Part I. Principles
A.
B.
C.
D.
E.
F.
Markets
Market failure
Discounting & PV
Markets 2
Dynamic efficiency
Pollution solutions (Part 2)
F. Pollution Solutions
Chapter 3
The Optimal Level of Pollution
• Optimal level of pollution minimizes the
total social costs of pollution (the sum of
total abatement costs and total damages).
• This level occurs at the point where
MAC = MDF
• Why?
The Optimal Level of Pollution
The Optimal Level of Pollution
• If E < E1, then MAC > MDF that the unit of
pollution would have caused.
 Doesn’t make sense to reduce pollution.
• If E > E1, then MDF > MAC associated with
reducing pollution by one unit.
 Better off eliminating unit of pollution.
Social Costs When Pollution Level
is Greater than Optimal
Social Costs When Pollution Level
is Greater than Optimal
• The optimal level of pollution is E1.
• The actual level of pollution is E2.
• Total costs associated with pollution have
been increased by the area of triangle abc.
• This represents marginal damages greater
than marginal abatement costs for the range
of pollution emissions between E1 and E2.
Social Costs When Pollution Level
is Less Than the Optimal
Social Costs When Pollution Level
is Less than Optimal
• The optimal level of pollution is E1.
• The actual level of pollution is E3.
• Total costs associated with pollution have
been increased by the area of triangle ade.
• This represents marginal abatement costs
greater than marginal damage for the range
of pollution emissions between E1 and E3.
Pursuing Environmental Quality
with Command and Control Policies
• One way to achieve an optimal level of pollution
is to mandate action to achieve the desired level of
pollution.
• Critics have argued that command and control
regulations generate more abatement costs than
necessary.
• Consider Figure 3.9 where both polluters are
required to reduce pollution by 50 percent.
Command and Control Policies
Command and Control Policies
• The aggregate MAC function (societal MAC
function) is the horizontal summation of the
individual MAC functions.
• With no environmental regulation, polluter 1
would emit 10 units and polluter 2 would emit 6.
• A requirement to reduce emissions by 50%,
regardless of cost, would reduce polluter 1 to 5
units and polluter 2 to 3 units.
Pursuing Environmental Quality by
Equating MAC
• When both polluters are required to reduce
emissions by 50%, regardless of marginal
abatement costs, polluter 2 incurs a higher cost
($3) than polluter 1 ($2).
• Higher cost represents a misallocation of resources
from society’s point of view, because minimum
costs of obtaining any level of emissions will
occur when MAC equal across polluters
Equating MAC
• Society’s total abatement costs can be
lowered by keeping total emissions
constant, but reallocating level of emissions
according to marginal abatement costs.
• ***The optimal level of emissions will be
where MAC are equal, for a given level of
emission***
Equating MAC
Equating MAC
• Since polluter 2 has higher MAC, polluter 2
should be allowed to emit more, and polluter 1
will be required to pollute less.
• Polluter 1 reduces pollution by ½ unit (to 4 ½) and
polluter 2 increases pollution by ½ unit (to 3 ½).
• Polluter 1’s MAC increase and polluter 2’s MAC
decrease.
• *Key: decrease in 2’s costs > increase in 1’s
=> Reallocation reduces costs to society as a whole
Equating MAC
• Only when MAC equal will there be NO
POSSIBLE cost-saving reallocations of
emissions
• Total abatement costs are minimized
• C & C not likely to equate MAC’s (gov’t
does not know firms’ costs, firms do not
face same costs)
The Role of
Command and Control Policies
•
Despite their inability to equate MAC across
polluters, C & C policies may still be the most
desirable policy instrument under the following
circumstances:
1. When monitoring costs are high (littering)
2. When the optimal level of emissions is at or
near zero (initial MDC >> MAC – e.g.
radioactive waste)
3. During random events or emergencies that can
change the relationship between emissions and
damages (e.g., smog, droughts)
1. High monitoring costs
• While it might be possible to achieve an optimal
amount of litter through the use of a tax or per
person allocation, this would require the “litter
police”.
• It is easier to make ALL littering illegal and
establish a punitive fine for those caught littering.
• The fine multiplied by the probability of being
caught would be factored into the choice to litter.
2. Optimal pollution = 0
• When the optimal level of pollution is at or near
zero, direct controls make sense.
• Extremely dangerous pollutants, such as heavy
metals and radioactive waste.
• Damages associated with these pollutants are quite
severe.
• Direct controls also make sense in other cases
where initial damages are quite high compared to
initial marginal abatement costs.
– An example is CFC’s, where accumulated amounts
are dangerous but there are low cost alternatives.
3. Emergencies
• Emergency situations may make direct
controls the preferable policy instrument.
• These events occur in random and
unpredictable fashion.
• Examples include smog alerts (LA – singleperson commuting prohibited, schools
closed) and droughts.
Pursuing Environmental Quality
with Economic Incentives
• Economists advocate policies based on
economic incentives for 2 primary reasons:
1. Economic incentives minimize total abatement
costs by equating MAC across polluters and
encouraging a broader array of abatement
options.
2. Economic incentives encourage more research
and development into abatement technologies
and alternatives to the activities that generate
the pollution.
Economic Incentives and
Minimized Total Abatement Costs
Economic Incentives &
Minimized Total Abatement Costs
• A polluter is polluting at an unregulated
level of 10 units.
• The government imposes a tax equal to t
dollars per unit of pollution.
• The polluter compares the tax of t dollars
(cost on 10th unit – rectangle under t btw. 9
and 10) to the marginal abatement cost
(MAC) of reducing pollution (triangle under
MAC btw. 9 and 10)
Minimized Total Abatement Costs
• As long as the MAC < tax, polluter will
reduce level of emissions.
• If MAC > tax, can reduce costs by
increasing pollution and paying lower tax
rather than high abatement
• Each polluter will choose an emission level
at which MAC = tax.
• As long as all facing same tax, MAC equal
across polluters
How to set tax?
• If the aggregate MAC function is known, then
achieving a targeted level of pollution is easily
accomplished.
• If the aggregate MAC function is not known, the
appropriate tax level is much harder to determine.
• Consider Figure 3.16, where evidence suggests
that the true MAC function lies between an upper
and lower bound set of MAC’s.
How to set tax?
How to set tax?
• Suppose policymakers believe MAC1b is the true
MAC. In an effort to achieve an emissions level
of E1, they impose a tax of t1.
• However, if MACt describes how polluters will
respond, the emissions level will be E2.
• E2 is higher than the desired level of pollution.
• Excess costs of triangle abc
Weitzmann (1974)
• Flatter MAC – greater disparity btw.
“arrived at” level pollution and target level
• Steeper MDC – greater the social losses
associated with disparity
• C & C may be better since less uncertainty
In summary:
• Pollution taxes are preferable to command and
control techniques since pollution taxes minimize
abatement costs and provide other desirable
incentives.
• Because of uncertainty, pollution taxes are less
proficient than command and control techniques in
achieving a desired level of pollution.
C & C or taxes?
• One minimizes abatement costs, other better
at achieving target level of pollution
• Another instrument can do both!
• Marketable pollution permits – also called
transferable discharge permits, pollution
allowances, tradable credits, offsets, and
tradable pollution quotas.
Marketable Pollution Permits
• Marketable pollution permits are permits which
give a firm the right to emit a specific number of
units of pollution.
• Polluters are free to buy and sell these rights to
pollute.
• A marketable pollution permit system can both
minimize total abatement costs, provide flexibility
in the choice of mechanisms used to meet
pollution goals, and achieve the desired level of
pollution emissions.
Marketable Pollution Permits
• A system of marketable pollution permits begins
with the determination of the target level of
pollution.
• The next step is to allocate pollution across
polluters.
• This allocation can be based on historic pollution
levels, auctions, a lottery, or some other allocation
scheme.
• The buying and selling of pollution permits will
reallocate the emission rights.
Example
• 100 polluters
• Optimal pollution = 1,000 units
• Could just authorize each polluter to pollute
10 units (this is C & C)
• Difference with MPP – once initial
allocation made, polluters free to buy and
sell right to pollute.
Marketable Pollution Permits
• Marketable pollution permits equate MAC across
polluters. How?
• Each polluter compares MAC with the price of a
permit.
• If the MAC > price of permit, they have an
incentive to buy.
• If the MAC < price of permit, they have an
incentive to sell.
• Buying and selling will continue until the
equilibrium price is reached which equates MAC
across all firms.
Doesn’t matter how you start
• Initial distribution of permits can be by historic
pollution level, auctioned to highest bidder,
distributed by lottery, etc.
• As long as permits are tradable, polluters attempts
to minimize their total pollution costs (abatement
+ cost of permit) will result in MC being equalized
over all polluters =>
min. total abatement costs to achieve
target level of pollution
Marketable Pollution Permits and
Geographic Considerations
• Geographic location of emissions can have a big
impact on the damages the pollution generates for
some categories of pollution.
• Central to the importance of location of emissions
is the manner in which the pollution disperses
when it enters the environment.
• Pollution controls must take into consideration the
geographic variation in the effect of pollution on
society.
Geographic Considerations
• Pollutants that deplete ozone have same
effect regardless of location, so system of
MPP easier
• Air pollution – tends to move from west to
east (the prevailing wind direction in much
of N. America)
• Water pollution – dispersion downstream
Geographic Considerations
• 1 unit of carbon monoxide released in
Tallahassee, FL would create more damages
than a unit released in Jacksonville FL
• For pollution controls to be effective, must
take geographic variations into account
Geographic Considerations
•
•
•
A pollution control system based on taxes could
take variation into account by charging higher
taxes in areas where emissions are more
damaging.
A MPP system must divide the overall region
into subregions.
These subregions can account for geographic
variability in one of two ways:
1. Receptor (pollution measurement location)-based
system
2. Separate markets for subregions
Receptor (Ambient)-based
Permit System
• A receptor-based or ambient-based system
allocates pollution receptors across the subregion.
• Locations relatively close to, and downwind from,
the polluter may require more permits.
• In the following figure, the location of a particular
polluter is denoted by a star and receptors are
designed by letters. This polluter may have to buy
some combination of 15 different types of permits.
Ambient-based Permit System
Ambient-based Permit System
• For each unit of pollution polluter at the star emits,
may need to purchase 1 “I” permit but only ¼ “A”
permit
• The polluter would have to buy 15 different types
of permits (one for each receptor, A – O)
• System does good job dealing with geographic
variability, but high transactions costs since so
many markets
Emissions-based Permit System
• An alternative to the ambient-based system is to
divide the subregions into separate markets.
• Polluters need only purchase permits for the
subregion in which they are located.
• The inability to trade across subregions may mean
that firms with lower abatement costs will not be
able to trade permits with higher abatement cost
firms in another subregion.
Emissions-based Permit System
Emissions-based Permit System
• Polluter located at the star only has to buy
permits for subregion “L”
• Greatly reduces transactions costs,but
cannot trade with polluter in other
subregion (so low-cost polluter cannot trade
with high-cost polluter, although in
society’s interest to do so)
Other Types of
Economic Incentives
•
•
•
•
Deposit-refund
Bonding systems
Liability systems
Pollution subsidies
Deposit-refund
• Deposit-refund systems are a good way of
employing economic incentives when monitoring
costs are high. “Bottle Bill”
• This system is based on requiring a payment up
front for undesirable acts and then building in a
refund when a desirable action occurs.
• The most common example of this is the depositrefund system in place for beverage containers.
• This system has also been used for cars and
batteries in other countries.
Bonding systems
• Closely related to deposit-refund systems.
• Requires a potential degrader of the environment
to place a large sum of money in an escrow
account.
• Money is returned if the environment is
undamaged (or returned to its original condition)
and will be forfeit otherwise.
• Bonds need to be large enough to provide an
incentive to use appropriate safeguards and/or
cover the cost of clean up if damage occurs.
Liability systems
• Define legal liability for the damages caused by
certain types of pollution discharges and
facilitating collection of these damages.
• The Comprehensive Environmental Response,
Compensation and Liability Act of 1980
(CERCLA) defines legal rights to natural
resources for local, state and federal governments
and defines how damages can be measured.
Pollution subsidies
• Pay each polluter a fixed amount of money for
each unit of pollution reduced.
• The polluter would reduce pollution to the point
where the subsidy = MAC
• While the outcome is the same as a tax on
polluters, there are distributional effects, problems
with political acceptability and the possibility that
strategic behavior would lead to higher initial
levels of pollution in order to obtain the subsidy.
In addition, the subsidy could potentially attract
more polluters into the industry.
Conclusion
• Market failures associated with environmental
externalities generate losses in welfare.
• Command and control policies are the basis of
current policy but do not equate marginal
abatement costs across polluters.
• Economic incentives, such as taxes or marketable
pollution permits do equate marginal abatement
costs.
• While there are some problems with economic
incentives, they do create additional motivation
for technological innovation to reduce pollution.