Topics Today 91808

1
Topics Today (9/18/08)

• Green Taxes
• Command-and-Control (CAC)
• Tradable Pollution Permits
• Homework 2 is on the web due in class on
  Tuesday, 9/23/08.
• Read 1, 2, and skim 3 from your outside
  reading list for next time.

2
The Efficient Level of Pollution
The efficient level of pollution occurs where the
marginal abatement costs equate marginal
pollution damage.
3
Solutions to Market Failure Green Taxes

• Green Taxes (Set the price of social damage)
• Premise Force people to bear all costs of their
  actions gt internalize the externality by
  taxing them.
• Required A government with the power of
  taxation.
• Key Point The tax forces polluters to clean up
  pollution until their marginal abatement cost
  equals the tax.

4
Solutions to Market Failure Green Taxes

• Previous example of upstream paper mill and
  downstream fishing company.
• Suppose the paper mill has to pay 550 for each
  unit of pollution. How much pollution would be
  cleaned up?
• 5 units (units 10 through 6).
• As shown earlier, this is the efficient level of
  pollution.

5
Solutions to Market Failure Green Taxes

• Green taxes can be used to achieve the efficient
  level of pollution.
• The optimal tax (t) is set at the point where
  MPD MAC.

MPD
t
MAC
Q
?Pollution Reduced
6
Solutions to Market Failure Green Taxes

• Property right to the use of the environment
  under Green Taxes?
• Government owns the property right.
• Agents pay the government for the right.
• Primary advantage of Green Taxes over Coase?
• No free-riding.
• Works with large number of parties.
• Disadvantage is that Government needs to know MAC
  and MPD to set t.

7
Least Cost Pollution Control
Pollution abatement at least cost implies that
MAC is the same for all firms This implies that
firms with lower abatement costs cut back more

MACJones
MACSmith
MACAggregate
MAC
Q
Q
? Pollution Reduction
8
Solutions to Market Failure Command and Control
(CAC)

• Command and control (CAC) approach
• The government specifies the amount of emissions
  from each firm, and usually specifies how the
  emission reduction is to be obtained.
• Most common approach in the U.S. at controlling
  pollution (e.g. U.S. Clean Air Act of 1970, Clean
  Water Act of 1972).

9
Solutions to Market Failure Command and Control
(CAC)

• Property rights to the environment under CAC
• Over the limit right belongs to the government.
• Below the limit right belongs to polluters.
• Is the property right well-defined?
• No.
• Property right is not tradable.

10
Solutions to Market Failure CAC

• Suppose the governments goal is to reduce total
  pollution to 10 units.
• CAC approach might require, for instance, equal
  pollution across firms.

11
Solutions to Market Failure CAC

• The equal pollution CAC approach would set a
  standard of 5 pollution units per firm.
• The total cost of reducing 10 units of pollution
  would be
• 1002005001500 for Jones.
• 75125275875 for Smith.
• Total cost 2375.

Least Cost
12
Solutions to Market Failure CAC

• The government could obtain the least-cost
  reduction of pollution if it knew the MAC curves
  of both firms, but this is highly unlikely (and
  such information is expensive to obtain).
• Tie-in to last week policies that grant
  consumers and producers flexibility in achieving
  a social goal tend to be more efficient.

13
Solutions to Market Failure Green Taxes

• What tax rate, t, would reduce total pollution
  to 10 units?
• Suppose t390.
• Jones reduces 3 units.
• Smith reduces 7 units.
• A tax rate between 375 and 400 would be optimal.

14
Solutions to Market Failure Green Taxes

• What is the total cost of pollution reduction
  under the green tax?
• Jones pays 100200300600.
• Smith pays 751253751575.
• The total cost is 2175 gt the least-cost
  solution as derived last class.
• Under CAC, both reduce 5 units for a total cost
  of 2375.

15
Solutions to Market Failure Green Taxes

• Green taxes offer society the least-cost
  solution.
• Why are green taxes more efficient than
  regulation?
• The property right is transferable under green
  taxes and not under regulation.
• Green taxes ensure that marginal abatement costs
  are equal.

16
Solutions to Market Failure Green Taxes

MACJones
MACSmith
t
A
B
?Pollution Abatement
AbatementSmith
AbatementJones
t MACJonesMACSmith A the amount Smith pays
in taxes AB the amount Jones pays in taxes
17
Sidebar on Economic Costs

• An economic cost involves the actual consumption
  or expending of some combination of
  capital/labor/energy/natural resources so that
  they are no longer available to society.
• So, the revenues generated by green taxes are
  considered a transfer, not a cost.

18
Solutions to Market Failure Tradable Pollution
Permits

• Basic idea behind TPPs is to create tradable
  rights to pollute.
• TPPs define a pollution standard similar to CAC.
• In contrast to CAC, the property right is
  transferable.
• Since the rights are tradable, and because
  reducing pollution is costly, permits become
  valuable.

19
Solutions to Market Failure Tradable Pollution
Permits

• Suppose the government wants to reduce total
  pollution to 10 units.
• In contrast to CAC, Jones and Smith can trade
  their pollution permits.

20
Solutions to Market Failure Tradable Pollution
Permits

• Suppose both Jones and Smith are given 5 permits.
• Smith has an incentive to sell two permits (for
  units 5 and 4) to Jones.
• The final allocation would be for Jones to have 7
  permits and Smith to have 3.
• The price of the permits would be between 375
  and 400.

21
Solutions to Market Failure Tradable Pollution
Permits

• Total pollution abatement costs are
• Jones pays 100200300600.
• Smith pays 751253751575.
• Total cost 2175.
• Tradable pollution permits also offer the
  least-cost solution.

22
Solutions to Market Failure TPPs

MACJones
MACSmith
p
A
B
?Pollution Abatement
AbatementSmith
AbatementJones
p MACJonesMACSmith p is market permit price
23
Solutions to Market Failure Tradable Pollution
Permits

• Disadvantages of TPPs
• Potentially high transactions costs.
• A large number of firms are needed for
  competition.
• Pollutants must mix uniformly.

24
Solutions to Market Failure Tradable Pollution
Permits

• Advantages of TPPs
• Pollution is reduced at least-cost.
• Government doesnt need to know firms MAC curves
  to reduce pollution at least-cost.
• Firms will prefer TPPs to taxes.
• The initial allocation of permits to firms
  doesnt matter for efficiency.

25
Solutions to Market Failure Incentives to
Innovate

• Suppose a firm has the opportunity to invest in a
  new technology which reduces their marginal
  abatement costs.
• Original marginal abatement cost curve MAC.
• New marginal abatement cost curve MACt.

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Green Taxes and Tradable Permits
MACJones
MACAvg

MACSmith
tp
?Pollution Reduced
QSmith
QJones
QCAC
Note toptimal tax ppermit price
QCAC(1/2)(QSmith QJones)
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Incentives to Innovate for a Single Firm when
QQCAC
MACt Firms MAC after Innovation
MAC

MACt
a Firms savings under CAC
ab Firms savings under TPP / Taxes
tp
b
a
?Pollution Reduced
Qt
QQCAC
Pollution under taxes / permits with innovation
Pollution under taxes / permits
Pollution under CAC
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Incentives to Innovate for a Single Firm when
QltQCAC
MACt Firms MAC after Innovation
MAC

MACt
a Firms savings under CAC
tp
abc Firms savings under TPP / Taxes
c
b
a
?Pollution Reduced
Qt
QCAC
Q
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Incentives to Innovate for a Single Firm when
QgtQCAC
MACt Firms MAC after Innovation
MAC

MACt
abd Firms savings under CAC
abc Firms savings under TPP / Taxes
d
tp
c
b
a
?Pollution Reduced
Qt
Q
QCAC
If cgtd, then incentives to innovate are higher
under TPP / Taxes than under CAC
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Incentives to Innovate for the Average Firm
MACtavg Firms MAC after Innovation
MACavg

MACtavg
a Firms savings under CAC
ab Firms savings under TPP / Taxes
tp
b
a
?Pollution Reduced
Qt
QQCAC
31
Solutions to Market Failure Incentives to
Innovate

• Since permits are transferable, they are valuable
  on the open market, and firms have an incentive
  to lower their MAC.
• Tradable pollution permits and green taxes are
  dynamically efficient relative to CAC.