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W2 on W3 Pricing Damages

ENVS 4510: Ecological Economics. W2 on W3 Pricing Damages. Presented Jan 13, 2012 By Eric Miller ewmiller@yorku.ca. Pricing Damages: Learning Objectives. Understand price- and quantity-based solutions to correct market failure Understand some ways of pricing negative externalities.

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W2 on W3 Pricing Damages

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  1. ENVS 4510: Ecological Economics W2 on W3Pricing Damages Presented Jan 13, 2012 By Eric Miller ewmiller@yorku.ca

  2. Pricing Damages: Learning Objectives • Understand price- and quantity-based solutions to correct market failure • Understand some ways of pricing negative externalities

  3. Externalities in the market model • The consequence of a transaction that affects another person without being reflected in prices. It could be positive or negative. • Open access resources suffer from externalities • All goods and services involve transformation of materials/energy, using ecosystem services that are not excludable and rival  negative externalities impacting the environment are widespread • Add externalities into simple market model to see how market failure impacts efficiency, and what to do about it

  4. Problem: Negative externalities affecting markets • Negative externalities lead to inefficient market outcome where more is produced and sold than is efficient Social Cost Curve Price ($) Cost of Negative externality Original (Market) Supply Curve B P A P Market outcome A is inefficientEfficient outcome is at B Demand Curve Quantity Q Q

  5. Solution1: Correct market price with a special tax • Apply a tax to cover negative externality and let market adjust the quantity supplied; called a “pigouvian” tax after Pigou (1920) New Market Supply Curve Price ($) Green Tax of Cost of Externality Original (Market) Supply Curve B P A P B is new (efficient) market outcomeunder green tax Market Demand Curve Quantity Q Q

  6. Solution2: Correct quantity with tradable permits • Cap quantity of output that can be supplied with tradable permits and let the market adjust the price of permits, after Dales (1968) New Market Supply Curve Price ($) Original (Market) Supply Curve B P A P B is new (efficient) market outcome under tradable permit system Market Demand Curve Quantity Q Q Maximum Permitted Output

  7. Solution1 or 2? (Taxes vs. Permits) • Ease of pricing externality or determining maximum quantity? • Market characteristics: is externality-producing market competitive? • Administrative burden: how to allocate initial permits? How to administer the tax? • Durability: impact of shifting demand and supply curves? • Political burden: is one easier to sell than another?

  8. Approaches to pricing damages Each approach is increasingly challenging, but less limiting in scope: • Market price of the loss from externality Method: Market price / productivity method • (or) Price revealed by effect of externality on another transaction Method: Hedonic analysis of affected good/service • (or) Price is stated by a surveyed sample contingent upon paying it Method: Contingent valuation of willingness to pay or accept payment

  9. E.g. Pricing Ontario’s alternatives to electricity from coal Cost 3 alternatives to coal versus baseline cost of sustaining coal (DSS, 2005) Private market cost • Construction, operating and maintenance (market prices) + Cost of external damages to human health • Willingness to pay to avoid minor illnesses (stated price) • Health care system costs of emergency room visits (market price) • Reduced productivity from lost work of health-impaired workers (market price) • Willingness to pay to avoid premature mortality (stated price) + Cost of external damages to the environment • Fixing materials corroded from pollutants (market price) • Lost agricultural productivity from pollutants (market price) • Hypothetical cost of purchasing greenhouse gas emissions permits (market price) = Social cost of electricity

  10. E.g. Pricing Ontario’s alternatives to electricity from coal Baseline keep Coal Replaced byGas Replaced by Gas & Nuclear Replaced byClean Coal Private market cost $ 0.04 $ 0.08 $ 0.06 $ 0.05 + External health cost $ 0.11 $ 0.01 $ 0.01 $ 0.04 + External environmental cost $ 0.01 $ 0.01 $ 0.00 $ 0.01 = Social cost (2005 CDN) $ 0.16 $ 0.10 $ 0.07 $ 0.11

  11. References • Dales, J. H. 1968. "Land, water, and ownership." Canadian Journal of Economics1(4): 791-804. • DSS. 2005. “Cost-Benefit Analysis: Replacing Ontario’s Coal-Fired Electricity Generation.” Report for the Ontario Ministry of Energy. [online] • Pigou, A. C. 1920. The economics of welfare. London, Macmillan.

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