1. Taxes, Standards and Tradable Permits 6-09-2009
Econ 201 Lecture 10.1c
Taxes, Standards
and Tradable Permits

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 Pi Pa

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