1. Economic Solutions to Environmental Problems The Market Approach
Chapter 5
Economic Solutions to Environmental Problems The Market Approach
© 2007 Thomson Learning/South-Western
Callan and Thomas, Environmental Economics and Management, 4e.

2. Overview
Market approach refers to incentive-based policy that encourages conservative practices or pollution reduction strategies
Difference between market approach and command-and-control approach is how each approach attempts to achieve its objectives
Types of Market Instruments
Pollution charge
Subsidies
Deposit/refund systems
Pollution permit trading systems

3. Pollution Charges

4. Pollution Charge Fee that varies with amount of pollutants released
Based on “Polluter-Pays Principle”
Types of pollution charges
Effluent/emission fees
Product charge
User charge
Administrative charge

5. Product Charge
Fee added to price of pollution-generating product, which generates negative externality
Impose product charge as per unit tax on product, e.g., gas tax
How does the tax on gasoline in the US compare with that of other nations?
If the tax equals the marginal external cost (MEC) at QE, it is called a Pigouvian tax

6. Selected International Gasoline Tax Rates
Tax Rate % of Price (2004)
United States 20
U.K. 73
France 71
Italy 65
Japan 50
Spain 59
Source: International Energy Agency, August 13, 2004

7. Modeling a Pigouvian Tax$
MSC = MPC + MEC
MPCt
MPC a
Amount of tax b
MPB = MSB QE QC
Q of gasoline

8. Assessing the Model In theory, achieves an efficient outcome
In practice, difficult to identify the value of MEC at QE
Allows only for an output reduction to reduce pollution

9. Emission (Effluent) Charge
A fee imposed directly on the discharge of pollution
Assigns a price to pollution
Typically implemented through a tax

10. Model: Single Polluter Case
Government sets an abatement standard at AST
Policy options to polluter are:
Abate up to AST and incur those costs OR
Pay a constant per unit tax, t, on any abatement less than AST
Total Tax = t(AST - AO)
where AO is actual abatement level
Marginal Tax (MT) = t
Because t is constant, t = MT
Firm will choose the least-cost option: the marginal tax (MT) or the marginal abatement cost (MAC)

11. Modeling Emission Charge Single Polluter$
Firm abates up to Ao since
MAC < MT; firm pays tax
between AO and AST, since
MAC > MT in that range
MAC
0aAO = cost to abate AO
AOabAST = tax on pollution
not abated up to AST c a b MT t AO
AST
Abatement (A)

12. Model: Multiple Polluter Case
To facilitate comparison, we use the same model as in the uniform standard case
Assumptions
2 polluting sources in some region
Each generates 10 units of pollution
Government sets emissions limit for region as 10 units, which implies AST = 10
Policy: To achieve AST, government imposes an emission charge as a unit tax (t) of $5

13. Model: Multiple Polluter Case
Each firm responds as in the single polluter case
Abates as long as MAC < MT
Pays emission charge when MAC > MT
Polluter 1: TAC1 = 1.25(A1) MAC1 = 2.5(A1)
where A1 is pollution abated by Polluter 1
Polluter 2: TAC2 = (A2) MAC2 = 0.625(A2)
where A2 is pollution abated by Polluter 2
Find each firm’s abatement level. Then, find each firm’s total abatement costs (TAC) and tax payment at that level. Support with a graph.

14. Solution Polluter 1: Polluter 2:
Abates up to the point where MAC1 = MT,
Set 2.5(A1) = $5, or A1 = 2
Incurs TAC1 = 1.25(2)2 = $5
Incurs Total Tax = 5(10 - 2) = $40
Polluter 2:
Abates up to point where MAC2 = MT
Set 0.625(A2) = $5, or A2 = 8
Incurs TAC2 = (8)2 = $20
Incurs Total Tax = 5(10 - 8) = $10

15. Modeling An Emission Charge Multiple Polluter
MAC1
MAC2
Total Abatement Level = 10 = As
TAC1 + TAC2 = $25 (right triangles)
Total Tax Payments = $50 (rectangles)
25.00
MAC1
6.25
MT = 5.00
MT = 5.00
MAC2 10 10 2
Polluter 1’s Abatement 8
Polluter 2’s Abatement

16. Assessing the Model (pros)
Abatement standard is met
Generates $40 in tax revenues from high-cost abater and $10 from low-cost abater
Low-cost abaters do most of cleaning up
Cost-effective solution is obtained
MACs are equal at $5 tax rate
Combined TAC of $25 is lower than $39.06 under command-and-control with a uniform standard

17. Assessing the Model (cons)
Tax authority will not know where MACs are equal
Will have to adjust rate until objective achieved
Monitoring costs potentially higher
Firms might evade tax by illegally disposing pollutants
Distributional implications
Consumers may pay higher prices due to tax
Job losses may result from polluter paying new taxes and/or changing technology to abate

18. Pollution Charges in Practice
Internationally, the pollution charge is the most commonly used market-based instrument
Some countries use effluent charges to control the noise pollution generated by aircraft
Others levy charges on products such as motor vehicles, pesticides, fertilizers, batteries and gasoline

19. Environmental Subsidies

20. Environmental Subsidies
Two major types of subsidies:
Abatement equipment subsidies
Pollution reduction subsidies

21. Abatement Equipment Subsidy
Defined as a payment aimed at lowering the cost of abatement technology
Goal is to internalize the positive externality associated with the consumption of abatement activities
If the subsidy (s) equals the marginal external benefit (MEB) at QE, it achieves an efficient equilibrium and is called a Pigouvian subsidy

22. Pigouvian Subsidy Market for Scrubbers
($ millions)
MSC
MPB
MSB
QC = 200
QE = 210
PC = 170
PE = 175
Subsidy = $14 million
MPBS
Q of scrubbers
PE – s = 161 K L

23. Assessing the Model It is difficult to measure the MEB
May bias polluters’ decisions about how best to abate

24. Pollution Reduction Subsidy
To implement, government pays the polluter a subsidy (s) for every unit of pollution abated below some pre-established level ZST
Per unit subsidy = s(ZST - ZO), where ZO is the actual level of pollution
Analogous to an emission charge

25. Assessing the Model Might be less disruptive than an equipment subsidy
Can have the perverse effect of elevating pollution levels in the aggregate since the subsidy lowers unit costs and raises profit, encouraging entry

26. Subsidies in Practice
Environmental subsidies typically are implemented as grants, low-interest loans, tax credits or exemptions, and rebates
Many countries around the world use these instruments, including Austria, Finland, Japan, and Turkey
In the U.S., common uses include federal funding to build publicly-owned treatment works and subsidies to encourage the development of cleaner fuels and low-emission vehicles

27. Deposit-Refund Systems

28. Deposit/Refund Systems
A deposit/refund system is a market instrument that imposes an up-front charge to pay for potential damages and refunds it for returning a product for proper disposal or recycling
Targets the potential vs. actual polluter
The deposit is intended to capture the MEC of improper waste disposal (IW) in advance
Preventive vs. ameliorative

29. Modeling Deposit/Refund System IW disposal market
MECIW: health damages + aesthetic impairment from litter, trash accumulation, etc.
MPCIW: costs to disposer (e.g., trash receptacles, collection fees, plus forgone revenue from not recycling)
MSCIW = MPCIW + MECIW
MPBIW: demand for improper disposal
Assume MEBIW = 0, so MPBIW = MSBIW

30. Deposit-Refund Model $ MSCIW MPCIW + Deposit MPCIW a b MPBIW = MSBIW
Deposit converts % of overall waste disposal, measured by (QIW - QE), from improper methods to proper
MSCIW
MPCIW + Deposit
MPCIW a
Deposit=MEC at Qe b
MPBIW = MSBIW QE
QIW
Improper Waste Disposal (%)
100
Proper Waste Disposal (%)
100

31. Assessing the Model Promotes responsible behavior
Requires minimal supervision by government
Can help slow the use of virgin raw materials by improving availability of recycled materials

32. Deposit/Refund Systems in Practice
Deposit/refund systems are used worldwide
Many nations use these systems to encourage proper disposal of beverage containers
In the US, 11 states have bottle bills
Other applications include systems used to promote responsible disposal of used tires, car hulks, and lead-acid batteries

33. Pollution Permit Trading Systems

34. Pollution Permit Trading Systems
A pollution permit trading system establishes a market for rights to pollute by issuing tradeable pollution credits or allowances
Credits are issued for emitting below a standard
Allowances indicate how much can be released
Two components of the system are
Fixed number of permits is issued based on an “acceptable” level of pollution set by government
The permits are marketable
Bargaining gives rise to a market for pollution rights

35. How Permit Trading Works
There is an incentive to trade as long as polluters face different MAC levels
Suppose a firm has 50 permits but normally emits 75 units of SO2. What must it do?
Answer
Abate 25 units of emissions OR
Buy 25 permits from another producer
Which option will the firm choose?
Whichever option is cheaper

36. Result
Low-cost abaters will clean up pollution and sell excess permits to other firms
They will sell at any P higher than their MAC
High-cost abaters will buy permits rather than abate
They will buy at any P lower than their MAC
Trading will continue until the incentive to do so no longer exists, at which point, the cost-effective solution is obtained, i.e., the MACs across firms are equal

37. Assessing the Model
Trading establishes the price of a right to pollute without government trying to “search” for a price
No tax revenues are generated
Trading system is flexible
Note that an emissions standard can be adjusted by changing the number of permits issued

38. Pollution Trading Systems in Practice
International examples
Trading of greenhouse gas allowances are part of the Kyoto Protocol, an international accord aimed at global warming
Canada has a trading program for ozone-depleters
Denmark has one for carbon dioxide emissions
Most of the evolution of trading is occurring in the U.S.
An important example is the establishment of an allowance-based trading program to control sulfur dioxide emissions under the Clean Air Act Amendments of 1990