Class 7

Environmental Policy Tools

http://www.agecon.purdue.edu/staff/shively/courses/AGEC406/index.htm

Possible Interventions

1. Moral suasion

2. Government provision of goods

3. Damage prevention

4. Command and control

5. Economic Incentives

Economic Incentives

1. Tax (per-unit penalty)

2. Subsidy (per-unit reward)

3. Transferable Permits (market-based)

Focus on case of negative externality and compare:

1. Command and control (direct regulation)

2. Tax

3. Subsidy

Command and Control

Set limit on emission or specify technology

SMC = PMC + MD

Q Q M

PMC

PMB=SMB

MAX

Pigouvian Tax

Set tax = marginal damage rate

SMC = MC + tax

Q

MC

Tax = MD

Subsidy

Often used in conjunction with technology

MSC (Tech 1)

MPC (Tech 1)

MPC (Tech 2)

MSC (Tech 2)

Subsidy

Command and Control

1. When monitoring costs are high

2. When optimal emission is near zero

3. During random or emergency events

Consists of government-specified rules and regulations, often with fines and charges for violations. Most effective:

Drawback of C+C:

If marginal abatement costs are different for different pollutors, then C+C will lead to an inefficient allocation of clean up burden among different producers.

Marginal abatement cost function

Marginal abatement = pollution reduction of one unit.

The marginal abatement cost (MAC) function measures the dollar amount of the cost of reducing pollution by one unit.

Marginal abatement cost function

EmissionsE1

Cost MAC

Total Abatement CostC1

EU

Marginal Abatement Cost

Shape of curve depends on technology of clean-up

Marginal damage function

Dollar measure of incremental damage from pollution

EmissionsE

DamagesMD

Total DamageD

Optimal level of pollution

EmissionsE1

MAC

Total Abatement Cost

EU

Damages,Costs MD

Total Damage

Socially inefficient (sub-optimal) levels of pollution

Excess social cost from too much abatement

Excess social cost from too little abatement

EmissionsE1

MAC

EU

Damages,Costs MD

Advantages of Economic Incentives

1. In most cases economic incentives will minimize the total costs of

abatement.

2. By penalizing polluting behavioror rewarding clean behavior, economic incentives tend to encourage research into better

abatement measures.

Pollution tax

Goal: set tax = marginal damage cost

Why: encourage polluter to “internalize” the externality

Key: Tax the externality, not the product.

Actual Tax Payment

Tax Avoidance

Potential Tax Payment

Polluter behavior with tax

EmissionsE1=6

CostsMAC = 10 - E

Tax=4

EU=10

T*Q=24

Key points regarding tax

1. Tax achieves socially optimal level of pollution

2. MAC may exceed MD for some levels of pollution. Therefore, the optimal level of pollution is likely to be greater than 0.

3. Individual polluters adjusts emissions to pointwhere MAC = tax, therefore MACs are

equalfor all polluters, which minimizes total costof obtaining target level of pollution.

Tradable Pollution Permits

1975 the U.S. EPA started an Emissions Trading Program to reduce air pollution.

Support for this market-based approach has grown both among businesses and environmentalists.

What is a tradable permit?

Flexible approach to reaching target level of pollution

Any source that reduces emissions more than required receives an “emission reduction credit” (ERC).

ERCs can be used to satisfy emission targets at other discharge points for which the MAC is higher.

ERCs can transferred or sold, thus allowing sources to find the cheapest means to controlling emissions.

Policy contextERC is “currency”

Policies governing use include:

Offset policy: firm uses ERC to continue polluting at another source

Bubble policy: total emissions within “bubble”are regulated, trade within is OK.

Emissions banking: firm can “stockpile” ERCs

ApplicationsAir pollution (1975)

Lead in gasoline (1982-1987)

CFCs and other ozone-depleting chemicals (1988-)

SO2 Acid rain (1993-)

Mobile sources (1993-)

Greenhouse gases (proposed)

Polluter behavior with regulation: Specify 4 units of emission each

E1=4

CostsMAC = 10 - E1

C1=6

E2=4

CostsMAC = 8 - 2 E2

C2=0EU=10

18

Polluter behavior with permit

1. Total Target Emission Level = 8, so E1 + E2 = 8

2. Set MAC1=MAC2 and solve.

10 - E1 = 8 - 2E2

10 - E1 = 8 - 2(8-E1)

10-8+16 = 3 E1

18 = 3 E1

6 = E1

Polluter behavior with permit: firms determine allocation of emissions

E1=6

CostsMAC = 10 - E1

C1=4

E2=2

CostsMAC = 8 - 2 E2

C2=4

EU=10

8

EU=4

4

Key messages:

1. Target Emission Level is reached.

2. Total cost of abatement is lower (12 vs. 18)

3. Optimal allocation is reached where firms equate MACs.

4. Permits allow low-cost firms to abate more than they otherwise would.

Implementation Problems:

1. Transaction costs

2. Spatial considerations

3. Temporal considerations

4. Market power

5. Environmental justice (equity)