Chapter 5
Economic Solutions to
Environmental Problems
The Market Approach
© 2007 Thomson Learning/South-Western
Callan and Thomas, Environmental Economics and Management, 4e.
Overview

Market approach refers to incentive-based policy that
encourages conservative practices or pollution reduction
strategies


Difference between market approach and command-and-control
approach is how each approach attempts to achieve its
objectives
Types of Market Instruments




Pollution charge
Subsidies
Deposit/refund systems
Pollution permit trading systems
2
Pollution Charges
Pollution Charge
 Fee that varies with amount of pollutants
released

Based on “Polluter-Pays Principle”
 Types of pollution charges




Effluent/emission fees
Product charge
User charge
Administrative charge
4
Product Charge
 Fee added to price of pollution-generating product,
which generates negative externality
 Impose product charge as per unit tax on
product, e.g., gas tax


How does the tax on gasoline in the US compare with
that of other nations?
If the tax equals the marginal external cost (MEC) at QE,
it is called a Pigouvian tax
5
Selected International Gasoline Tax Rates
Nation
Tax Rate % of Price
(2004)
United States
20
U.K.
73
France
71
Italy
65
Japan
50
Spain
59
Source: International Energy Agency, August 13, 2004
6
Modeling a Pigouvian Tax
MSC = MPC + MEC
MPCt
MPC
a
Amount of tax
b
MPB = MSB
0
QE
QC
Q of gasoline
7
Assessing the Model
 In theory, achieves an efficient outcome
 In practice, difficult to identify the value of
MEC at QE
 Allows only for an output reduction to reduce
pollution
8
Emission (Effluent) Charge
 A fee imposed directly on the discharge of
pollution

Assigns a price to pollution
 Typically implemented through a tax
9
Model: Single Polluter Case
 Government sets an abatement standard at AST
 Policy options to polluter are:


Abate up to AST and incur those costs OR
Pay a constant per unit tax, t, on any abatement less than
AST
 Total Tax = t(AST - AO)


where AO is actual abatement level
Marginal Tax (MT) = t

Because t is constant, t = MT
 Firm will choose the least-cost option: the marginal
tax (MT) or the marginal abatement cost (MAC)
10
Modeling Emission Charge
Single Polluter
$
Firm abates up to Ao since
MAC < MT; firm pays tax
between AO and AST, since
MAC > MT in that range
0aAO = cost to abate AO
AOabAST = tax on pollution
c
t
0
a
AO
MAC
not abated up to AST
b
AST
MT
Abatement (A)
11
Model: Multiple Polluter Case
 To facilitate comparison, we use the same model
as in the uniform standard case
 Assumptions




2 polluting sources in some region
Each generates 10 units of pollution
Government sets emissions limit for region as 10
units, which implies AST = 10
Policy: To achieve AST, government imposes an
emission charge as a unit tax (t) of $5
12
Model: Multiple Polluter Case
 Each firm responds as in the single polluter case
 Abates as long as MAC < MT
 Pays emission charge when MAC > MT
 Polluter 1:

where A1 is pollution abated by Polluter 1
 Polluter 2:

TAC1 = 1.25(A1)2
MAC1 = 2.5(A1)
TAC2 = 0.3125(A2)2
MAC2 = 0.625(A2)
where A2 is pollution abated by Polluter 2
 Find each firm’s abatement level. Then, find each firm’s
total abatement costs (TAC) and tax payment at that
level. Support with a graph.
13
Solution
 Polluter 1:
 Abates up to the point where MAC1 = MT,
 Set


2.5(A1) = $5, or A1 = 2
Incurs TAC1 = 1.25(2)2 = $5
Incurs Total Tax = 5(10 - 2) = $40
 Polluter 2:

Abates up to point where MAC2 = MT



Set 0.625(A2) = $5, or A2 = 8
Incurs TAC2 = 0.3125(8)2 = $20
Incurs Total Tax = 5(10 - 8) = $10
14
Modeling An Emission Charge
Multiple Polluter
MAC1
MAC2
Total Abatement Level = 10 = As
TAC1 + TAC2 = $25 (right triangles)
Total Tax Payments = $50 (rectangles)
25.00
6.25
MT = 5.00
MT = 5.00
0
2
10
8
Polluter 1’s Abatement
Polluter 2’s Abatement
10
0
Assessing the Model (pros)
 Abatement standard is met
 Generates $40 in tax revenues from high-cost
abater and $10 from low-cost abater
 Low-cost abaters do most of cleaning up
 Cost-effective solution is obtained


MACs are equal at $5 tax rate
Combined TAC of $25 is lower than $39.06 under
command-and-control with a uniform standard
16
Assessing the Model (cons)
 Tax authority will not know where MACs are equal
 Will have to adjust rate until objective achieved
 Monitoring costs potentially higher
 Firms might evade tax by illegally disposing
pollutants
 Distributional implications

Consumers may pay higher prices due to tax

Job losses may result from polluter paying new taxes
and/or changing technology to abate
17
Pollution Charges in Practice

Internationally, the pollution charge is the most
commonly used market-based instrument


Some countries use effluent charges to control the noise
pollution generated by aircraft
Others levy charges on products such as motor
vehicles, pesticides, fertilizers, batteries and gasoline
18
Environmental Subsidies
Environmental Subsidies

Two major types of subsidies:


Abatement equipment subsidies
Pollution reduction subsidies
20
Abatement Equipment Subsidy

Defined as a payment aimed at lowering the cost
of abatement technology


Goal is to internalize the positive externality associated
with the consumption of abatement activities
If the subsidy (s) equals the marginal external
benefit (MEB) at QE, it achieves an efficient
equilibrium and is called a Pigouvian subsidy
21
Pigouvian Subsidy
Market for Scrubbers
($ millions)
MSC
K
Subsidy = $14 million
PE = 175
PC = 170
MSB
L
PE – s = 161
MPBS
MPB
0
QC = 200
QE = 210
Q of scrubbers
22
Assessing the Model
 It is difficult to measure the MEB
 May bias polluters’ decisions about how best to
abate
23
Pollution Reduction Subsidy

To implement, government pays the polluter a
subsidy (s) for every unit of pollution abated
below some pre-established level ZST
 Per unit subsidy = s(ZST - ZO), where ZO is the
actual level of pollution

Analogous to an emission charge
24
Assessing the Model
 Might be less disruptive than an equipment
subsidy
 Can have the perverse effect of elevating
pollution levels in the aggregate since the
subsidy lowers unit costs and raises profit,
encouraging entry
25
Subsidies in Practice
 Environmental subsidies typically are implemented as
grants, low-interest loans, tax credits or exemptions,
and rebates
 Many countries around the world use these
instruments, including Austria, Finland, Japan, and
Turkey
 In the U.S., common uses include federal funding to
build publicly-owned treatment works and subsidies to
encourage the development of cleaner fuels and lowemission vehicles
26
Deposit-Refund Systems
Deposit/Refund Systems

A deposit/refund system is a market
instrument that imposes an up-front charge
to pay for potential damages and refunds it
for returning a product for proper disposal
or recycling

Targets the potential vs. actual polluter
The deposit is intended to capture the MEC of
improper waste disposal (IW) in advance


Preventive vs. ameliorative
28
Modeling Deposit/Refund System
IW disposal market
 MECIW: health damages + aesthetic impairment
from litter, trash accumulation, etc.
 MPCIW: costs to disposer (e.g., trash receptacles,
collection fees, plus forgone revenue from not recycling)
 MSCIW = MPCIW + MECIW
 MPBIW: demand for improper disposal
 Assume MEBIW = 0, so MPBIW = MSBIW
29
Deposit-Refund Model
Deposit converts % of overall waste
disposal, measured by (QIW - QE),
from improper methods to proper
MSCIW
MPCIW + Deposit
MPCIW
a
Deposit=MEC at Qe
b
MPBIW = MSBIW
QE
0
100
QIW
Improper Waste Disposal (%)
100
Proper Waste Disposal (%)
0
Assessing the Model
 Promotes responsible behavior
 Requires minimal supervision by government
 Can help slow the use of virgin raw materials
by improving availability of recycled materials
31
Deposit/Refund Systems in Practice

Deposit/refund systems are used worldwide

Many nations use these systems to encourage
proper disposal of beverage containers


In the US, 11 states have bottle bills
Other applications include systems used to
promote responsible disposal of used tires,
car hulks, and lead-acid batteries
32
Pollution Permit Trading
Systems
Pollution Permit Trading Systems

A pollution permit trading system establishes a
market for rights to pollute by issuing tradeable
pollution credits or allowances



Credits are issued for emitting below a standard
Allowances indicate how much can be released
Two components of the system are
1.
2.
Fixed number of permits is issued based on an
“acceptable” level of pollution set by government
The permits are marketable
 Bargaining gives rise to a market for pollution rights
34
How Permit Trading Works

There is an incentive to trade as long as
polluters face different MAC levels
 Suppose a firm has 50 permits but normally
emits 75 units of SO2. What must it do?

Answer



Abate 25 units of emissions OR
Buy 25 permits from another producer
Which option will the firm choose?

Answer

Whichever option is cheaper
35
Result
 Low-cost abaters will clean up pollution and sell
excess permits to other firms

They will sell at any P higher than their MAC
 High-cost abaters will buy permits rather than abate

They will buy at any P lower than their MAC
 Trading will continue until the incentive to do so no
longer exists, at which point, the cost-effective
solution is obtained, i.e., the MACs across firms are
equal
36
Assessing the Model
 Trading establishes the price of a right to
pollute without government trying to “search”
for a price
 No tax revenues are generated
 Trading system is flexible

Note that an emissions standard can be adjusted
by changing the number of permits issued
37
Pollution Trading Systems in Practice

International examples




Trading of greenhouse gas allowances are part of the
Kyoto Protocol, an international accord aimed at
global warming
Canada has a trading program for ozone-depleters
Denmark has one for carbon dioxide emissions
Most of the evolution of trading is occurring in
the U.S.

An important example is the establishment of an
allowance-based trading program to control sulfur
dioxide emissions under the Clean Air Act
Amendments of 1990
38