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PPA 723: Managerial Economics
Lecture 19:
Externalities and Public Policy
The Maxwell School, Syracuse UniversityProfessor John Yinger
Managerial Economics, Lecture 19: Externalities & Policy
Outline
Alternative Policies to Address Externalities
Fees vs. Standards
Pollution Markets
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.
Managerial Economics, Lecture 19: Externalities & Policy
Alternative PoliciesCharge 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.
Managerial Economics, Lecture 19: Externalities & Policy
$
Pollution Reduction
100%
MC
MB
OptimalStandard
0%
OptimalFee
Fees and Standards
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.
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 Philadelphiahttp://www.epa.gov/enviro/zipcode.html http://www.scorecard.orghttp://www.formyworld.com
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
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.
Managerial Economics, Lecture 19: Externalities & Policy
Costs and Benefits Cost of reducing ozone are greater
expenses ofmanufacturing driving
The benefits arebetter health in urban areasincreased agricultural yields in rural areas
Consequently, optimal level differs in urban and rural areas.
Managerial Economics, Lecture 19: Externalities & Policy
Estimated Benefits and Costs
Kim, Helfand, and Howitt (1998) estimate that meeting the CA’s 0.09 ppm standardhealth benefits range from $2.58 million to $51.58
millionconsumer surplus ranges from $229 million to $270
millionproducer surplus ranges from $297 million to $348
million
Welfare is maximized at slightly below 0.14 ppm (conservative estimates)
Managerial Economics, Lecture 19: Externalities & Policy
Emissions Standards for Ozone
0.12 0.11 0.10 0.090.16 0.15 0.14 0.13Ozone concentration, ppm
Marginal benefit,Marginal cost, $ millions
400
300
200
100
MC
MB
0.12 0.11 0.10 0.090.16 0.15 0.14 0.13Ozone concentration, ppm
State standardFederal standardOptimalCost
Benefit
Benefit, Cost, $ millions(a) Cost and Benefit
1,000
800
600
400
200
(b) Marginal Cost and Marginal Benefit
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.
Managerial Economics, Lecture 19: Externalities & Policy
Costs for FirmsFees, 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.
Managerial Economics, Lecture 19: Externalities & Policy
Government Revenues
$
Pollution Reduction
100%
MC
MB
OptimalStandard
0%
OptimalFee
Government Revenue
Clean-upCosts
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.
Managerial Economics, Lecture 19: Externalities & Policy
$
Pollution Reduction
100%
MC = MC1 + MC2
MB
Optimal = R1+R20%
MC2
MB*
R1 R2
MC1
Variation in Firms’ Costs
Managerial Economics, Lecture 19: Externalities & Policy
$
Pollution Reduction
100%
MC = MC1 + MC2
MB
R* = R1+R20%
MC2
MB*
R1 R2R* 2
Lossfrom Standard
Inefficient Pollution Reduction
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.
Managerial Economics, Lecture 19: Externalities & Policy
Uncertainty about Costs
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 MC1, the optimal standard is S1 and the optimal fee is f1
Setting f too low causes DWL=Setting S too high causes DWL =So the fee look better.
1fDWL1SDWL
Managerial Economics, Lecture 19: Externalities & Policy
Figure (cont.)
Similarly, it’s better to use the fee if the true MC is MC2.
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.
Managerial Economics, Lecture 19: Externalities & Policy
Uncertainty about Benefits
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 MB1, the optimal standard is S1 and the optimal fee is f1, so setting f or S (too high) causes DWL= DWL1
If MB2 is the true MB, setting f or S (too low) causes DWL= DWL2.
Thus, DWL from a mistaken belief about MB does not depend on whether the government uses a fee or a standard.
Interpretation of Figure
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).
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.
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.
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.
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.
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.