Econ 100
Lecture 9.2
Taxes, Standards
and Tradable Permits
3-04-09
1
Negative Externality
• Marginal Private Costs < Marginal Social Costs
Ideal
Actual
Pi
Pa
2
Negative Externalities
• An Example: Pollution
• Emitted by factories as a by product of the
production process
– Air, water, electricity
• Emitted by vehicles
– Typically treated as a “zero-cost” input into the
production process
• Source will be “over” consumed (beyond point
marginal benefit = marginal cost as mc = 0)
3
What Are the Consequences?
• Without Intervention
– Consumers/producers will not take such costs into
economic decisions
• Produce too much of the good & externality (e.g.,
pollution)
4
Two Big Questions?
• What is the optimal level of pollution?
• How is that amount allocated among
firms/sources?
5
How Do We Set the Standard?
Equate MC of damage
To MC of abatement
6
What Do We Know About
the Costs of Reducing Pollution?
• Costs of reducing
– Additional costs of reducing pollution will be
greater when level of pollution is higher
• An Example:
– First electrostatic precipitator reduces emissions by 80%
– Second (added) EP by another 80%
» Effectively 80% x 20% (remaining) = 16%
– Third EP
» 80% x 4% = 3%
7
What Does the Cost Curve Look
Like?
Cost of Reducing Pollution
500
Total Costs
400
300
200
100
0
% of Emissions Reduced
8
How Do We Set the Standard?
Equate MC of damage
To MC of abatement
9
Remedies for Negative
Externalities
• Standards
– Permissible level of emissions for each factory in an
industry (each industry gets same target), or
– Targets how much emissions must be reduced by
each factory (again, same target for all)
Taxes
– Direct tax on emissions
• Indirect on input/output if there is a direct correlation between
input/output and pollution
– E.g., tax on gasoline, coal based on sulfur content
• Tradable permits
– Gives each firm the “right” to pollute to a certain level
– Firms are allowed to trade/sell permits
10
Standards
• Emission standards
– Could be set at same “optimal” amount of pollution as
the tax
Two approaches
• Establishes the level of pollution that can be emitted by
“polluter”
• Require all firms to reduce pollution by “x” amount
– Typically divided up among the firms equally
• Disregards technological/cost differences between firms
• Therefore will not be cost efficient
11
Standards
• Same amount of pollution for all firms
– Newer firms with newer/efficient technology able to
easily meet standard and may not even reach it
• Same amount of reduction
– Newer firms already emitting less
• Maybe increasingly more costly for them to reduce pollution
by x amount then firms with older technology
• Either way
– Approach is not cost efficient
– Provides no incentive for firms to reduce emissions
below standard
12
Negative Externalities & Taxes
•
How to Set the Optimal tax
– Set at point where MBen = MCost of Pollution
• Tax: equals difference between MSC and MPC and
– “internalizes” it into the consumption decision
• Firm’s cost = price*quantity of inputs plus tax*emissions/output
Tax
13
EmissionTaxes
• Emission taxes
– Will be cost-efficient
• Firms will adopt new technology if marginal
abatement costs are less than marginal cost of tax
– Otherwise will pay the tax
• Consequently firms will adopt least cost approach
to meeting optimal pollution goal
– Taxes have lower administrative costs
• Can be easily raised/lowered to fine tune meeting
of the standard
• Do not require litigation
14
Cost-Minimizing Control of Pollution
with an Emission Charge
15
Cost Savings from Technological
Change: Charges versus Standards
16