CHAPTER 6
Pollution control:
instruments
MC
200

MCB = 3ZB
MCA = 3ZA
100

75











5
10
15
20
25
30
35
40
Z
Pollution abatement, Z
Figure 6.1 Marginal abatement cost functions for the two firms
Figure 6.2 Expected damages, reducing as the amount of precaution taken, Q, increases
Expected damages
The amount of precaution taken, Q
B(Q)
C(Q)
Figure 6.3
The socially efficient
level of precautionary
behaviour
Q*
The level of precaution
applied is socially efficient
when the net benefit (B – C)
from precaution is maximised.
This is shown at Q = Q*. Note
that the slopes of the B and C
functions are equalised at this
point. Hence, as shown in the
lower half of the graphic, the
marginal quantities are
equated. That is, the marginal
benefit of precaution and the
marginal cost of precaution are
equal at the socially efficient
level of precaution, Q*. That
is, MB(Q*) = MC(Q*).
Precaution, Q
MC(Q)
MB(Q)
Q*
Precaution, Q
Ambient pollution
levels
Emissions output
Quantity of goods produced
Production technique
Inputs used
Figure 6.4a The pollution process
Location of
emissions
Ambient pollution
requirements
Zoning
Emissions
licenses
Output
quotas
Technology controls
Input restrictions
Figure 6.4b Command and control instruments
Marginal damage
Marginal benefit
(before tax)
*
Marginal
benefit (after
tax)
0
M*
ˆ
M
Emissions, M
Figure 6.5 An economically efficient emissions tax
Marginal cost of
abatement
*
Marginal benefit of
abatement
0
Z* =
ˆ  M*
M
Figure 6.6 The economically efficient level of emissions abatement
Z
Emissions abatement,
Z
Pre-tax or pre-subsidy
marginal benefit
μ~
0
.
Post-tax or post-subsidy
marginal benefit
.
~
M
.
ˆ
M
Emissions, M
Figure 6.7 Emissions tax and abatement subsidy schemes when marginal damage is unknown, or
when a target is being set on grounds other than economic efficiency
Suppose that the EPA does not have sufficient information to deduce the economically efficient
level of emissions, or it wishes to set an overall emissions target on some other basis. Figure 6.7
makes it clear that to attain ANY specific emissions target using a tax or subsidy instrument,
knowledge of the aggregate (pre-tax or pre-subsidy) marginal benefit of emissions function
would be sufficient.
Pre-tax or pre-subsidy
marginal benefit
Marginal damage
Post-tax or post-subsidy
marginal benefit
*
0
S3
S5
S4 S6
M*
S2
S1
ˆ
M
Emissions, M
Figure 6.8 Emissions tax and abatement subsidy schemes: a comparison
An emissions tax and an emissions abatement subsidy (at the same rate)
differ in terms of the distribution of gains and losses. This has important
implications for the political acceptability and the political feasibility of the
instruments. It also could affect the long-run level of pollution abatement
under some circumstances, via alteration of the size of the industry.
Marginal abatement cost
(aggregate)
Fixed supply of
permits
*
0
M*
A firm will bid to
purchase an
additional emissions
permit whenever the
marginal cost of
abating emissions
exceeds the permit
price. The market
equilibrium permit
price is determined
by the value of the
aggregate marginal
abatement cost at the
level of abatement
implied by the total
number of issued
permits.
ˆ
M
Figure 6.9 The determination of the market price of emissions permits
Auctioned permits case
Emissions,
M
Demand for permits
Supply of permits
*
0
EP*
Emission permits
(EP)
Figure 6.10 The determination of the market price of emissions permits: free initial
allocation case
Marginal abatement cost
Figure 6.11: Efficient abatement with two firms and marketable permits
200
180
MC(B)
160
140
Equilibrium permit price =
Marginal abatement cost for
each firm = 75
120
MC(A)
100
MC(INDUSTRY)
80
60
40
20
0
0
5
10
15
20
25
Emissions abatement, Z
30
35
40
45
50
Required industry wide abatement
Under tradable permit schemes, in equilibrium marginal abatement costs will be equal over all firms. Hence
marketable permits, like taxes and subsidies, achieve any given target at least cost. Moreover, if the total
quantity of permits issued is M* and that quantity is identical to the level of emissions which would emerge
from an emissions tax (or an abatement subsidy) at the rate * then a marketable permit scheme will generate
an equilibrium permit price *.
.
Controlled
sector
.
2
1
. .
3
Firm 3, one of six
controlled large
power station
sources of CO2
.
4
.
6
5
Figure 6.12.a A ‘cap and trade’ permit system
Controlled
sector
.
.
2
Firm 3, one of
six controlled
large power
station sources
of CO2
3
.
1
.. .
A
Uncontrolled
sectors (of
other CO2
emitters)
.
4
.
5
C
.
A
6
. .
D
Figure 6.12.b A flexible permit system with offsets
B
Figure 6.13 Dynamic incentives under emissions tax controls
£
MC1
MC2



0
Z1*
Z2*
Emissions abatement, Z
Ci
i •
Ci  αi  βi M*i  δi M*i2
M*i
0
•
M*i
ˆ
M
i
Figure 6.14 The firm’s abatement cost function.
M*i