Part I. Principles

A. Markets

B. Market failure

C. Discounting & PV

D. Markets 2

E. Dynamic efficiency

F. Pollution solutions (Part 2)

F. Pollution Solutions

Chapter 3

The Optimal Level of Pollution

• Optimal level of pollution minimizes the total social costs of pollution (the sum of total abatement costs and total damages).

• This level occurs at the point where MAC = MDF

• Why?

The Optimal Level of Pollution

The Optimal Level of Pollution

• If E < E1, then MAC > MDF that the unit of pollution would have caused.

Doesn’t make sense to reduce pollution.

• If E > E1, then MDF > MAC associated with reducing pollution by one unit.

Better off eliminating unit of pollution.

Social Costs When Pollution Level is Greater than Optimal

Social Costs When Pollution Level is Greater than Optimal

• The optimal level of pollution is E1.• The actual level of pollution is E2.

• Total costs associated with pollution have been increased by the area of triangle abc.

• This represents marginal damages greater than marginal abatement costs for the range of pollution emissions between E1 and E2.

Social Costs When Pollution Level is Less Than the Optimal

Social Costs When Pollution Level is Less than Optimal

• The optimal level of pollution is E1.• The actual level of pollution is E3.

• Total costs associated with pollution have been increased by the area of triangle ade.

• This represents marginal abatement costs greater than marginal damage for the range of pollution emissions between E1 and E3.

Pursuing Environmental Quality with Command and Control Policies• One way to achieve an optimal level of pollution

is to mandate action to achieve the desired level of pollution.

• Critics have argued that command and control regulations generate more abatement costs than necessary.

• Consider Figure 3.9 where both polluters are required to reduce pollution by 50 percent.

Command and Control Policies

Command and Control Policies

• The aggregate MAC function (societal MAC function) is the horizontal summation of the individual MAC functions.

• With no environmental regulation, polluter 1 would emit 10 units and polluter 2 would emit 6.

• A requirement to reduce emissions by 50%, regardless of cost, would reduce polluter 1 to 5 units and polluter 2 to 3 units.

Pursuing Environmental Quality by Equating MAC

• When both polluters are required to reduce emissions by 50%, regardless of marginal abatement costs, polluter 2 incurs a higher cost ($3) than polluter 1 ($2).

• Higher cost represents a misallocation of resources from society’s point of view, because minimum costs of obtaining any level of emissions will occur when MAC equal across polluters

Equating MAC

• Society’s total abatement costs can be lowered by keeping total emissions constant, but reallocating level of emissions according to marginal abatement costs.

• ***The optimal level of emissions will be where MAC are equal, for a given level of emission***

Equating MAC

Equating MAC

• Since polluter 2 has higher MAC, polluter 2 should be allowed to emit more, and polluter 1 will be required to pollute less.

• Polluter 1 reduces pollution by ½ unit (to 4 ½) and polluter 2 increases pollution by ½ unit (to 3 ½).

• Polluter 1’s MAC increase and polluter 2’s MAC decrease.

• *Key: decrease in 2’s costs > increase in 1’s=> Reallocation reduces costs to society as a whole

Equating MAC

• Only when MAC equal will there be NO POSSIBLE cost-saving reallocations of emissions

• Total abatement costs are minimized

• C & C not likely to equate MAC’s (gov’t does not know firms’ costs, firms do not face same costs)

The Role of Command and Control Policies

• Despite their inability to equate MAC across polluters, C & C policies may still be the most desirable policy instrument under the following circumstances:1. When monitoring costs are high (littering)2. When the optimal level of emissions is at or

near zero (initial MDC >> MAC – e.g. radioactive waste)

3. During random events or emergencies that can change the relationship between emissions and damages (e.g., smog, droughts)

1. High monitoring costs

• While it might be possible to achieve an optimal amount of litter through the use of a tax or per person allocation, this would require the “litter police”.

• It is easier to make ALL littering illegal and establish a punitive fine for those caught littering.

• The fine multiplied by the probability of being caught would be factored into the choice to litter.

2. Optimal pollution = 0

• When the optimal level of pollution is at or near zero, direct controls make sense.

• Extremely dangerous pollutants, such as heavy metals and radioactive waste.

• Damages associated with these pollutants are quite severe.

• Direct controls also make sense in other cases where initial damages are quite high compared to initial marginal abatement costs.– An example is CFC’s, where accumulated amounts are

dangerous but there are low cost alternatives.

3. Emergencies

• Emergency situations may make direct controls the preferable policy instrument.

• These events occur in random and unpredictable fashion.

• Examples include smog alerts (LA – single-person commuting prohibited, schools closed) and droughts.

Pursuing Environmental Quality with Economic Incentives

• Economists advocate policies based on economic incentives for 2 primary reasons:1. Economic incentives minimize total abatement

costs by equating MAC across polluters and encouraging a broader array of abatement options.

2. Economic incentives encourage more research and development into abatement technologies and alternatives to the activities that generate the pollution.

Economic Incentives and Minimized Total Abatement Costs

Economic Incentives &Minimized Total Abatement Costs• A polluter is polluting at an unregulated

level of 10 units.• The government imposes a tax equal to t

dollars per unit of pollution.• The polluter compares the tax of t dollars

(cost on 10th unit – rectangle under t btw. 9 and 10) to the marginal abatement cost (MAC) of reducing pollution (triangle under MAC btw. 9 and 10)

Minimized Total Abatement Costs

• As long as the MAC < tax, polluter will reduce level of emissions.

• If MAC > tax, can reduce costs by increasing pollution and paying lower tax rather than high abatement

• Each polluter will choose an emission level at which MAC = tax.

• As long as all facing same tax, MAC equal across polluters

How to set tax?

• If the aggregate MAC function is known, then achieving a targeted level of pollution is easily accomplished.

• If the aggregate MAC function is not known, the appropriate tax level is much harder to determine.

• Consider Figure 3.16, where evidence suggests that the true MAC function lies between an upper and lower bound set of MAC’s.

How to set tax?

How to set tax?

• Suppose policymakers believe MAC1b is the true MAC. In an effort to achieve an emissions level of E1, they impose a tax of t1.

• However, if MACt describes how polluters will respond, the emissions level will be E2.

• E2 is higher than the desired level of pollution.

• Excess costs of triangle abc

Weitzmann (1974)

• Flatter MAC – greater disparity btw. “arrived at” level pollution and target level

• Steeper MDC – greater the social losses associated with disparity

• C & C may be better since less uncertainty

In summary:

• Pollution taxes are preferable to command and control techniques since pollution taxes minimize abatement costs and provide other desirable incentives.

• Because of uncertainty, pollution taxes are less proficient than command and control techniques in achieving a desired level of pollution.

C & C or taxes?

• One minimizes abatement costs, other better at achieving target level of pollution

• Another instrument can do both!

• Marketable pollution permits – also called transferable discharge permits, pollution allowances, tradable credits, offsets, and tradable pollution quotas.

Marketable Pollution Permits

• Marketable pollution permits are permits which give a firm the right to emit a specific number of units of pollution.

• Polluters are free to buy and sell these rights to pollute.

• A marketable pollution permit system can both minimize total abatement costs, provide flexibility in the choice of mechanisms used to meet pollution goals, and achieve the desired level of pollution emissions.

Marketable Pollution Permits

• A system of marketable pollution permits begins with the determination of the target level of pollution.

• The next step is to allocate pollution across polluters.

• This allocation can be based on historic pollution levels, auctions, a lottery, or some other allocation scheme.

• The buying and selling of pollution permits will reallocate the emission rights.

Example

• 100 polluters

• Optimal pollution = 1,000 units

• Could just authorize each polluter to pollute 10 units (this is C & C)

• Difference with MPP – once initial allocation made, polluters free to buy and sell right to pollute.

Marketable Pollution Permits• Marketable pollution permits equate MAC across

polluters. How?• Each polluter compares MAC with the price of a

permit.• If the MAC > price of permit, they have an incentive

to buy.• If the MAC < price of permit, they have an incentive

to sell.• Buying and selling will continue until the equilibrium

price is reached which equates MAC across all firms.

Doesn’t matter how you start

• Initial distribution of permits can be by historic pollution level, auctioned to highest bidder, distributed by lottery, etc.

• As long as permits are tradable, polluters attempts to minimize their total pollution costs (abatement + cost of permit) will result in MC being equalized over all polluters =>

min. total abatement costs to achieve target level of pollution

Marketable Pollution Permits and Geographic Considerations

• Geographic location of emissions can have a big impact on the damages the pollution generates for some categories of pollution.

• Central to the importance of location of emissions is the manner in which the pollution disperses when it enters the environment.

• Pollution controls must take into consideration the geographic variation in the effect of pollution on society.

Geographic Considerations

• Pollutants that deplete ozone have same effect regardless of location, so system of MPP easier

• Air pollution – tends to move from west to east (the prevailing wind direction in much of N. America)

• Water pollution – dispersion downstream

Geographic Considerations

• 1 unit of carbon monoxide released in Tallahassee, FL would create more damages than a unit released in Jacksonville FL

• For pollution controls to be effective, must take geographic variations into account

Geographic Considerations

• A pollution control system based on taxes could take variation into account by charging higher taxes in areas where emissions are more damaging.

• A MPP system must divide the overall region into subregions.

• These subregions can account for geographic variability in one of two ways:

1. Receptor (pollution measurement location)-based system 2. Separate markets for subregions

Receptor (Ambient)-based Permit System

• A receptor-based or ambient-based system allocates pollution receptors across the subregion.

• Locations relatively close to, and downwind from, the polluter may require more permits.

• In the following figure, the location of a particular polluter is denoted by a star and receptors are designed by letters. This polluter may have to buy some combination of 15 different types of permits.

Ambient-based Permit System

Ambient-based Permit System

• For each unit of pollution polluter at the star emits, may need to purchase 1 “I” permit but only ¼ “A” permit

• The polluter would have to buy 15 different types of permits (one for each receptor, A – O)

• System does good job dealing with geographic variability, but high transactions costs since so many markets

Emissions-based Permit System

• An alternative to the ambient-based system is to divide the subregions into separate markets.

• Polluters need only purchase permits for the subregion in which they are located.

• The inability to trade across subregions may mean that firms with lower abatement costs will not be able to trade permits with higher abatement cost firms in another subregion.

Emissions-based Permit System

Emissions-based Permit System

• Polluter located at the star only has to buy permits for subregion “L”

• Greatly reduces transactions costs,but cannot trade with polluter in other subregion (so low-cost polluter cannot trade with high-cost polluter, although in society’s interest to do so)

Other Types of Economic Incentives

• Deposit-refund

• Bonding systems

• Liability systems

• Pollution subsidies

Deposit-refund

• Deposit-refund systems are a good way of employing economic incentives when monitoring costs are high. “Bottle Bill”

• This system is based on requiring a payment up front for undesirable acts and then building in a refund when a desirable action occurs.

• The most common example of this is the deposit-refund system in place for beverage containers.

• This system has also been used for cars and batteries in other countries.

Bonding systems

• Closely related to deposit-refund systems.• Requires a potential degrader of the environment

to place a large sum of money in an escrow account.

• Money is returned if the environment is undamaged (or returned to its original condition) and will be forfeit otherwise.

• Bonds need to be large enough to provide an incentive to use appropriate safeguards and/or cover the cost of clean up if damage occurs.

Liability systems

• Define legal liability for the damages caused by certain types of pollution discharges and facilitating collection of these damages.

• The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) defines legal rights to natural resources for local, state and federal governments and defines how damages can be measured.

Pollution subsidies

• Pay each polluter a fixed amount of money for each unit of pollution reduced.

• The polluter would reduce pollution to the point where the subsidy = MAC

• While the outcome is the same as a tax on polluters, there are distributional effects, problems with political acceptability and the possibility that strategic behavior would lead to higher initial levels of pollution in order to obtain the subsidy. In addition, the subsidy could potentially attract more polluters into the industry.

Conclusion

• Market failures associated with environmental externalities generate losses in welfare.

• Command and control policies are the basis of current policy but do not equate marginal abatement costs across polluters.

• Economic incentives, such as taxes or marketable pollution permits do equate marginal abatement costs.

• While there are some problems with economic incentives, they do create additional motivation for technological innovation to reduce pollution.