Transcript Slide 1
Sidney Innerebner, PhD, PE, CWP
Indigo Water Group
Outline for P2 Economics
A brief introduction to economics and markets
Pollution as a Market Failure
Command and Control Instruments
Economic Instruments
Failure of Regulatory Controls
Law of Demand
Consumers are willing to buy more of a commodity at
lower prices than at higher prices, given constant
demand pressures
Law of Supply
Sellers are willing to provide more of a given good at
higher prices than at lower prices, given constant
supply parameters
Economic Terms
Marginal Benefit
Marginal Cost
Abatement Cost
Deadweight Loss
Marginal Benefit
Additional satisfaction created by the consumption of
one more unit of a good or service
When I am hungry, $15 for a sandwich doesn’t sound
like such a bad deal.
But… a second sandwich isn’t as satisfying as the first.
Cost goes down.
Marginal Cost
Cost to produce one additional unit
Compare to sunk costs
Example – Webinar Series
FIXED COST
MARGINAL COSTS
Digital Voice Recorder -- $100
GoToTraining -- $149 per month
Camtasia Software -- $300
iSpring Hosting -- $127 per month
iSpring Software -- $700
Engineer Intern -- $75 per webinar
Training Unit Fee -- $50
Web Programming - $600
$1750
+
$351
#
Webin
ars
1
2
3
4
5
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7
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9
10
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15
16
Fixed Marginal Cost per
Cost
Cost Webinar
1750
351
$2,101
1750
426
$1,088
1750
501
$750
1750
576
$582
1750
927
$535
1750
1002
$459
1750
1077
$404
1750
1152
$363
1750
1503
$361
1750
1578
$333
1750
1653
$309
1750
1728
$290
1750
2079
$295
1750
2154
$279
1750
2229
$265
1750
2304
$253
#
Webin
ars
17
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21
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27
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31
32
Fixed Marginal Cost per
Cost
Cost Webinar
1750
2655
$259
1750
2730
$249
1750
2805
$240
1750
2880
$232
1750
3231
$237
1750
3306
$230
1750
3381
$223
1750
3456
$217
1750
3807
$222
1750
3882
$217
1750
3957
$211
1750
4032
$207
1750
4383
$211
1750
4458
$207
1750
4533
$203
1750
4608
$199
** Assume 4 webinars per month
** Equates to $69 per month in fixed, recurring costs.
5000
4500
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Fixed Cost
2500
Marginal Cost
Cost per Webinar
2000
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Deadweight Loss
The extent to which the value and impact of a tax, tax
relief or subsidy is reduced because of its side-effects.
For instance, increasing the amount of tax levied on
workers’ pay will lead some workers to stop working or
work less, so reducing the amount of extra tax to be
collected. However, creating a tax relief or subsidy to
encourage people to buy life insurance would have a
deadweight cost because people who would have
bought insurance anyway would benefit.
First Fundamental Theorem
Markets are efficient if:
A complete set of markets exists with well-defined
property rights
Consumers and producers behave competitively by
maximizing benefits and minimizing costs
Consumers and producers know all prices
Transparency!
Transaction costs are zero so that charging a price does
not consume resources
First Fundamental Theorem
If these conditions hold, markets are said to be
efficient
Essentially, all gains from trade have been exhausted
No reallocation of resources in society could improve
someone’s well being without making someone else
worse off
In other words – the market pushes the most efficient
use of the resource…… but an individual might not be
happy with the result
Property Rights
The first condition required that property rights be
well-defined.
Property rights represent a set of legal entitlements
over assets.
This is crucial as it allows goods to flow from low-value
to high-value uses.
Property Rights
Property Rights are well-defined if:
Comprehensively assigned: All assets have privately or
collectively assigned property rights, and all
entitlements are enforced
Exclusive: All benefits and costs accrue to the owner
exclusively, and no others, either through the use or sale
of the asset
Property Rights
Transferable: All property rights must be transferable
from one owner to another. The possibility of resale
encourages owners to consider not only their current use
value, but also the future value to other agents
Secure: All property rights should be secure from seizure
by other individuals, firms or the government. Provides
an incentive to improve and preserve assets
Incomplete Markets
Historically, there are many goods that lack property
rights or a market
Air, water, fisheries, rangelands for example
Many environmental problems can be traced to a lack
of a market or property rights
Market Success
Markets work successfully when the prices of goods
communicate their relative demands and scarcities to a
decentralized and diffuse society
Markets can organize collective information and
allocate goods and services to the highest-valued use
Market Success
Price signal is a powerful ‘coordination’ mechanism
When prices are correct, there is no need for central
planning to determine prices or quantities
At best they could only replicate the market outcome
Prices are only correct when all costs of doing business
have been internalized
Market Failures
The invisible hand pushes in such a way that
individual decisions do not lead to socially desirable
outcomes.
What is Market Failure?
Market failure occurs when freely-functioning
markets, operating without government intervention,
fail to deliver an efficient or optimal allocation of
resources
Therefore, economic and social welfare may not be
maximized
This leads to a loss of economic efficiency
Definition of Market Failure
Market failure exists when the competitive outcome of
markets is not efficient from the point of view of the
economy as a whole
This is usually because the benefits that the market
confers on individuals or firms carrying out a
particular activity diverge from the benefits to society
as a whole
Definition of Market Failure
Put another way, markets fail when the private returns
which an individual or firm receives from carrying out
a particular action diverge from the returns to society
as a whole – resulting in a sub-optimal amount of it
being done
Markets can also fail when the individual or firm does
not have sufficient information to recognize the
returns from taking an action
Main Causes of Market Failure
Externalities causing private and social costs and/or
benefits to diverge
Common Property
Pure public goods and quasi-public goods
Imperfect information
Market dominance and abuse of monopoly power
Equity (fairness) issues. The market can generate an
unacceptable distribution of income and social
exclusion
Externalities
Any cost or benefit borne by an agent who receives no
compensation for the cost nor pays for the benefit
The absence of a market means this externality isn’t
resolved through bargaining
Can be negative or positive
Externalities
In the case of a negative externality, an agent fails to
account for the costs he imposes on others
Pollution is a classic negative externality
Examples of Negative
Externalities
Smokers ignore the impact of passive smoking on non
smokers
Acid rain from power stations in the UK can damage
the forests of Norway
Air pollution from road use
The social costs of drug abuse
The environmental damage caused by the growing use
of fertilizers in agriculture
Noise pollution from aircraft taking off and landing
A Negative Externality Example
Marginal social cost includes all the marginal costs
borne by society.
– It is the marginal private costs of production
plus the cost of the negative externalities
associated with that production.
A Negative Externality Example
When there are negative externalities, the competitive
price is too low and equilibrium quantity too high to
maximize social welfare.
A Negative Externality*
S1 = Marginal social cost
Cost
S = Marginal private cost
Marginal cost
from externality
P1
P0
D = Marginal
social benefit
0
Q1
Q0
Quantity
Externalities
Firms set private marginal costs = private marginal
benefits in deciding pollution levels
Since pollution harms other people, the marginal
social costs exceed the marginal private benefits
We get an overprovision of pollution (or any other
negative externality) – market failure
Externalities
On the other hand, with positive
externalities, we get an
underprovision of the good –
market failure
Lighthouses for example
Providers of the positive
externality do not account for the
benefits of their actions that
accrue to others
Marginal social benefits exceed
marginal private benefits
Transferable Externalities
Related problem is when externalities can be
transferred to others at a relatively low cost
Think towns on either side of a river bank building a
levee higher and higher
We get an overprovision of self-protection – market
failure
Common Property
There appears, then, to be some truth in the conservative
dictum that everybody's property is nobody's property.
Wealth that is free for all is valued by none because he who
is foolhardy enough to wait for its proper time of use will
only find that it has been taken by another. The blade of
grass that the manorial cowherd leaves behind is valueless
to him, for tomorrow it may be eaten by another's animal;
the oil left under the earth is valueless to the driller, for
another may legally take it; the fish in the sea are valueless
to the fisherman, because there is no assurance that they
will be there for him tomorrow if they are left behind today.
Gordon, 1954
Common Property
In 1968, Hardin published “The
Tragedy of the Commons”
Lack of property rights (open access)
causes people to trash the resource
Each individual thinks “what is my
private cost from using the resource”
But everyone makes that same
calculation, trashing the resource
Common Property
A firm polluting the “commons” has a private cost
of emissions lower than the social cost of
emissions.
A cabin on a lake dumps their waste in a common
lake.
Pollution is diluted to all other cabins on the lake
Private cost is less than the social cost.
But each cabin comes to the same conclusion
Common Property
Hardin’s analysis is essentially a “Prisoner’s Dilemma”
– noncooperation is the only rational strategy
Even if every agent recognizes that it would be better
to cooperate and preserve the commons, it’s
individually rational to overuse it.
Prisoner’s Dilemma
(P1, P2)
Cooperate
Defect
Cooperate
(3,3)
(1,4)
Defect
(4,1)
(2,2)
(Defect, Defect) is the only Nash Equilibrium
Even though (Cooperate, Cooperate) would be
better for both players
Public Goods
In the case of public goods, when use is non-rival and non-
excludable:
Non-rivalry means that consumption of the good by one
individual does not reduce availability of the good for
consumption by others; and
Non-excludability that no one can be effectively excluded
from using the good
…no decentralized pricing system can serve to determine
optimally these levels of collective consumption
Samuelson, 1954
Underprovision is the result
Examples of Public Goods
Clean Air
Street Lights
Public Fireworks
National Defense
Public Goods
Excludable
Rivalrous
Nonrivalrous
Nonexcludable
Private goods
food, clothing, toys,
furniture, cars
Common goods
water, fish, timber,
coal
Club goods
cinemas, private
parks, cable TV
Public goods
national defense, freeto-air television, air
Global Public Goods
One particularly challenging problem is that of global
public goods
A global public good is one where the impacts are
indivisibly spread across the globe (global warming,
ozone, Shakespeare, terrorism, proliferation)
Public goods and market failure
Free-market economy will fail to deliver efficient
quantity of public goods because of their
characteristics
A problem arising from public goods is the free rider
issue
People take a free ride when they benefit from
consuming a good or service without paying for the costs
of provision
Many goods have a public element but they are not pure
public goods for example a congested motorway
Imperfect Information
For the market to work, agents need:
Perfect information about the availability of goods and
services and
Complete information about prices charged by suppliers
Costs and Benefits aren’t always easily quantified
Global warming
Increased cancer risk from air pollution
Asymmetric information occurs when somebody
knows more than somebody else in the market
Market Failure Under
Monopoly or Monopsony
Imperfect competition can lead to a misallocation of
resources
Monopoly prices will normally be above those in
competitive markets
Loss of consumer surplus
Output is below the competitive equilibrium level
Loss of static efficiency
Monopolists may waste scarce resources
High levels of advertising and marketing designed to
increase brand loyalty and build entry barriers
Market Failure Under
Monopoly
Monopoly power can also bring economic benefits
Exploitation of economies of scale
Profits used to fund research and development – leading
to a faster pace of innovation and gains in dynamic
efficiency
Many monopolies face international competition and
many domestic markets have become more contestable
Recap
Why do we regulate pollution?
Environmental goods often suffer from market failure
Allocation of environmental goods is inefficient, which
provides a rationale for regulation
Government intervention to
correct market failure
The economic rationale for government intervention
Correction for market failure/loss of economic efficiency
Desire for greater degree of equity in the distribution of
income and wealth
Several forms of government intervention are possible
to correct for the perceived market failure
Pollution Control Mechanisms
Design standards
Quotas
Charges/Taxes/Fees
Subsidies
Combination
Fees/Permits
Tradable Permits
Deposit-Refund
Schemes
Government Solution
Market Solution
Command
One approach is command—rather than imposing a
tax or offering a subsidy, the government simply
requires or commands the activity.
For a negative externality like pollution, the
government simply requires the company to stop
polluting.
For a positive externality, like inoculation, the
government requires certain classes of citizens to be
inoculated.
Design Standards
Historically popular form of pollution control – form
of Command and Control
Government determines the standards that processes
must meet
Ex. Installation of SO2 scrubbers, catalytic converters
Benefit: clear requirements for polluting firms to meet
Design Standards
But design standards have many issues
Firms have differing compliance costs
Government picks a “winning” technology that all firms
must adopt
Technically costly to enforce and regulate
Little innovation for firms to innovate their own ways to
reduce pollution
Byzantine regulations
Pollution Quotas/Limits
Also historically popular, and probably the form of
pollution control most familiar
Government determines the maximum level of each
pollutant that a firm may emit
Ex. Clean Water Act, CAFE
Benefit: If government can determine socially optimal
level of pollution, boom, they can pick it
Pollution Quotas/Limits
This measure allows a bit more flexibility for firms –
they can choose how to meet the quota
If everyone complies, we get the “optimal” level of
pollution
Pollution Quotas/Limits
Problems:
Strong incentive for firms to shirk (moral hazard)
Short run Marginal benefits of shirking exceed costs
Byzantine regulations
Uniform application means we could get the same
reduction in pollution for less investment if high cost
firms could pay low cost firms to abate for them
Regulation in Fisheries Example
Historically, fisheries have been Open Access –
Tragedy of the Commons
Despite initial optimism about our inability to exhaust
the oceans resources, by the mid-20th Century fisheries
were getting depleted
In response to overexploitation, governments moved
to implement regulations
Regulation in Fisheries Example
Thought #1: If we have too many fishermen, we need
to limit the number of boats that can fish
Regulation in Fisheries Example
Thought #1: If we have too many fishermen, we need
to limit the number of boats that can fish
Response #1: The remaining fishermen in the industry
built bigger boats to catch the “extra” fish
Regulation in Fisheries Example
Thought #2: If they have too big of boats, we should
limit vessel size
Regulation in Fisheries Example
Thought #2: If they have too big of boats, we should
limit vessel size
Response #2: Fishermen cut off the prow of their boats
and loaded it with lots of crew
Regulation in Fisheries Example
Thought #3: If they have too many crew members, we
should limit the crew size
Regulation in Fisheries Example
Thought #3: If they have too many crew members, we
should limit the crew size
Response #3: Fishermen loaded up their boats with
tons of fishing gear
Regulation in Fisheries Example
Thought #4: This is getting ridiculous, we’ll just close
the season once a quota of fish have been caught
Regulation in Fisheries Example
Thought #4: This is getting ridiculous, we’ll just close
the season once a quota of fish have been caught
Response #4: Fishermen set out the first day of the
season and catch and catch and catch… and seasons
which used to end in 180 days ended in 2 days
Regulation in Fisheries Example
Thought #5: Well, we’ll just set days on which they can
fish
Regulation in Fisheries Example
Thought #5: Well, we’ll just set days on which they can
fish
Response #5: Fishermen buy enormous motors to “race
for fish” creating a very dangerous “Fish Derby!”
Regulation in Fisheries Example
Thought #5: Well, we’ll just set days on which they can
fish
Response #5: Fishermen buy enormous motors to “race
for fish” creating a very dangerous “Fish Derby!”
Why did all these regulatory measures fail?
Incentives Matter
We now look at alternative means of regulating the
environment
Key take away point: Incentives matter!
The preceding fishery regulations failed because they
failed to account for the fundamental incentives
driving fisherman behavior
Ignoring incentives can lead to bad policy
Economic Instruments
Many advantages over Command and Control
Static Efficiency (cheaper now)
Dynamic Efficiency (cheaper later)
Revenue Raising
Provide MARKET BASED incentives for pollution
control
Often result in lower total cost per unit of pollution
controlled AND lower total pollution
Pollution Tax
One class of solutions to the externality problems
involve internalizing the costs and benefits, so that the
market can work better.
Pollution Tax: if a firm is creating a negative
externality in the form of pollution, create a tax on the
polluting firm equal to the cost of cleaning up the
pollution.
Regulation Through Taxation*
Marginal social cost
Cost
Marginal private cost
P1
Efficient tax
P0
Marginal social
benefit
0
Q1
Q0
Quantity
Emission Fees/Taxes
Relatively newer concept – adopted overseas in a
number of contexts
Pigouvian Tax
Government determines a marginal fee per unit of
pollution equal to the difference between social and
private costs
Creates a profit incentive to reduce pollution
Emission Fees/Taxes
Now firms factor in their social damages, leading to an
optimal level of pollution
Equimarginal principle is met – on the margin,
benefits equal costs
High cost firms will abate less, low cost firms will abate
more
Also provides an incentive to innovate ways to reduce
pollution
Emission Fees/Taxes
Still, problems remain
Regulator might not be able to determine optimal tax
level
Regulating joint production of multiple pollutants
Equity concerns (regressive)
Need to be able accurately measure emissions to charge
them (tailpipe, runoff)
Tradable Permits
Newest form of pollution control – very popular
among economists
Government essentially creates a market for the right
to pollute
Determine a cap on total emissions, and then dole out a
share of that cap (grandfather or auction)
Agents can then trade these rights
Tradable Permits
Ex. US and Canada sulfur dioxide, New Zealand and
Iceland fisheries, European carbon market
Like the quota/limit system, government gets to
determine optimal social pollution
But now, firms can trade permits
High cost firms can buy permits from low cost firms
Provides incentives to innovate
Tradable Permits
Again, problems exist
Government still needs measurement and enforcement
Government still needs to determine “optimal” total
pollution
Hotspots and non-uniform mixing pollutants
Market power
Initial allocation process is contentious
Subsidies
Essentially create false demand OR falsely lower costs
Cash for Clunkers – a success story
Corn ethanol
Farm subsidies
Banned import of sugar cane ethanol
Unintended consequence: increased food prices
Regulatory Failure
Laws and regulations may institutionalize the tragedy
of the commons
Rule of capture for oil and minerals
Water rights, esp. groundwater
Lobbyists may support regulations as a way of hurting
their competition
Clean Air Act – grandfathered plants could operate
cheaply compared to new sources
CAA – cut sulfur emissions by using low sulfur coal OR
by installing scrubbers
Regulatory Failure
Hard Cases Make Bad Law
1970’s Petroleum prices and lead
2001 Power shortage in California
Regulations often have unintended side effects
New source standards in CAA have perpetuated old
technology and kept it in operation too long
Corn ethanol and food prices
Fishing boat example
Regulatory Failure
Regulators don’t bear the costs of their regulations
Forest Service and timber roads
Roads paid out of US Treasury
Forest Service keeps some proceeds
Incentive to build lots of roads to nowhere
Timber value < road costs
More negative consequences
Deforestation
Loss of habitat
Soil erosion
Regulatory Failure
Command and Control can stifle innovation
The existence of regulations and regulatory bodies
gives people a false sense of security
Bernie Madoff?
BP Oil Spill
Melamine in baby food
Regulatory Successes
Phosphorus loading in Colorado
Cap and Trade for SOx and NOx
Refund-Deposit schemes for bottles, batteries, white
goods, and more
Safe Drinking Water Act
Food and Drug Administration (some failure here too)
Fuel Tax