Lecture 1 Economic Analysis and Policies for Environmental Problems Presented before the CES annual conference June 2009, paper to be published in Pacific Economic Review 9/21/2018

Outline 1. Problems of the environment – case of China 2. Economic Analysis of Environmental problems – One illustrative Example 3. Examples of Three Other Types of Economic models for the Analysis of Environmental Problems 4. How to Improve the Regulation of Air and Water Pollution in China 5. Problems of Uncertainty and of Decision for Many Countries 6. A proposal to the United Nations to limit CO2 emission 9/21/2018

1. Problems of the environment – case of China Economic activities of production and consumption require the use of energy Use of energy creates environmental problems 1. Air pollution 2. Water pollution 3 CO2 that affects global warming 4. Possible future energy shortage China has all four problems. In 1998 WHO reported that among the 10 most polluted cities in the world 8 were in China. 9/21/2018

China’s environmental protection laws and their enforcement Article 26 of the 1982 Constitution: “the state protects and improves the environment in which people live and the ecological environment. It prevents and controls pollution and other public hazards.” Water Pollution Prevention and Control Law of 1984 Air Pollution Prevention and Control Law of 1987, 2002 Solid Waste Law of 1995 Energy Conservation Law of 1997 Kyoto and Montreal Protocols on CO2 emission Laws enforced by the Environmental Protection Ministry. Law enforcement problems – local governments do not cooperate. 9/21/2018

2. Economic Analysis – An illustrative Example Treating environment as a basic resource assume the representative consumer to have the utility function log c + θ log (M – e) = log y + θ log (M – ayd) (1) c = consumption = output y = Aeδ, inverse of demand for emission equation e = ayd e = emission = use of clean natural resource M larger than maximum toterable amount of emission 9/21/2018

Optimum amount of emission e Benefit and cost of pollution can be balanced by maximizing (1) respect to e. Setting to zero the derivative of (1) with respect to e yields the optimum amount of pollution e = M δ/(θ+δ) (2) Can also maximize (1) respect to y to get yd = M/[a(θd+1)]; e = ayd, d =1/ δ 9/21/2018

Market solution – the invisible hand at work Consumer maximizes L = log c + θ log (M-e) –λ(y –qe) with respect to c and e: c-1=λ and θ(M-e)-1=qλ. Eliminating λ yields e = M- θc/q. supply equation of e; e increases with q Producer maximizes profit Aeδ - qe with respect to e: e=δy/q. demand equation for e; e decreases with q Equating supply of and demand for e gives e= Mδ/(θ+δ), same as before. Important lesson: optimum allocation of resources can be achieved by decentralized market decisions. 9/21/2018

3. Three Other Types of models 9/21/2018

A2) Emissions by two parties as a game Let player 1 solve the following problem: L1 = log(Ae1δ1) + θ1log(M-e1-e2) Maximizing utility with respect to e1 gives e1 = (M-e2) δ1 /(θ1 +δ1) (1) Similarly e2 = (M-e1) δ2 /(θ2 +δ2) (2) In an (e1, e2) diagram, (1) and (2) are two linear reaction functions showing the optimal strategy e1 of player 1 as a function of e2, and the optimal strategy e2 of player 2 as a function of e1. Nash equilibrium is the intersection of (1) and (2). Interesting to analyze the equilibrium as a function of the four parameters. Dynamic model can explain the difference in viewpoint concerning policy for global warming between rich and poor nations. 9/21/2018

B1) optimum time path of pollution to maximize a multi-period utility function Et = total accumulation of CO2 in the atmosphere at the beginning of year t et= the amount of CO2 emission in year t. Et+1 = .998Et+ .5et β = discount factor L = Σt { βt [log(Aetδ) + β θlog(M-Et)] – βt+1λt+1(Et+1 - .998Et-.5et)} Differentiate L with respect to the control variable et and the state variable Et for each t to obtain a set of first order conditions. Solving these first order conditions will yield an optimal control policy for et as a function of Et. Reference: G C Chow Dynamic Economics: Optimization by the Lagrange Method. Oxford University Press, 1997. 9/21/2018

B2) Dynamic game To understand why rich and poor countries disagree on control of CO2 emission, set up a dynamic game with 2 players (groups of countries). Group i (i=1,2) maximizes Li = Σt{ βit [log(Aeitδi)+βi θlog(M-Et)] – βit+1λ t+1(Et+1 - .998Et-.5e1t - .5e2t ) The two groups of countries have different values for βi, δi and θi and will have different optimal time paths of CO2 emission. 9/21/2018

4. How to Improve the Regulation of Air and Water Pollution in China Imagine the possibility of giving property rights of the atmosphere (or water) to consumers who can sell it to producers in the form of emission permits at market price. The market forces of demand for and supply of emission permits would make the amount of air pollution optimal. Concrete steps to implement this policy follow. 9/21/2018

4. Proposal to improve the regulation of air or water pollution Local office of the Environmental Protection Ministry issues pollution permits to producers using air or water to protect the interest of local residents. interest of local residents in rural areas represented by the publicly elected village heads or an association of them; in urban areas, by the publicly elected representatives of their locality or an association of them. These representatives or their association will suggest to the local office of the EPM how many pollution permits to issue. Given the total number issued, the pollution permits can be traded at prices determined by the market. The revenue received will be distributed to the residents through the above association or used to improve the welfare of the local residents. The local residents will participate in the determination of, and hence will have an incentive to enforce, policies to protect the environment; help the implementation of environmental policy. 9/21/2018

5. Problems of Uncertainty and of Decision for Many Countries Uncertainty can be introduced into the models by making the parameters stochastic and assuming the economic agents to maximize the expectation of an objective function. Nations in the world may not be able to agree on a strategy to protect the environment, e.g. to limit CO2 emission. 9/21/2018

6. A proposal to the United Nations to limit CO2 emission 1. To decide the total amount each member of the United Nations submits a desired amount of total world emission of CO2 for a given period (of one to three years). The median amount will be adopted. 2. The total amount will be distributed among member nations in proportion to population under the premise that all citizens in the world have equal rights to the atmosphere. 9/21/2018

UN proposal – use of emission permits Emission permits are required when carbon is emitted. The total number of permits issued equals the total amount of world emission as decided in the proposal. Permits will be distributed by the UN to member nations in proportion to population. Emission permits can be brought and sold at prices mutually agreed upon. The government of each country has the responsibility to insure that the total amount of emission in the country shall not exceed the amount allowed by the permits that it possesses. 9/21/2018

Roles of developing and developed countries Developing countries like China and India emit less CO2 per capita and are likely to support the proposal. They will have extra permits to sell. Developed countries like the US need to purchase emission permits in the world market. The US can use this as a way to support the less developed countries in the control of CO2 emission. 9/21/2018

Answers to possible criticisms of the proposal This proposal does not penalize the developed countries for the past accumulation of CO2. This proposal does not reward any country for its past contribution to the world economy by technological innovations while engaging in CO2 emission. Countries using energy efficient technology do not get more permits because they are already rewarded by the low cost of their products. Countries producing for exports should not get more permits because they already benefit from the exports and the cost of the exports should include the cost of polluting the environment which this proposal helps to determine. 9/21/2018

Thank you 9/21/2018