Economics of Pollution Control: An Overview Chapter 13 Economics of Pollution Control: An Overview Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Why Is There Pollution? Pollution is a by-product of the production process Treated as a zero-priced input Dispose of waste for free Otherwise have to purchase abatement equipment Since price = 0 => consume to the point: MV = 0 However MC ≠ 0 So have a deadweight loss due to MV < MC Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Negative Externality Marginal Private Costs < Marginal Social Costs Ideal Actual Pi Pa Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Economics and Pollution Control The Two Big Questions What is the optimal level of pollution? How should it be allocated among its sources (firms)? Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

What Do We Need for Efficiency? Economic efficiency requires Minimize the costs of Damages caused by pollution Costs of reducing pollution At the margin (or at the optimum) Marginal (additional) costs of reducing pollution (pollution abatement costs) = marginal damages caused by incremental change in emissions Alternatively Maximize the benefits (derived from goods produced) While minimizing abatement and damage costs Yields same solution Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Determining the Optimal Amount of Pollution Tax Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Optimal Level of Pollution Occurs where Marginal damage costs = marginal abatement costs Some simplifications that we’ve made Optimum can vary Each firm will have different abatement costs Not all geographic area have same damage costs More densely populated areas likely to have higher damage costs Differences in absorbing capacity of different geographic areas Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

How Do We Get There? Standards (command and control) Set the overall standard at Q* Calculate the amount of reduction necessary Set uniform reduction goal for all firms Taxes/Emission Charges Set the tax = externality cost at the optimum Q* Firms will internalize the cost Tradable Permits (Coase) Allocate right to pollute (Q*/N) Allow firms to set price for trading permits Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Cost-Effective Pollution Control Policies Emission Standards An emission standard is a legal limit on the amount of the pollutant an individual source is allowed to emit. This approach is referred to as command-and-control. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Emissions charges An emission charge is a per-unit of pollutant fee, collected by the government. Charges are economic incentives. Each firm will independently reduce emissions until its marginal control cost equals the emission charge. This yields a cost-effective allocation A difficulty with this approach is determining how high the charge should be set in order to ensure that the resulting emission reduction is at the desired level. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

FIGURE 15.4 Cost-Minimizing Control of Pollution with an Emission Charge Tax = mc of control Tax Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

FIGURE 15.5 Cost Savings from Technological Change: Charges versus Standards Both firms reduce to the same level But have different mcosts Using tax Get less emissions standard Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Emissions Trading All sources are allocated allowances to emit either on the basis of some criterion or by auctioning. The allowances are freely transferable. The equilibrium price will be the price at which the marginal control costs are equal for both (or across all) firms. The market equilibrium for an emission allowance system is the cost-effective allocation. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

FIGURE 15.6 Cost-Effectiveness and the Emission Permit System Standard MC of emitting 8 Bid range Tax MC of emitting 7 Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Tradable Permits A Property Rights Approach “Common” Property Problem No one “owns” the air/water; therefore no one benefits from managing (pricing) its usage Solution is to assign the property right to one party and allow them to trade its use in the marketplace Coase Theorem

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

Assigning the Property Rights If assigned to the firm Farmer is willing to “bribe” the firm to reduce pollution Willing to pay firm to reduce gallons discharged up to marginal value of crop damage due to pollution Firm: willing to accept payments that are >= marg costs of treatment/reduction

Assigning Property Rights Assigned to the Farmer Firm is willing to pay farmer up to the marginal value of “avoided” treatment costs Farmer is willing to accept payments >= marginal cost of crop damage Either way: socially efficient (marginal value = marginal cost) solution However, there are different income effect Concluding which is best => normative statement

FIGURE 15.3 Cost-Effective Allocation of a Uniformly Mixed Pollutant Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Comparison of Approaches Standards Can also produce optimal level of pollution But set same standard for all firms (and are not productively efficient, e.g. min cost) To set individual quotas: requires knowledge of each firm’s costs But have higher administrative costs Not only have to monitor emissions Enforcement costs: legal proceedings (time delays and expense) Not very flexible: regulatory process for changing standards Provide no incentive for firms to reduce pollution below current “authorized” levels Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Comparison of Approaches Standards Are most useful when: Problem is short-lived (“burn” bans for high pollution days) Optimal level is zero – pollutant is highly toxic Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Comparison of Approaches Taxes Can produce “optimal” amount of pollution at minimum costs and lower administrative costs Kneese (1977): comparing taxes versus standards found that desired quality costs half as much using taxes Automatically allocates pollution levels among firms based on their costs Provides incentive for firms to reduce pollution levels through technological innovation Easy to adjust/”tune” Tax revenues can be used finance admin costs Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Comparison of Approaches Tradable Permits Cost efficient Firms will purchase permits from more efficient firms if permit cost < abatement (technology) costs Technological incentive to reduce pollution Marginal cost of abatement = permit cost Similar to taxes Administratively simpler Require less information about the firms’ cost Better able to handle “spatial” variation in pollution Fewer permits auctioned in bad areas Adjust “automatically” for changes in inflation and growth If auctioned -> revenues for admin costs or for “buyback” programs Copyright © 2009 Pearson Addison-Wesley. All rights reserved.