ECON 3680
Homework 4 Answers
1. (20 points) Stavins makes a number of points. I asked for two. Among them are :
a. Market approaches can both meet environmental goals and do it at considerable cost
savings. What I take away from this is that economic reasoning is not at odds with
improvements in environmental quality.
b. Economic approaches can reduce the likelihood of lawsuits slowing down the
implementation of environmental policy. This can also reduce the cost of
implementation and speed its enactment.
c. Tradable permit programs can be more flexible than other programs because regulators
can easily adjust the quantity of permits. This makes it easier to fine tune the program.
It also allows for more varied responses from polluters and their suppliers.
d. A simple program works better than a complex program. Uncertainty about a program’s
future will lead participants to stall implementation of efforts to reduce pollution and
opens the door for excuses for non-compliance. Simple is better.
e. Monitoring and enforcement is important to give a program teeth. The lack of ability to
either monitor or punish non-compliance leaves little incentive to spend efforts to
reduce emissions.
f. The initial distribution of permits can have significant economic and political costs (or
benefits). The choice to freely allocate the permits was expedient and politically
popular but made it a little more difficult for the market to discover the cost of the
permits. I would counter that the annual EPA auction served this purpose well.
g. The private sector is good at filling profitable niches. Brokerage companies quickly
stepped up to help negotiate deals to take advantage of arbitrage opportunities.
Economists hold that no Pareto improvement will go unexploited.
2. (30 points) I will leave the graphs out of this one. You may want to graph them. I can just about
assure you I will ask you to find the allocation of emissions reduction that achieves the
equimarginal point on the final:
a. If MAC = 0 for each plant (both owners spend nothing on abatement) then emissions
will be: E1 = 400 and E2 = 250.
b. If E1 and E2 = 200 then
MAC1 = 1,200 – 3*200 = 600 and TAC1 = 600*(400-200)/2 = 60,000
MAC2 = 500 – 2*200 = 100 and TAC1 = 100*(250-200)/2 = 2,500
c. Efficiency requires MAC1 = MAC2 and E1 + E2 = 400 (the total allocation of permits). One
way to solve this is the use the first equality and solve for one of the emissions
quantities as a function of the other and then substitute this equation into the second
equality to give you an equation with only one unknown:
1,200 – 3*E1 = 500 – 2*E2  700 – 3*E1 = – 2*E2  E2 = 3/2*E1 – 350
Which means E1 + 3/2*E1 – 350 = 400  5/2*E1 = 750  E1 = 300 and then E2 = 100
d. Checking to see the equimarginal condition is met:
MAC1 = 1,200 – 3*300 = 300 and TAC1 = 300*(400-300)/2 = 15,000
MAC2 = 500 – 2*100 = 300 and TAC1 = 300*(250-100)/2 = 22,500
e. 62,500/37,500 = 1.67 – that is, the command-and-control approach is 67% more
expensive.
f. Notice that if we just focus on total abatement cost the second plant appears to be
spending more on abatement under the tradable permit program than under the
ECON 3680
Homework 4 Answers
command-and-control program. That might lead you to believe that they would prefer
to remain under the command-and-control regime. This, however, would be incorrect.
Under the tradable permit program the only reason the second plant reduces emissions
more than the 300 units it initially has to abate under the command-and-control policy
(or under its initial allocation of permits) is because plant 1 is willing to buy those 100
permits at a price greater than or equal to the cost of abating those units of emissions
for Plant 2. Therefore, the additional abatement at plant 2 is actually being paid for by
Plant 1.
3. (25 point) Demonstrate an understanding of three variants of externality taxes – All the taxes
have the potential to raise revenue so I will not include that as a pro or a con. Tax revenue from
any of these taxes could be used to offset other distortionary taxes.
a. Pigouvian tax – a tax on a product (electricity is the example I will use)
Pros – corrects the market price of electricity to reflect the true cost of its production.
This will provide information to both buyers and sellers and will allow them to better
allocate their resources.
Fairly easy to measure. If the tax is imposed at the point of purchase it is easy to assess
the tax.
Cons – does not create an incentive for polluters to find better ways to produce their
product. In a sense it “villainizes” a product that is otherwise beneficial such as
electricity.
b. Input tax – A tax on harmful inputs.
Pros – creates an incentive for producers to choose among competing inputs based on
their true cost.
Also relatively easy to measure. The point of purchase will be an intermediate
transaction (producer to producer) but it is no less easy to tax at that point.
Cons – Does not encourage efforts to abate beyond fuel choices. If coal can be burned
in a clean way with the proper technology the produce has no incentive to develop or
adopt that technology if coal is taxed to a higher price than natural gas (for example).
c. Pollution taxes – Tax directly on emissions
Pros – taxes the thing that causes damage directly. This will allow the market to use all
possible approaches to address the problem (less consumption, input switching,
abatement technology and so forth). Ideally we would like to create a market for the
harm directly.
Cons – often (but not always) difficult to measure. For some stationary sources (electric
power plants, for example) it might be relatively easy to measure emissions. But for
other sources (such as automobile emissions) it is relatively hard.
d. From the above statements you may gather that I would not choose a pollution tax for
cars – the inability to accurately measure emissions from each vehicle would make it a
difficult tax to impose. The other two options have merit. You could impose a tax (or
subsidy) based on average emissions. At the margin, this would encourage people to
consider less polluting vehicles. But once they own the vehicles it would not change
their driving habits. My money would be on a fuel tax. It would encourage the
ECON 3680
Homework 4 Answers
purchase of more fuel efficient vehicles and still discourage additional driving. But your
arguments may vary.
4. (25 points) Some of these acts have multiple interesting features. I will list the ones in the book.
a. 1972 Water Pollution Control Act Amendments – The primary economic aspect was the
establishment of technology-based effluent standards. This directly imposes costs on
polluters and requires them to adopt abatement technology.
b. 1977 Clean Water Act – There are two key elements you could focus on – either the
ratcheting up of technology-based effluent standards (to become more onerous and -- if
you have learned the equimarginal principle – less likely to be efficient as the
differences in marginal abatement costs are likely to get larger). The second element is
the increased authority to subsidize municipal waste water treatment plants which
alters their cost relative to other municipal expenditures.
c. 1970 Clean Air Act Amendments – The biggie here is the establishment of national
ambient air quality standards for criteria pollutants. This defines what the agency
means by clean or dirty air. Other parts that are also important include new source
performance standards, the requirement of state implementation plans, and emission
standards for toxic chemicals.
d. 1990 Clean Air Act Amendments – The biggie here is the creation of the Sulfur Dioxide
emission trading program. It represents the first national program of tradable emission
allowances and is the culmination of decades of economists badgering the EPA to use
market-based approaches to address pollution. While all the other “chapters” of the
legislation are interesting, none stands out like the tradable permit program.
e. 1980 Comprehensive Environmental Response, Compensation and Liability Act – This is
the law that creates the “Superfund” program – so called because of the magnitude of
the financial requirements necessary to clean up the backlog of contaminated areas.
Because of the extensive nature of the liability – responsible parties (no matter how
minimal their contribution to the overall damage at a site) can be obligated to fund the
complete cleanup of a hazardous site. This has the perverse incentive for companies to
attempt to hide their involvement in past activities.