Chapter 13 Economics of Pollution Control: An Overview Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Why Is There Pollution? • Pollution is a by-product of the production process Treated as a zero-priced input • Dispose of waste for free Otherwise have to purchase abatement equipment • Since price = 0 => consume to the point: MV = 0 However MC ≠ 0 • So have a deadweight loss due to MV < MC Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-2 Negative Externality • Marginal Private Costs < Marginal Social Costs Ideal Actual Pi Pa Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-3 Economics and Pollution Control The Two Big Questions 1. What is the optimal level of pollution? 2. How should it be allocated among its sources (firms)? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-4 What Do We Need for Efficiency? • Economic efficiency requires Minimize the costs of 1. Damages caused by pollution 2. Costs of reducing pollution At the margin (or at the optimum) • Marginal (additional) costs of reducing pollution (pollution abatement costs) = marginal damages caused by incremental change in emissions Alternatively • Maximize the benefits (derived from goods produced) • While minimizing abatement and damage costs • Yields same solution Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-5 Determining the Optimal Amount of Pollution Tax Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-6 Optimal Level of Pollution • Occurs where Marginal damage costs = marginal abatement costs • Some simplifications that we’ve made Optimum can vary • Each firm will have different abatement costs • Not all geographic area have same damage costs More densely populated areas likely to have higher damage costs Differences in absorbing capacity of different geographic areas Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-7 How Do We Get There? • Standards (command and control) Set the overall standard at Q* Calculate the amount of reduction necessary Set uniform reduction goal for all firms • Taxes/Emission Charges Set the tax = externality cost at the optimum Q* Firms will internalize the cost • Tradable Permits (Coase) Allocate right to pollute (Q*/N) Allow firms to set price for trading permits Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-8 Cost-Effective Pollution Control Policies Emission Standards An emission standard is a legal limit on the amount of the pollutant an individual source is allowed to emit. This approach is referred to as command-andcontrol. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-9 Emissions charges An emission charge is a per-unit of pollutant fee, collected by the government. Charges are economic incentives. Each firm will independently reduce emissions until its marginal control cost equals the emission charge. This yields a cost-effective allocation 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-10 FIGURE 15.4 Cost-Minimizing Control of Pollution with an Emission Charge Tax = mc of control Tax Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-11 FIGURE 15.5 Cost Savings from Technological Change: Charges versus Standards Both firms reduce to the same level But have different mcosts Using tax Get less emissions standard Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-12 Emissions Trading • All sources are allocated allowances to emit either on the basis of some criterion or by auctioning. The allowances are freely transferable. • The equilibrium price will be the price at which the marginal control costs are equal for both (or across all) firms. • The market equilibrium for an emission allowance system is the cost-effective allocation. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-13 FIGURE 15.6 Cost-Effectiveness and the Emission Permit System Standard MC of emitting 8 Bid range Tax MC of emitting 7 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-14 FIGURE 15.3 Cost-Effective Allocation of a Uniformly Mixed Pollutant Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-15 Comparison of Approaches • Standards Can also produce optimal level of pollution • But set same standard for all firms (and are not productively efficient, e.g. min cost) • To set individual quotas: requires knowledge of each firm’s costs But have higher administrative costs • Not only have to monitor emissions • Enforcement costs: legal proceedings (time delays and expense) • Not very flexible: regulatory process for changing standards Provide no incentive for firms to reduce pollution below current “authorized” levels Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-16 Comparison of Approaches • Standards Are most useful when: • Problem is short-lived (“burn” bans for high pollution days) • Optimal level is zero Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-17 Comparison of Approaches • Taxes Can produce “optimal” amount of pollution at minimum costs and lower administrative costs • Kneese (1977): comparing taxes versus standards found that desired quality costs half as much using taxes Automatically allocates pollution levels among firms based on their costs • Provides incentive for firms to reduce pollution levels through technological innovation Easy to adjust/”tune” Tax revenues can be used finance admin costs Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-18 Comparison of Approaches • Tradable Permits Cost efficient • Firms will purchase permits from more efficient firms if permit cost < abatement (technology) costs Technological incentive to reduce pollution • Marginal cost of abatement = permit cost Administratively simpler • Require less information about the firms’ cost • Better able to handle “spatial” variation in pollution Similar to taxes Fewer permits auctioned in bad areas • Adjust “automatically” for changes in inflation and growth If auctioned -> revenues for admin costs or for “buyback” programs Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15-19