1. PPA 723: Managerial Economics Lecture 19: Externalities and Public Policy The Maxwell School, Syracuse University Professor John Yinger

2. Managerial Economics, Lecture 19: Externalities & Policy Outline  Alternative Policies to Address Externalities  Fees vs. Standards  Pollution Markets

3. Managerial Economics, Lecture 19: Externalities & Policy Reducing Externalities  Competitive markets produce excessive negative externalities, as indicated by deadweight loss.  Hence government intervention may benefit society.

4. Managerial Economics, Lecture 19: Externalities & Policy Alternative Policies  Charge approach: effluent fee (a charge per unit of pollution) or a tax on products of polluting firms.  Regulatory approach: emissions standard (quantity restrictions on outputs or inputs)  Because output and pollution move together, either approach works in principle.

5. Managerial Economics, Lecture 19: Externalities & Policy $ Pollution Reduction 100% MC MB Optimal Standard 0% Optimal Fee Fees and Standards

6. Managerial Economics, Lecture 19: Externalities & Policy Optimal Regulation  Unfortunately, the government often does not know enough to regulate optimally.  The government needs to know:  The marginal benefits from pollution reduction.  The marginal costs of pollution reduction.

7. Managerial Economics, Lecture 19: Externalities & Policy Enforcement  Even if government knows enough to set optimal regulation, it must enforce regulation to achieve social optimum  U.S. Environmental Protection Agency (EPA) smog standards violated in 33 metro areas  including Baltimore, Boston, Chicago, Houston, LA, Milwaukee, New York, and Philadelphia  http://www.epa.gov/enviro/zipcode.html http://www.epa.gov/enviro/zipcode.html  http://www.scorecard.org http://www.scorecard.org  http://www.formyworld.com http://www.formyworld.com

8. Managerial Economics, Lecture 19: Externalities & Policy Emission Standards for Ozone  Ozone is a major air pollutant.  It is formed in the atmosphere through a chemical reaction between organic gases and nitrogen oxides in sunlight

9. Managerial Economics, Lecture 19: Externalities & Policy Standards for Ozone  The Clean Air Act of 1990 sets national air- quality standards for major pollutants:  0.12 parts per million (ppm).  California Air Resources Board (CARB) has an even tighter standard: 0.09 ppm.

10. Managerial Economics, Lecture 19: Externalities & Policy Costs and Benefits  Cost of reducing ozone are greater expenses of  manufacturing  driving  The benefits are  better health in urban areas  increased agricultural yields in rural areas  Consequently, optimal level differs in urban and rural areas.

11. Managerial Economics, Lecture 19: Externalities & Policy Estimated Benefits and Costs  Kim, Helfand, and Howitt (1998) estimate that meeting the CA’s 0.09 ppm standard  health benefits range from $2.58 million to $51.58 million  consumer surplus ranges from $229 million to $270 million  producer surplus ranges from $297 million to $348 million  Welfare is maximized at slightly below 0.14 ppm (conservative estimates)

12. Managerial Economics, Lecture 19: Externalities & Policy Emissions Standards for Ozone 0.120.110.100.090.160.150.140.13 Ozone concentration, ppm Marginal benefit, Marginal cost, $ millions 400 300 200 100 MC MB 0.120.110.100.090.160.150.140.13 Ozone concentration, ppm State standardFederal standardOptimal Cost Benefit Benefit, Cost, $ millions (a) Cost and Benefit 1,000 800 600 400 200 (b) Marginal Cost and Marginal Benefit

13. Managerial Economics, Lecture 19: Externalities & Policy Fees vs. Standards  Although fees and standards can, in principle, both achieve the optimal pollution level, they are very different in practice in the following ways:  Costs imposed on firms.  Ability to account for variation in pollution reduction costs across firms.  Cost of errors under conditions of uncertainty.

14. Managerial Economics, Lecture 19: Externalities & Policy Costs for Firms  Fees, but not standards, produce tax revenues.  When a standard is used rather than a fee, firms are better off, and the government is worse off, by the amount of the fees.  In either case, firms must pay for clean-up.

15. Managerial Economics, Lecture 19: Externalities & Policy Government Revenues $ Pollution Reduction 100% MC MB Optimal Standard 0% Optimal Fee Government Revenue Clean-up Costs

16. Managerial Economics, Lecture 19: Externalities & Policy Variation in Firms’ Costs  Standards (not fees) require the same actions of all firms—limit pollution to a certain level, install certain equipment, etc.  But firms’ pollution-reduction costs may differ.  As a result, standards may not reduce pollution in the least costly way.

17. Managerial Economics, Lecture 19: Externalities & Policy $ Pollution Reduction 100% MC = MC 1 + MC 2 MB Optimal = R 1 +R 2 0% MC 2 MB* R1R1 R2R2 MC 1 Variation in Firms’ Costs

18. Managerial Economics, Lecture 19: Externalities & Policy $ Pollution Reduction 100% MC = MC 1 + MC 2 MB R* = R 1 +R 2 0% MC 2 MB* R1R1 R2R2 R* 2 Loss from Standard Inefficient Pollution Reduction

19. Managerial Economics, Lecture 19: Externalities & Policy Uncertainty  If the government has imperfect information about the cost of pollution reduction,  Then the optimal policy depends on the shapes of MB and MC curves for abating pollution.

20. Managerial Economics, Lecture 19: Externalities & Policy Uncertainty about Costs

21. Managerial Economics, Lecture 19: Externalities & Policy Interpretation of Figure  The preceding figure shows the deadweight loss from an improperly set fee or standard.  If the true MC curve is MC 1, the optimal standard is S 1 and the optimal fee is f 1  Setting f too low causes DWL=  Setting S too high causes DWL =  So the fee look better.

22. Managerial Economics, Lecture 19: Externalities & Policy Figure (cont.)  Similarly, it’s better to use the fee if the true MC is MC 2.  However, if the MB curve is very steep, which implies that there is a threshold of pollution reduction that yields huge benefits, we might conclude that the standard was better.  If reducing pollution below a certain level would save many lives, it makes no sense to use a fee that might not be high enough to reduce pollution this much.

23. Managerial Economics, Lecture 19: Externalities & Policy Uncertainty about Benefits

24. Managerial Economics, Lecture 19: Externalities & Policy  The preceding figures shows the deadweight loss from an improperly set fee or standard.  If the true MB curve is MB 1, the optimal standard is S 1 and the optimal fee is f 1, so setting f or S (too high) causes DWL= DWL 1  If MB 2 is the true MB, setting f or S (too low) causes DWL= DWL 2.  Thus, DWL from a mistaken belief about MB does not depend on whether the government uses a fee or a standard. Interpretation of Figure

25. Managerial Economics, Lecture 19: Externalities & Policy Pollution Markets  Many economists argue in favor of using markets to reduce pollution.  With this approach, the government must first assign property rights (i.e. the rights to pollute) and let them be traded.  This approach combines aspects of standards (control total, no revenue to government) and fees (most efficient pollution reduction).

26. Managerial Economics, Lecture 19: Externalities & Policy U.S. Clean Air Act of 1990  This act created a market for sulfur dioxide (SO2) pollution generated by power plants.  The law set an emissions cap of 8.7 million tons for 1995, when it would take effect.  Actual production in 1995, however, fell nearly 50% to just 5.3 million tons, and at a cost between ½ and 1/3 of traditional standard approach as firms used smokestack scrubbers (which remove sulfur from exhaust gases) and low-sulfur coal to cut pollution.

27. Managerial Economics, Lecture 19: Externalities & Policy Permits  EPA issues permits, each of which allows a firm to produce 1 ton of emissions of sulfur dioxide annually, equal to the aggregate emissions cap.  Electric utilities that operate the 445 largest and dirtiest coal-fired power plants in the United States received permits in proportion to the amount of fuel they used in a historical period.

28. Managerial Economics, Lecture 19: Externalities & Policy Effects  U.S. SO2 emissions from power plants in 2001 were 1/3 that in 1990.  Schmalensee et al. (1998) estimated that, in mid-1990s, the pollution reduction under the market program cost about a ¼ to 1/3 less than if permits had not been tradable, with a savings of $225 to $375 million per year.  Environmental groups encourage citizens to buy up and retire pollution permits: cleanairconservancy.org/Markets/le.sulfur.html  For $10, you can buy the rights to about 200 pounds of SO2.

29. Managerial Economics, Lecture 19: Externalities & Policy Brokers  Brokers trade 30 types of air pollution, including from SO2, nitrogen oxides (NOx), and carbon dioxide (CO2).  Cantor Fitzgerald Environmental Brokerage Service, www.emissionstrading.com/index_mpi.htm, lists prices at which permit trade.  In 2002, the SO2 market was $4 billion a year and growing.

30. Managerial Economics, Lecture 19: Externalities & Policy Other Pollution Markets  A southern Californian smog market started in 1994.  The South Coast Air Quality Management District (AQMD) regulates emissions in four southern California counties  It allocates credits for nitrogen oxides or sulfur oxides, two key pollutants, to firms  AQMD believes that allowing trading cuts the cost of complying with clean air regulations by $58 million, 42% of the total.