Regulatory Options & Efficiency What guidance can economics provide about how to regulate polluting industries or firms?

Why regulate? Does free market efficiently provide goods and services? Market failure (externalities, public goods, etc.) Market power (monopolies inefficiently restrict production to raise prices) Information problems (damages uncertain, food safety, env quality)

Types of questions in regulation 1.What is the “optimal” amount of pollution? 2.To reduce by X%, who should reduce and by how much? 3.What regulatory instrument(s) should be used to achieve that level?

The efficient amount of pollution Marginal Control Cost Marginal Damage Cost $/unit Units of pollution Q* Total Damage Cost Total Control Cost

Recall example from 1 st day 60 firms, each pollute 100 tons 30 low abatement cost ($100/ton) 30 high abatement ($1000/ton) Everyone reduces 1 ton: Cost=$33,000 Total reduction = 60 tons. For same cost could have reduced 330 tons.

If low cost firms abate: Either: Reduce more pollution for the same amount of money…or Reduce the same amount of pollution for less money. So we always want low-cost firm to abate.

If costs aren’t constant: greenhouse emissions of Nitrogen Cost ($)  N MC A MC B Who should abate the 1 st unit of N?

How much abatement from each? MC A MC B $ (A) $ (B) A: B: Loss from equal reduction

How did he do that? 1.Determine how much total abatement you want (e.g. 80) 2.Draw axis from 0 to 80 (A), 80 to 0 (B) 3.Sum of abatements always equals Draw MC A as usual, flip MC B 5.Lines cross at equilibrium 6.Price is MC for A and for B.

The “equimarginal principle” Not an accident that the marginal abatement costs are equal at the most efficient point. Equimarginal Principle: Efficiency for a homogeneous pollutant requires equating the marginal costs of control across all sources.

Control costs Should include all other costs of control monitoring & enforcement administrative Equipment High cost firms have incentive to innovate and change production technology Regulatory uncertainty increases costs.

Instruments for regulation Taxes: charge $X per unit emitted. This increases the cost of production. Forces firms to internalize externality. Quotas/standards: uniform standard (all firms can emit Y) or non-uniform. Tradable permits: All firms get Y permits to pollute, can buy & sell on market. Other initial dist’n mechanisms.

Example 1: Taxes in China China: extremely high air pollution – causes significant health damage. Instituted wide-ranging system of environmental taxation 2 tiers World Bank report estimates that MC of abatement << MB of abatement.

A creative quota: bubble policy Multiple emissions sources in different locations. Contained in an imaginary “bubble”. Regulation only governs amount that leaves the bubble. May apply to emissions points within same plant or emissions points in plants owned by other firms.

Example 2: Bubble policy in RI Narraganset Electric Company: 2 generation facilities in Providence, RI. Required to use < 2.2% sulfur in oil. Under bubble policy: Used 2.2% in one plant, burned natural gas at other plant Savings: $3 million/year

$/unit Dirty GoodQcQc MSC MPC MEC Q* P* PpPp D

What tax or quota is required? We know: Optimal level of pollution is Q* Marginal Social Cost at the optimum is P* Marginal Private Cost at optimum is P p. Optimal tax exactly internalizes externality: t* = P* - P p Effectively raises MC of production

$/unit Q (pollution)QcQc MSC MPC (no tax) Q* P* PpPp MPC (with tax) t* D

Taxing consumption instead Taxing consumption: Taxing consumers for every unit of a polluting good that is purchased. E.g. Automobile gasoline Can equivalently be used: Instead of raising production costs, a consumption tax lowers demand.

$/unit Q (pollution)QcQc MSC MPC (no tax) Q* P* PpPp t* D (no tax) D (with tax)