of whether it is a substitute or a complement (i.e., whether price rises or falls). This result is a consequence of the fact that the change in consumers' surplus in the indirectly linked market must be computed using the new demand
llAnderson and Settle (1977) and Gramlich (1981) show figures for the relevant areas. ~2Since the assumption employed in computing surplt/s changes in ceteris paribus (no changes in other prices), adjustments in other markets where prices do not change have already been taken into account entirely in our measurement. There is no danger that the change in consumers' surplus for automobiles somehow will be offset or increased by changes in consumers' surplus in markets for substitutes or complements, as long as prices in those markets do not change (Mishan 1976).
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price
S P1 PO
J
~
D1 D2 output
FIGURE 4. "Ripple effects" on substitutes or complements.
curve (after the price increase in the directly affected market). The price increase for the substitute is made even more onerous because new consumers have joined the old ones in the market for the substitute. But when the price of a complement falls, much of the benefit that would have otherwise been realized is negated by the price increase in the directly affected market, again leaving a net loss in the indirectly affected market. EXTENSION OF T H E ANALYSIS TO INTERMEDIATE GOODS Some analysts have extended the consumers' surplus analysis to an intermediate good by computing areas under the derived demand curve for an intermediate good used as an input into a "downstream" market for final output. Others have argued that the analysis must not take place at the level of the intermediate good but trace through the impacts on all final consumer goods as well (Bohm 1973; Stevenson 1976; Harris arid Sullivan 1979; Schmalensee 1971). The validity of applying the methodologies in Equation (1) to intermediate goods raises major methodological and empirical issues for environmental analysis. To begin with, much of the environmental regulation problem arises at the level of heavy industry which often sells inputs to final goods industries, not directly to final customers. Second, if study of the immediate effects in the directly affected industry were inadequate, the analysis task and data requirements for measuring social cost would be vastly expanded. Lastly, the apparent
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disagreement on the appropriate methodology tends to undermine confidence in and encourage disputes over the results. Fortunately, the issue appears to have been cleared up by a recent article by Stephen E. Jacobsen (1979). He shows that under very general conditions, the area under the demand curve for an intermediate good is the sum of lost producers' surplus by the buyer of the intermediate good (i.e., the losses imposed on the sellers in the downstream market) plus the consumers' surplus losses in the downstream market--as long as that downstream market is perfectly competitive. In this case, downstream effects can be safely ignored unless there is interest in ultimate distributional effects. However, for the downstream market that is a monopoly (or imperfectly competitive), Jacobsen demonstrates the rather surprising result that the area under tho upstream demand curve represents only the losses of profit to the downstream monopolist and ignores entirely the downstream effects on consumers.13 Applying Jacobsen's results, first consider the simplest case where the environmental regulation affects the costs of supplying an intermediate good produced in a highly competitive market (such as the world market for a commodity). If costs rise, the opportunity costs of foregone output because of the regulation are borne completely by losses in producers' surplus in the directly affected market because the cost increase cannot be passed on. 14 Since the price of the producer good does not change, neither does the price or demand for final consumer goods and the analysis can stop at this point. If the price of the intermediate good rises, the analysis can also be limited to the intermediate good market as long as it is selling its output to competitive industries. A more complicated case might involve changes in the price of an intermediate good sold to a monopolist. Jacobsen's results require one to trace through the downstream effects by applying the basic identity of the two methods: 1) using Method 1, compute the downatream losses in consumers' surplus resulting from the price increase and add them to the loss of consumers' and producers' surplus in the directly affected market; or 2) using Method 2, compute the downstream losses in consumers' and producers' surplus resulting from the loss of output of the intermediate good and add these to compliance costs in the directly affected market. 15 t3Schrnalensee (1976) corrected his earlier paper and pointed out that all downstream effects would be captured in the upstream analysis as long as downstream markets are competitive. He also recognized that welfare effects in upstream markets underestimate downstream effects if final markets are monopolistic. Jacobsen generalized these results and proved that the underestimation in the upstream analysis is exactly equal to the loss of consumers' surplus in the downstream market. See also Spencer and Brander (1983) and Just and Hueth (1979). ~*rhe analysis assumes that producers buy all their inputs in competitive markets and it is impossible to "pass back" the losses to sellers in these markets. When producers am able to pass their losses back upstream, the situation is entirely analogous to our downstream results. The upsteam analysis is omitted for simplicity in the presentation that follows. ~Slt is important to note that the downsU~am effects of price changes in the market for an intermediate good are not to be added to compliance costs. Once aggregate cost has been determined by Method 1, it may then be desirable to distinguish between compliance costs in the directly affected markets and lost producers' and consumers' (or more accurately, buyers') surpluses on the foregone output in the directly affected market.
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CONCLUSIONS This paper suggests the following conclusions and guidelines for applying social cost analysis: 1. Social costs are the aggregate of private costs as measured by lost consumers' and producers' surpluses, which in the ceteris paribus case involve only the directly affected market. 2. These social costs can also be computed as the costs of compliance on postregulation output plus lost consumers' and producers' surpluses on output losses in the directly affected industry (corrected for discrepancies between price and marginal cost for the monopoly case). 3. Although there are examples of confusing the two approaches in the theoretical literature, these errors have not yet found their way into practice simply because practitioners have not yet attempted to employ social cost as a tool for estimating the cost of environmental regulation. 4. The possibility of substantial "ripple effects" must be considered when prices in other markets are affected. An important case is when the price of a critical resource, such as disposal sites for hazardous wastes, is bid up as a result of compliance efforts. Postregulation estimates of social costs that do not account for this windfall gain overstate social costs in this case. In the cases of both substitutes and complements, the estimate of social costs is increased above the level in the directly affected industry alone by considering ripple effects. For intermediate goods, it does not appear to be unreasonable to ignore upstream or downstream effects unless there is concern over the incidence of costs or there is evidence of imperfect competition in the upstream or downstream markets.
This paper is based on research initiated in connection with a project undertaken for the Office of Solid Waste of the U.S. Environmental Protection Agency (EPA) by Putnam, Hayes & Bartlett, Inc. (PHB). The purpose of the project was to define methodologies for measuring the social costs resulting from Resource Conservation and Recovery Act .(RCRA) regulations. However, the views in this paper are entirely those of the author. Special thanks go to Nancy HammeR, a co-author of the original PHB study, for her inspiration to write this paper and her invaluable suggestions. Lawrence Buc, formerly with EPA, identified the need for the PHB study and encouraged its development and circulation at EPA.
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