should likely be subject to a benefit-cost analysis of pollution control measures to see whether further pollution control is warranted.

Economic theory also suggests efficient methods for regulating the externalities associated with air pollution. For example, the first best solution to internalizing the damages in Figure 1-1 could be achieved by imposing a tax on SO2 emissions equal to the marginal damage that the emissions impose—a tax equal to the height of the marginal damage curve. This solution could also be achieved by a pollution permit market in which firms traded rights to pollute denominated in damage terms (Roumasset and Smith 1990; Hung and Shaw 2005).3 In either case, a firm would have an incentive to reduce its rate of SO2 emissions to E*.4 Information on the marginal damages associated with various pollutants, which we quantify for fossil-fueled power plants, is relevant to the efficient regulation of air pollution externalities.5

Nonexternality Market Distortions and Impacts

In markets related to energy production and consumption, many other distortions occur that create opportunities for improvement of social welfare but that are not externalities. Because these distortions are outside the purview of this study, the committee touches only briefly on them here, largely to be clear that we do not attempt to identify and quantify the social costs associated with those distortions and to recognize that the magnitude of externalities can be directly affected by the presence of these distortions.

One form of market distortion that affects energy markets is the presence of market power—in the extreme, a single supplier of energy (monopoly) or a single buyer (monopsony). In such cases, a firm with market power can affect the price and quantity traded to its advantage and impose costs on others that exceed its gains. Cartels, such as OPEC, or large purchasers of oil, such as the United States, can exhibit market power.

Another form of market distortion that affects energy markets is the presence of taxes or subsidies (“tax breaks”) that do not correct externali-


An important caveat to these points is that no significant market distortions (for example, other externalities left unregulated or imperfectly competitive markets) are assumed for the rest of the economy.


Imposing a tax equal to SO2 damages per kilowatt-hour—that is, to the size of damages divided by electricity production—would not provide the same incentive. Indeed, it need bear no particular relationship to the marginal damages associated with SO2.


External damages per unit of output (for example, damages per kilowatt-hour or per mile) may also help to inform the choice among technologies (for example, whether a new power plant should be gas-fired or coal-fired). However, the choice among technologies should be based on the private as well as social costs.

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