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Environmental Economics: Lecture 7PowerPoint Presentation

Environmental Economics: Lecture 7

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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

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 PA

MPC (supply curve)

Quantity

MSC= MPC+MED

MED (externality)

D= Marginal SocialBenefit

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

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

- 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

P

MSC

$180

Deadweight Social Loss

MPC = S

PA = $100

D

Q

10,000 Units

Equilibrium Output

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

- 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

- 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

- 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

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

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

- 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

- 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

- 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

- Case 1 (MC steep, MB flat)
- In this case, taxes lead to smaller dead-weight loss.

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.

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