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Environmental Economics: Lecture 7. Comparing Policy Instruments (cont.). Outline. Review 3 graphs & basic tools Key results so far New areas Midnight Dumping Innovation Areas not addressed in our survey so far. Our model so far: graph #1. Price and Cost. Equilibrium Price P A.

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Environmental economics lecture 7 l.jpg

Environmental Economics: Lecture 7

Comparing Policy Instruments (cont.)


Outline l.jpg
Outline

  • Review 3 graphs & basic tools

  • Key results so far

  • New areas

    • Midnight Dumping

    • Innovation

  • Areas not addressed in our survey so far


Our model so far graph 1 l.jpg
Our model so far: graph #1

Price

and Cost

Equilibrium

Price PA

MPC (supply curve)

Quantity

MSC= MPC+MED

MED (externality)

D= Marginal SocialBenefit


Basic tools l.jpg
Basic Tools

  • When changing quantity, we focus on areas under curves

    • Below MB = Change in benefits

    • Below MC = Change in costs

    • Below MED = Area between SMC & MPC = change in externality

  • With perfect competition, P=MR=MPC, which determines the “competitive output.”

  • With perfect competition, area below MB, but above price = consumer’s surplus


Equilibrium with a negative externality l.jpg
Equilibrium with a Negative Externality

Price

and Cost

MSC

B

MPC (supply curve)

A

Equilibrium

Price PA

D= Marginal SocialBenefit

8,000 Units

10,000 Units

Quantity

Economically Efficient Output

Equilibrium Output


Result 1 inefficiency of externality l.jpg
Result #1: inefficiency of externality

  • We used graph #1 to identify the costs of moving from “competitive equilibrium quantity”, to “socially optimal quantity.”

  • Specifically we compared

    • Lost benefits (below MB), to:

    • Private cost savings (below PMC) & Reductions in Externality (below MED=between PMC & MED).

  • Result: Reduction in costs (both types) is greater than reduction in ben.

  • Implication: competitive market inefficient (dead-weight loss).


Economic inefficiency with a negative externality l.jpg
Economic Inefficiency with a Negative Externality

P

MSC

$180

Deadweight Social Loss

MPC = S

PA = $100

D

Q

10,000 Units

Equilibrium Output


Result 2 coase theorem l.jpg
Result #2: Coase theorem

  • Considered case where MB and MED both affect only a small number of people.

  • Argued that if we assign “rights to pollute” there would be substantial incentives to negotiate a side payment that results in efficient level.Two scenarios

  • Bart compensates Lisa (who has the right to prevent pollution).

  • Lisa “bribes” Bart to pollute less (even though he has the right)


List of policy instruments l.jpg
List of Policy Instruments

  • As a class, we developed a full list of potential policies a government could use to correct an externality.

  • In order to compare instruments, we need to move beyond some of the limitations implicit in graph #1.


Limitations of graph 1 l.jpg
Limitations of Graph #1

  • Has output on the horizontal axis.

    • Implication: the only way to reduce pollution is to reduce output.

    • Extension: Graph #2 (Fullerton, SEJ) uses pollution (not output) on horizontal axis

  • Has a single MC curve for the entire industry.

    • Implication: all firms are the same.

    • Extension: Graph #3 models the marginal cost of abatement (pollution reduction) faced by firms. Graph allows MAC to differ by firm.


Graph 2 l.jpg
Graph #2

  • Pollution on horizontal axis (assumes perfect competition)

  • Here, “price” implies the price associated with the polluting input.

  • The consumer’s total price (and CS) is in some sense the sum of prices associated with each input.

  • Reducing pollution might mean reducing output, or changing inputs, or doing filtration, etc.

  • Any of these raises price and reduces consumer’s surplus associated with the final good or service.


Result 3 l.jpg
Result #3

  • A variety of instruments that each achieve the efficient level of pollution have very different distributional consequences.


Graph 3 version a marginal abatement costs l.jpg
Graph #3 (version a): marginal abatement costs

  • Instead of looking at the decision about how much to pollute, the graph looks at the decision to reduce pollution relative to some “baseline” amount.

  • Abatement = negative pollution

  • If graph includes the marginal benefit of abatement we can identify an optimal level of abatement (version b).

  • In our first version of this graph, we simply depicted two firms with two different MAC curves (version a).


Result 4 cac performance standard is inefficient l.jpg
Result #4: CAC/performance standard is inefficient

  • A command and control policy requiring uniform abatement levels is inefficient when firms have differing marginal costs.

    • On graph, specify some point, A, that each firm has to abate.

    • On graph, find the additional costs to low marginal cost firm of abating a little more.

    • On graph, find the savings to high marginal cost firm of abating a little less.

    • If savings > additional costs, uniform policy is inefficient.

  • Caveat: result requires “perfect mixing”


Result 5 efficiency of incentive based instruments l.jpg
Result #5: Efficiency of incentive-based instruments

  • a tradable permit system or Pigouvian tax (emission fee) is efficient.

  • To show for permits, start again at point where firms do uniform level of abatement.

    • Consider their incentives to buy and sell rights to pollute.

    • Argue that pareto-improvements are possible.

    • Identify the point at which the price at which the high cost firm is willing buy permits equals the price at which the low-cost firm is willing to sell permits.

    • At this allocation, no pareto improvements are possible.

  • For taxes, start with a tax set at the price identified above.

    • Identify the point at which each firm prefers to pay the tax, rather than abate.

    • Show that it produces same allocation as permits (no Pareto improvements possible)


Graph 3 version b l.jpg
Graph #3, version b

  • Choice of policy instruments under uncertainty.

  • Here we again assume a single Marginal abatement cost curve, but add MB of abatement.

  • Also add uncertainty.


Uncertainty in marginal costs l.jpg
Uncertainty in Marginal Costs

  • Case 1 (MC steep, MB flat)

  • In this case, taxes lead to smaller dead-weight loss.


Graph 3b case 1 l.jpg
Graph 3b, case 1

MACAct

Cost

MACEx

MB

Abatement


Steps to finding dwl l.jpg
Steps to finding DWL

  • Find the Q* (optimal quantity)

  • Find the Qact (Abatement actually produced)

  • For the area between Qact and Q* find how much costs exceed benefits.

  • These steps are simpler for permit than for tax.


Graph 3b case 1 with q instrument l.jpg
Graph 3b, case 1 with Q-instrument

MACAct

Cost

MACEx

MB

Qact

Q*

Abatement


Graph 3b case 1 with q instrument21 l.jpg
Graph 3b, case 1 with Q-instrument

MACAct

Cost

MACEx

MB

Qact

Q*

Abatement


Graph 3b case 1 with tax l.jpg
Graph 3b, case 1 with tax

MACAct

Cost

MACEx

tax

MB

Abatement


Graph 3b case 1 with tax23 l.jpg
Graph 3b, case 1 with tax

MACAct

Cost

MACEx

tax

MB

Q*

Abatement

Qactual


Graph 3b case 1 with tax24 l.jpg
Graph 3b, case 1 with tax

MACAct

Cost

MACEx

tax

MB

Q*

Abatement

Qactual


Graph 3b case 1 with tax25 l.jpg
Graph 3b, case 1 with tax

MACAct

Cost

MACEx

tax

MB

Q*

Abatement

Qactual


Graph 3b comparing instruments l.jpg
Graph 3b, comparing instruments

MACAct

Cost

MACEx

MB

Abatement


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