II. Efficient policymaking in global markets

B. Trade and the environment

    Lesson in Econ.101: In well-functioning competitive markets, government intervention creates inefficiency
    True in a global economy too
    And in a global economy, true for trade policies as well as domestic policies
    A global economy does enhance the impact of domestic policies
    And domestic policies are in general better than trade policies for domestic policy goals

    But as in Econ101, we don't always have well-functioning competitive markets
    That's what we turn to now
    What do we do in cases of market failure?
        --externalities
        --market power

    These come up in lots of ways--we'll focus on 2:
        trade and the environment
        trade and market power 

    As always, we'll highlight how economic analysis often yields results that differ from what is popularly thought.

    Externalities: The effects of people's actions on bystanders (third parties)

    Basic distinction:
    Global externalities spill over to other countries
        Ex: Global warming

    Domestic externalities do not
        Ex: Air pollution in Mexico City

   We'll consider each in turn

1. Global externalities

Ex: global warming     US electricity market 1: free-market 2: domestic efficiency 3: global efficiency

   Global externalities require a global response
    Ex: the Kyoto protocol for global warming

    But if economic activity causes global external costs, then countries that do not participate in the global response are free riders

    Note: according to economic theory, voluntary measures are not sufficient to achieve efficiency in cases of externalities

2. Domestic externalities

        Ex: Air pollution in Mexico City

    Pollution that does not spill over to other countries

    With externalities, we have 3 groups to keep track of:
        1. consumers
        2. producers
        3. bystanders (third parties affected by externalities that do not get internalized)

    Economic analysis of trade and the environment worksheet 
    (SMC in this case results from producers taking steps to produce their output in a pollution-free way)

    Result 1: Countries with efficient environmental regulations gain from free trade.

    Result 2: Countries without efficient environmental regulations might gain or lose from free trade.
    In diagram: A = net gain from diverting existing output that sells for more abroad than it is worth at home
    B = net loss due to SMC > Pf on extra production
    +A -B = net change in social welfare

    Lesson: being part of the global economy is no excuse for failing to protect your environment.

    Firms do look for ways to cut costs, so the risk of pressure to reduce environmental standards is genuine--but government must resist the pressure to achieve an efficient result
    Labor: the private market supply of labor already reflects its opportunity cost, so no intervention is needed to make market adjustments efficient
    Polluting products: the private market underestimates costs, so governments must use policies to get the pollution damage internalized.
    Effective government is necessary to protect social welfare
    Empirically, environmental costs are minor (about 1/4% of value added on average)