Econ 201
Externalities
Summary: Taxes, Standards
and Tradable Permits
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
Two Big Questions
1. What is the optimal level of pollution?
2. How should it be allocated among its
sources (firms)?
How Do We Set the Standard?
Equate MC of damage
To MC of abatement
Comparing Standards
• Essentially all 3 approaches can
theoretically be set to achieve an optimal
standard
– MC[damages] = MC[abatement]
• In practice
– Hard to obtain accurate data on damages
– Standards have been set arbitrarily in all 3
cases
Evaluating the Efficiency
of Allocation?
• Economic Efficiency
– Does the policy result in meeting the standard in a
least-cost manner?
• Administrative Cost Efficiency
– What are the monitoring, enforcement and other
administrative costs?
• Flexibility: responding to changes in market
dynamics, e.g., inflation, changes in demand?
– Self-adjusting or not?
Comparison of Approaches
• Standards
– Can produce optimal level of pollution
• But setting 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
• Provide no incentive for firms to reduce pollution below current
“authorized” levels
– 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
– Can not respond easily to changes in market conditions
• Require rewriting legislation, establishing new standards
Comparison of Approaches
• Standards
– Are most useful when:
• Problem is short-lived (“burn” bans for high
pollution days)
• Optimal level is zero – highly toxic with high
mortality rates
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 when 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” to “right” level
• But does not respond without change to tax rate
– Tax revenues can be used finance admin costs
Cost Savings from Charges
versus Standards
Standard
Firm 2
Lower Costs
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
– Similar to taxes
– Administratively simpler
• Require less information about the firms’ cost
• Better able to handle “spatial” variation in pollution
– Fewer permits auctioned in bad areas
• Adjust “automatically” for changes in inflation and growth
– E.g., Ca RECLAIM experience
– If auctioned -> revenues for admin costs
A Webinar on Tradable Permits
• http://www.sightline.org/research/energy/r
es_pubs/cap-in-trade-2009-sightlinewebinar