Econ 201
Lecture 8.2
Taxes, Standards
and Tradable Permits
Summer 2009
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When is Regulation Necessary?
• Externalities
– When there is a divergence between either:
• Social/Private Marginal Benefits, or
• Social/Private Marginal Costs
– Common property
• Commonly held property: e.g., fishing grounds,
common agricultural land
• Pure Public Goods
– My consumption of the good does not reduce
the amount available to others
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Negative Externality
• Marginal Private Costs < Marginal Social Costs
Ideal
Actual
Pi
Pa
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Negative Externalities
• Examples
– 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
– Will be “over” consumed (beyond point marginal benefit =
marginal cost as mc = 0)
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Negative Externalities
• Farm versus fresh salmon
– Farm raised appear to be more vulnerable to diseases and
transmit them to fresh salmon
• Fishing/Forestry
– Can’t benefit from postponing harvest today as can’t exclude
others from resource and thus realize benefit of postponement
• Cell phones
– Privacy issues (e.g., dining out)
– Traffic issues
• as likely to have an accident as DUI
• Traffic Congestion
– Each additional driver does not take into account that their entry
onto the freeway slows everyone else down
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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
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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
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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
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Negative Externalities & Taxes
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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
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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
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Tradable Permits
A Property Rights Approach
• “Common” Property Problem
– No one “owns” the air/water; therefore no one
benefits from managing (pricing) its usage
• Solution is to assign the property right to
one party and allow them to trade its use
in the marketplace
– Coase Theorem
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Coase’s Theorem
• If property rights exist and transaction
(bargaining) and information costs are low
– Then parties will be able to bargain among
themselves (without government intervention)
to obtain an efficient outcome
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An Example of the Coase Theorem
• Marketplace
– Firm upstream from a farmer
• Firm produce a good valued by consumer but
dumps pollutants into the river as a byproduct
• Cost of using the river to the firm is $0
– Farmer
• Downstream from the firm
• Uses water to irrigate his agricultural products
• Pollution affects/degrades his product
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Assigning the Property Rights
• If assigned to the firm
– Farmer is willing to “bribe” the firm to reduce
pollution
• Willing to pay firm to reduce gallons discharged up
to marginal value of crop damage due to pollution
• Firm: willing to accept payments that are >= marg
costs of treatment/reduction
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Assigning Property Rights
• Assigned to the Farmer
– Firm is willing to pay farmer up to the marginal
value of “avoided” treatment costs
– Farmer is willing to accept payments >=
marginal cost of crop damage
• Either way: socially efficient (marginal
value = marginal cost) solution
– However, there are different income effect
• Concluding which is best => normative statement
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Criticism of Coase’s Theorem
• If more than 1 farmer
– Transaction costs of getting all affected parties
together may be too great to get to optimal solution if
rights assigned to firm
• Demsetz (1964): “when transaction costs are too high; status
quo may be optimal”
– Leffler: “if it exists, it’s optimal. But, why?”
– Use of the government to lower transaction costs
• Strategic behavior
– Last individual may “hold” out (lower bribe/higher
payment) as key to agreement
– Fire protection example
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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
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Comparison of Approaches
• Standards
– Are most useful when:
• Problem is short-lived (“burn” bans for high
pollution days)
• Optimal level is zero
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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
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And They Are Endorsed
by the Sierra Club!
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Sierra Club Conservation Policies
Pollution Taxes
The Sierra Club advocates the establishment of pollution taxes which would make it less
expensive for a polluter to adopt alternative processes or invest in additional equipment to curtail
releases to the environment than it would be for him to continue as before. Such taxes would
supplement, and not replace, standards on maximum permissible emissions. These taxes should
be imposed when the following conditions are found to prevail generally:
for competitive or other reasons, cost-minimizing behavior tends to exist in the company or
industry;
the cost of abatement is expected to be significant, both in relation to revenue from sales and in
absolute terms; and
the quantity of the pollutant released to the environment can be determined with reasonable
accuracy, either by direct monitoring of every source, statistical sampling of a small fraction of
many similar sources produced by a few manufactures, or by indirect means. The cost of
monitoring should be small in relation to the tax revenue expected in the absence of abatement.
As a first step, a tax equal to 15 cents per pound should be imposed on sulfur contained in fuels
intended for combustion (with a rebate given to those who demonstrate that the sulfur was not
released to the environment), and on sulfur emitted from smelters, refineries, and sulfuric acid
plants. The tax on lead contained in gasoline ... should be promptly enacted.
The feasibility of taxes on the emission of nitrogen oxides, particulate matter, carbon monoxide,
and hydrocarbons should be investigated ... for possible action on these air pollutants; studies
should also be conducted on the practicality of similar taxes for various of the water pollutants.
Adopted by the Board of Directors, February 13-14, 1997
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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
– If auctioned -> revenues for admin costs
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