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 6 7 8 9 10 11 12 13 14 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 18 19 20 21 22 23 24 25 26 27 28 29 30 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 4000 3500 3000 Fixed Cost 2500 Marginal Cost Cost per Webinar 2000 1500 1000 500 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 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