ECON 201 Lec 10.1 b Environmental Economics Negative Externalities & Optimal Regulation

Wrapping Up: Incentive Regulation Sappington & Weisman –Implementation of rules that encourage a regulated firm to achieve desired goals by granting some, but not complete, discretion to the firm Three features of incentive design –Regulatory goals must be clearly specified before design –Regulated firm is granted some discretion –Regulated firm is not granted complete discretion

Why Not Complete Discretion? Why some discretion: –Firm has better information than the regulator about key aspects of the regulated industry e.g., costs structure/production technology, customer preferences/demand Why not complete discretion –Firm may have different goals than its customers/society Recent examples in Banking & Finance (AIG)

Environmental Economics What is it? –Application of economic analysis to environmental and natural resource issues Environmental –Air and Water Pollution (negative externality) Natural Resources: optimal management –Fisheries (common property) –Forestry (renewable) –Mining and oil production (non-renewable)

Why Are These Markets Different? Externality –Production/consumption of a good imposes a cost (negative) or benefit (positive) on others not involved in the market transaction

Externality Many negative externalities are related to the environmental consequences of production and use –Air pollution Greenhouse gases related to burning of gas, coal, oil used in heating, production and transportation –Water supplies Run-off from drainage systems (Downtown) Fertilizer run-off (Eastern Washington) Dumping of waste by-products (Duwamish) Nuclear contamination (Hanford)

What’s the Problem? Divergence between private and social marginal costs

What Are the Consequences? Without Intervention –Consumers/producers will not take such costs into economic decisions Produce too much of the good & externality (e.g., pollution)

What Are the Remedies? General types of solutions: –Criminalization: making it illegal to dump pollutants into the air/water/landfills. –Civil Tort law: For example, class action by smokers, various product liability suits. –Pigovian taxes or subsidies intended to redress economic injustices or imbalances.Pigovian taxes –Establishing/assigning property rights (Coase’s theorem)

Negative Externalities Pollution A Pigovian tax is a tax levied to correct the negative externalities of a market activity.tax negative externalities –may be levied on producers who pollute to encourage them to reduce pollution, –Also provides revenue to counteract the negative effects of the pollution –Certain types of Pigovian taxes are sometimes referred to as sin taxes, for example taxes on alcohol and cigarettes.sin taxesalcoholcigarettes Pigovian taxes are named after economist Arthur Pigou ( ) who also developed the concept of economic externalities.economist Arthur Pigoueconomic externalities

Pigovian Taxes

Market-based Solutions vs. Regulation Argument against the levying of Pigovian pollution taxes is that if the tax is too high it will lead to a level of pollution that is less than the social optimum. The alternative, regulation, is viewed as having a higher cost to society because Pigovian taxes raise revenue and respond automatically to changes in the market such as lowered cost of production or pollution mitigation.regulation With a Pigovian tax there is always an incentive to reduce pollution, whereas with direct regulation, a polluting company has no incentive to pollute any less than what is allowable.

Negative Externalities and Property Rights Solutions an alternative to Pigovian taxation –markets for "pollution rights" –not generally more efficient than Pigovian taxes but are often more appealing to policy makers because giving out the rights for free (or at less than market price) allows polluters to lose less profits or even gain profits (by selling their rights) relative to the unaltered market case. – Markets for emissions trading have been set up to bring better allocative efficiency and improved information sharing to the pollution externality problem. Pollution rights markets are a part of the field of Environmental Economics generally, and Free-market environmentalism specifically.emissions trading Environmental EconomicsFree-market environmentalism Perhaps the biggest problem with the Pigovian tax is the "knowledge problem" –"It must be confessed, however, that we seldom know enough to decide in what fields and to what extent the State, on account of [the gaps between private and public costs] could interfere with individual choice."

Coase’s Theorem If property rights exist and transaction (bargaining) and information costs are low –Then parties will be able to bargain among themselves (without government intervention) to obtain an efficient outcome

Establishing Property Rights Fishing Industry –ITQs: Individual Transferable Quotas Boats bid on the right to catch pre-determined amount of fish –Can either catch or sell license Cap and trade systems for pollution/air quality (Emission trading systems) –California –International Taxis –Taxi shields

Environmental Economics Externalities Externalities –When there is a divergence between either: Social/Private Marginal Benefits, or Social/Private Marginal Costs –Common property Commonly held property: e.g., fishing grounds, common agricultural land Pure Public Goods –Is this a useful distinction? (Positive Externality)