Transcript Environmental Economics

Environmental Economics
Class 7
Incentive Based Regulation: Basic
Concepts
Up to this point, the focus has been on
resource allocation.
Since the use of resources creates waste,
we address the questions of: 1) how much
waste is appropriate and 2) what are the
appropriate means for pollution reduction?
A Pollutant Taxonomy
The ability of the environment to absorb
pollutants is called its absorptive capacity.
Stock pollutants are pollutants for which the
environment has little or no absorptive capacity.
Stock pollutants accumulate over time and
include things like nonbiodegradable bottles,
heavy metals and chemicals such as PCBs.
Fund pollutants are pollutants for which the
environment has some absorptive capacity. If
the emission rate does not exceed the
absorptive capacity, fund pollutants do not
accumulate. These include organic pollutants
and carbon dioxide.
Local pollutants cause damage near the source of
emissions while regional pollutants cause damage at
greater distances. A pollutant could fit both categories
(e.g. sulfur and nitrogen oxides). This is the horizontal
dimension of influence.
The vertical zone of influence refers to whether the
pollution damages are mostly at ground level or if they
accumulate in the upper atmosphere.
Surface pollutants (water pollution) cause damage near
the earth’s surface, while global pollutants (carbon
dioxide and chlorofluorocarbons) cause damage in the
upper atmosphere. Some air pollutants are both surface
and global pollutants.
Efficient Allocation of Polutants
Fund pollutants can be examined using a static
analysis because the level of future damages is
independent of current emissions. Time periods
can thus be analyzed separately.
Pollution control is most easily analyzed from the
perspective of minimizing cost rather than
maximizing the net benefits from pollution.
Two types of costs associated with pollution are:
1. Damage costs; and
2. Pollution control or avoidance costs.
Marginal damage costs generally increase with the
amount of pollution. With small amounts, the pollutant
can be diluted in the environment. Larger amounts will
tend to cause substantially more damage. This
relationship can be represented by an upward sloping
function in a graph illustrating marginal cost as a function
of pollution emitted.
Marginal control costs typically increase with the amount
of pollution that is controlled or abated. Since the axis of
this graph is pollution emitted, this will be a downward
sloping function. This is equivalent to an upward sloping
function if the axis were to measure pollution controlled
or if the graph is read from right to left.
The cost-minimizing solution is found by equating marginal damage
costs to marginal control costs (or at Q* in Figure 13.2). Points to the
left of Q* (greater control) are inefficient because the marginal cost
of control is greater than the marginal damage and reflects higher
total costs. Likewise, points to the right of Q* are also inefficient, but
now because marginal damage costs are higher than marginal
control costs. There is too much pollution.
The optimal level of pollution would be zero only if the marginal
damage cost function is everywhere above the marginal control cost
function. An extremely toxic pollutant would cause this to be the
case. [How do you draw this.]
Optimal levels of pollution will vary by location and by pollutant.
Market Allocation of Pollution
Damage costs are externalities. Damages are downwind or
downstream of the sources (firms) that emit the pollutants. Thus, the
uncontrolled market will produce too much.
Control costs are not externalities.
For stock pollutants, the market would commit too few resources to
pollution control and the burden on future generations would be
inefficiently large.
Firms that attempt to control pollution unilaterally are placed at a
competitive disadvantage.
Therefore, the market fails to generate the efficient level of pollution
control and penalizes firms that attempt to control pollution.
Efficiency is achieved when the marginal cost of control
is equal to the marginal damage caused by the pollution
for each emitter.
One policy option for achieving efficiency would be to
impose a legal limit on the amount of pollution allowed
by each emitter.
Another approach would be to internalize the marginal
damage caused by each unit of emissions by means of a
tax or charge per unit of emissions. The charge could be
constant or it could rise with emissions. The efficient
charge would be equal to the marginal damage and
marginal control cost at the point where they are equal.
Knowing the level of pollution at which these two
curves cross is difficult at best. Control cost
information is not always available to the
pollution control authority and estimates of
damage costs are very difficult. [Review
nonmarket valuation.]
In the absence of that knowledge, pollution
control authorities could select legal levels of
pollution based on some other criteria such as
safety, human health or ecological heath. Once
this level is set, the most cost-effective policy
could be chosen.
Cost Effective Policies
1. Assume two emission sources are currently
emitting a total of 30 units of emission.
2. Assume the control authority decided a
mandatory reduction of 15 units is necessary.
3. The question then becomes: how should the
15-unit reduction be allocated between the two
sources in order to minimize cost?
Figure 13.3 illustrates the solution to the model.
The graph is drawn such that the left-hand
vertical axis measures the marginal control cost
to emission source 1 and the right-hand vertical
axis measures the marginal control cost to
emission source 2. The horizontal axis is the
constrained to equal 15 – measured from either
direction. This ensures that any point will
represent some combination allocated across
the two sources that adds to 15. [This is
equivalent to flipping over a graph measuring
control costs for source two and using the box
as the constrain.]
The cost-effective allocation is found by
equating the marginal control costs of the
two sources. Since total cost is the area
under the marginal control cost curve, total
costs across the two firms is minimized by
minimizing the two areas and is found by
equating the two marginal costs. Any other
allocation would result in higher total cost.
While simple in theory, the situation is
more difficult for control
authoritiesbecause control authorities do
not often have access to good information
about firms’ costs. Plant managers have
incentives to overstate costs. Other policy
options or pollution control policies must
be utilized.
Pollution control policies
1. Emission Standards
a. An emission standard is a legal limit on the
amount of the pollutant an individual source is
allowed to emit.
b. This approach is referred to as command-andcontrol.
c. The difficulty with this approach is determining
how the standard should be allocated across
sources. The simplest means of allocation –
allocating an equal share to each source – is
rarely cost-effective. In the example given, it is
not cost-effective.
2. Emissions charges
a. An emission charge is a per-unit of pollutant fee, collected by the
government.
b. Charges are economic incentives that reduce pollution because they cost
the firm money.
c. A profit-maximizing firm will control (abate) pollution whenever the fee is
greater than the marginal control cost.
d. Each firm will independently reduce emissions until its marginal control
cost equals the emission charge. This yields a cost-effective allocation
(Figure 13.4).
e. A difficulty with this approach is determining how high the charge should
be set in order to ensure that the resulting emission reduction is at the
desired level. An iterative or trial-and-error approach can be used to
determine the appropriate rate, but changing tax rates frequently is not
usually politically feasible.
f. Another difficulty is that with a charge system, the total amount of pollution
cannot be controlled. If many new sources enter the market, they will still
pay the fee, but total emissions will rise.
3. Transferable emissions permits
a. With a transferable emission permit system, all sources are
required to have permits in order to emit. Each permit specifies how
much the firm is allowed to emit. The permits are freely transferable.
b. The control authority issues the exact number of permits
necessary to achieve the standard.
c. Firms with high marginal costs of control will have incentives to
buy permits from firms with low marginal control costs. Firms with
low marginal control costs will have incentives to see if the permit
price is above their marginal control cost. The equilibrium permit
price will be the price at which the marginal control costs are equal
for both (or across all) firms.
d. The incentives embedded in this system ensure lowest costs and
the control authority does not need information on control costs.