Economic Solutions to Environmental Problems: The Market Approach

1. Economic Solutions to Environmental Problems: The Market Approach Chapter 5

2. Overview • Market approach refers to incentive-based policy that encourages conservative practices or pollution reduction strategies • Types of Market Instruments • Pollution charges • Subsidies • Deposit/refund systems • Pollution permit trading systems

3. 1. Pollution Charges • Fees based on “Polluter-Pays Principle (polluter should bear costs of control measures)” • Types of pollution charges • Product charge • Emission/Effluent charge

4. (1) Product Charge • A fee added to price of pollution-generating ___________, which generates negative externality • Impose product charge as per unit tax on product, e.g., gas tax • If the tax equals the marginal external cost (MEC) at QE, it is called a _________ _____ • How does the tax on gasoline in the US compare with that of other nations?

5. Selected International Gasoline Tax Rates Source: International Energy Agency, November, 2008

6. Modeling a Pigouvian Tax $ MSC = MPC + MEC MPCt MPC a Amount of tax b MPB = MSB 0 Q of gasoline QE QC

7. Making sellers pay a tax on each unit they sell is equivalent to an increase in the cost of producing each unit. Anything that increases production costs causes the S curve to shift up: in order for sellers to be willing to supply the same quantity as before, they must receive a higher price to compensate them for the increase in their costs.

8. By setting the unit tax equal to the MEC at QE, the MPC curve shifts up to MPCt. Equilibrium output is then determined by MPCt and MSB, which is QE.

9. 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

10. (2) Emission/Effluent Charge • A fee imposed directly on the discharge of _____________ • Typically implemented through a tax

11. Model: Single Polluter Case • Government sets an abatement standard at AST • A0 is actual abatement level. • Policy options to polluter are: • Abate up to AST and incur those costs, or • Pay a constant per unit tax, t (also called marginal tax, MT), on any abatement less than AST

12. Modeling Emission ChargeSingle Polluter $ MAC Firm abates up to A0 since MAC < MT; firm pays tax between A0 and AST, since MAC > MT c a b MT t 0 AST A0 Abatement (A)

13. Pollution Charges in Practice • Internationally, the pollution charge is the most commonly used market-based instrument • Australia, Bulgaria, France, and Japan, use fees or taxes to control noise pollution generated by aircraft • France, Mexico, and Poland are among the nations using effluent charges to protect water resources. • Others levy charges on products such as batteries, tires, lubricant oil, packaging, paint, paint containers, and gasoline

14. 2. Environmental Subsidies • Two major types of subsidies: • Abatement equipment subsidies • Pollution reduction subsidies

15. (1) Abatement Equipment Subsidy • 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 equals the marginal external benefit (MEB) at QE,it achieves an efficient equilibrium and is called a __________________

16. Pigouvian SubsidyMarket for Scrubbers Coal-burning power plants buy scrubbers; scrubber manufacturers sell scrubbers ($ millions) MSC K PE = 175 Subsidy = $14 million PC = 170 MSB L PE – s = 161 MPBS MPB 0 QC = 200 QE = 210 Q of scrubbers

17. In a competitive market, too few scrubbers are exchanged at too low a price because the MEB of a cleaner environment are not recognized by the market participants.

18. (2) Pollution Reduction Subsidy FYI • 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, total subsidy = s(ZST - ZO), where ZO is the actual level of pollution • Analogous to an emission charge

19. Subsidies in Practice FYI • 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 Belgium, Denmark, 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 low-emission vehicles

20. 3. Deposit/Refund Systems • 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 • The deposit is intended to capture the MEC of improper waste disposal (IW) in advance

21. Modeling Deposit/Refund System improper waste (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 FYI

22. Deposit-Refund Model FYI 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 QIW 0 Improper Waste Disposal (%) 100 Proper Waste Disposal (%) 0 100

23. 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

24. 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 U.S., 11 states have bottle bills • Other applications include systems used to promote responsible disposal of used tires, car hulks, and lead-acid batteries

25. 4. Pollution Permit Trading Systems • A pollution permit trading system establishes a market for rights to pollute by issuing _________ 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 • Fixed number of permits is issued based on an “acceptable” level of pollution set by government • The permits are marketable

26. How Permit Trading Works • There is an incentive to trade as long as polluters face different ________ 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

27. Result • Low-cost abaters will clean up pollution and sell excess permits to other firms • They will _____ at any P _____ than their MAC • High-cost abaters will buy permits rather than abate • They will _____ at any P _____ 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 _________

28. An Example (Ch4—slide 20) Polluter 1: TAC1 = 1.25(A1)2 MAC1 = 2.5(A1) • where A1 is pollution abated by Polluter 1 Polluter 2: TAC2 = 0.3125(A2)2 MAC2 = 0.625(A2) • where A2 is pollution abated by Polluter 2

29. Round 1: Government issues 5 permits to each polluter Polluter 1: Current pollution level: 10 units # of permit held: 5 abatement required: 5 MAC1 = 2.5(A1)=2.5( __ )= $12.50 TAC1 = 1.25(A1)2=1.25( __)2= $31.25 Polluter 2: Current pollution level: 10 units # of permit held: 5 abatement required: 5 MAC2 = 0.625(A2)=0.625( ___)= $3.125 TAC2 = 0.3125(A2)2=0.3125( ___)2= $7.81

30. Round 2: Polluter 1 purchases 1 permit ($8.00) from polluter 2 Polluter 1: Current pollution level: 10 units # of permit held: 6 abatement required: 4 MAC1 = 2.5(A1)=2.5( ___)= $10.00 TAC1 = 1.25(A1)2=1.25(___)2= $20.00 (cost of 1 permit purchased=$8.00) Polluter 2: Current pollution level: 10 units # of permit held: 4 abatement required: 6 MAC2 = 0.625(A2)=0.625(___)= $3.75 TAC2 = 0.3125(A2)2=0.3125(___)2= $11.25 (revenue from 1 permit sold=$8.00)

31. Final round: Polluter 1 purchases 3 permits ($8; $7; $5) from polluter 2; MAC1 = MAC2 Polluter 1: Current pollution level: 10 units # of permit held: 8 abatement required: 2 MAC1 = 2.5(A1)=2.5(___)= $5.00 TAC1 = 1.25(A1)2=1.25(___)2= $5.00 (cost of 3 permits purchased=$8+$7+$5=$20.00) Polluter 2: Current pollution level: 10 units # of permit held: 2 abatement required: 8 MAC2 = 0.625(A2)=0.625(___)= $5.00 TAC2 = 0.3125(A2)2=0.3125(___)2= $20.00 (revenue from 3 permits sold =$8+$7+$5=$20.00)

32. Assessing the Model Advantages: • Trading establishes the price of a right to pollute without government trying to “search” for a price • Trading system is flexible • Note that an emissions standard can be adjusted by changing the number of permits issued • Cost-effective solution is obtained

33. Disadvantages: • No tax revenues are generated • When there are too many buyers and sellers, transaction cost (the cost of conducting a negotiation) is big • The system creates “pollution hot spots” (localized areas face high concentrations of pollutants where most of the permit buying takes place)

34. Pollution Trading Systems in Practice • Most of the evolution of trading is occurring in U.S. • An important example is the allowance-based trading program to control sulfur dioxide emissions under the Clean Air Act Amendments of 1990 • More innovation has occurred at state and local levels • Ozone Transport Commission in the Northeast • California Regional Clean Air Incentives Market (RECLAIM) • Key international example • Trading of greenhouse gas allowances are part of the Kyoto Protocol, an international accord aimed at global warming • Includes the European Union Greenhouse Gas Emission Trading System (EU ETS), launched in 2005

35. FYI Positive Externalities from Education • A more educated population benefits society: • lower crime rates: educated people have more opportunities, so less likely to rob and steal • better government: educated people make better-informed voters • People do not consider these external benefits when deciding how much education to “purchase” • Result: market eq’m quantity of education—too low • How govt may improve the market outcome: • subsidizecost of education

36. FYI Other Examples of Positive Externalities • Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you. Thank you for not contaminating the fruit supply!

37. FYI Positive Externalities • In the presence of a positive externality, the social value of a good includes • private value – the direct value to buyers • external benefit – the value of the positive impact on bystanders

38. P FYI 50 $ 40 30 20 10 Q 0 0 10 20 30 ACTIVE LEARNING 1: Analysis of a positive externality The market for flu shots External benefit = $10/shot • Draw the social value curve. • Find the socially optimal Q. • What policy would internalize this externality? S D

39. FYI P 50 $ external benefit 40 30 20 10 Q 0 0 10 20 30 25 ACTIVE LEARNING 1: Answers The market for flu shots 25 Socially optimal Q= ___ shots To internalize the externality, use _______ = $10/shot. subsidy S Social value = private value + external benefit D 39

40. FYI Effects of Externalities: Summary If negative externality • market produces a larger quantity than is socially desirable If positive externality • market produces a smaller quantity than is socially desirable To remedy the problem, “internalize the externality” • tax goods with negative externalities • subsidize goods with positive externalities

41. FYI