1 Econ 201 Lecture 8.2 Taxes, Standards and Tradable Permits Summer 2009

2 When is Regulation Necessary? 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 –My consumption of the good does not reduce the amount available to others

3 Negative Externality Marginal Private Costs < Marginal Social Costs Ideal Actual Pa Pi

4 Negative Externalities Examples –Pollution Emitted by factories as a by product of the production process –Air, water, electricity Emitted by vehicles Typically treated as a “zero-cost” input into the production process –Will be “over” consumed (beyond point marginal benefit = marginal cost as mc = 0)

5 Negative Externalities Farm versus fresh salmon –Farm raised appear to be more vulnerable to diseases and transmit them to fresh salmon Fishing/Forestry –Can’t benefit from postponing harvest today as can’t exclude others from resource and thus realize benefit of postponement Cell phones –Privacy issues (e.g., dining out) –Traffic issues as likely to have an accident as DUI Traffic Congestion –Each additional driver does not take into account that their entry onto the freeway slows everyone else down

6 Remedies for Negative Externalities Standards –Permissible level of emissions for each factory in an industry (each industry gets same target), or –Targets how much emissions must be reduced by each factory (again, same target for all) Taxes –Direct tax on emissions Indirect on input/output if there is a direct correlation between input/output and pollution –E.g., tax on gasoline, coal based on sulfur content Tradable permits –Gives each firm the “right” to pollute to a certain level –Firms are allowed to trade/sell permits

7 Standards Emission standards –Could be set at same “optimal” amount of pollution as the tax Two approaches Establishes the level of pollution that can be emitted by “polluter” Require all firms to reduce pollution by “x” amount –Typically divided up among the firms equally Disregards technological/cost differences between firms Therefore will not be cost efficient

8 Standards Same amount of pollution for all firms –Newer firms with newer/efficient technology able to easily meet standard and may not even reach it Same amount of reduction –Newer firms already emitting less Maybe increasingly more costly for them to reduce pollution by x amount then firms with older technology Either way –Approach is not cost efficient –Provides no incentive for firms to reduce emissions below standard

9 Negative Externalities & Taxes How to Set the Optimal tax –Set at point where MBen = MCost of Pollution Tax: equals difference between MSC and MPC and – “internalizes” it into the consumption decision Firm’s cost = price*quantity of inputs plus tax*emissions/output Tax

10 EmissionTaxes Emission taxes –Will be cost-efficient Firms will adopt new technology if marginal abatement costs are less than marginal cost of tax –Otherwise will pay the tax Consequently firms will adopt least cost approach to meeting optimal pollution goal –Taxes have lower administrative costs Can be easily raised/lowered to fine tune meeting of the standard Do not require litigation

11 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

12 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

13 An Example of the Coase Theorem Marketplace –Firm upstream from a farmer Firm produce a good valued by consumer but dumps pollutants into the river as a byproduct Cost of using the river to the firm is $0 –Farmer Downstream from the firm Uses water to irrigate his agricultural products Pollution affects/degrades his product

14 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

15 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

16 Criticism of Coase’s Theorem If more than 1 farmer –Transaction costs of getting all affected parties together may be too great to get to optimal solution if rights assigned to firm Demsetz (1964): “when transaction costs are too high; status quo may be optimal” –Leffler: “if it exists, it’s optimal. But, why?” –Use of the government to lower transaction costs Strategic behavior –Last individual may “hold” out (lower bribe/higher payment) as key to agreement –Fire protection example

17 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

18 Comparison of Approaches Standards –Are most useful when: Problem is short-lived (“burn” bans for high pollution days) Optimal level is zero

19 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

20 And They Are Endorsed by the Sierra Club! Sierra Club Conservation Policies Pollution Taxes The Sierra Club advocates the establishment of pollution taxes which would make it less expensive for a polluter to adopt alternative processes or invest in additional equipment to curtail releases to the environment than it would be for him to continue as before. Such taxes would supplement, and not replace, standards on maximum permissible emissions. These taxes should be imposed when the following conditions are found to prevail generally: for competitive or other reasons, cost-minimizing behavior tends to exist in the company or industry; the cost of abatement is expected to be significant, both in relation to revenue from sales and in absolute terms; and the quantity of the pollutant released to the environment can be determined with reasonable accuracy, either by direct monitoring of every source, statistical sampling of a small fraction of many similar sources produced by a few manufactures, or by indirect means. The cost of monitoring should be small in relation to the tax revenue expected in the absence of abatement. As a first step, a tax equal to 15 cents per pound should be imposed on sulfur contained in fuels intended for combustion (with a rebate given to those who demonstrate that the sulfur was not released to the environment), and on sulfur emitted from smelters, refineries, and sulfuric acid plants. The tax on lead contained in gasoline... should be promptly enacted. The feasibility of taxes on the emission of nitrogen oxides, particulate matter, carbon monoxide, and hydrocarbons should be investigated... for possible action on these air pollutants; studies should also be conducted on the practicality of similar taxes for various of the water pollutants. Adopted by the Board of Directors, February 13-14, 1997

21 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