Basic options for the internalization of externalities

dr. Gabor Harangozo

Corvinus University of Budapest

Main regulatory options to achieve the social optimum of externalities(internalizing externalities)

1. Setting a norm (or standard or pollution limit)

2. Levy taxes on polluting activity (PPP-the polluter pays principle)

3. Enabling market forces (bargain) to achieve the social optimum

1. Setting of a norm

Norm

MEC

Qs Qp0

MNPB

Costs,

benefits

Economic

activity

Minimum penalty

Environmental norms in practice

Most common approach of regulation: in international and EU level

Almost exclusive in case of hazardous materials

Example: almost all fields of environmental protection

Types: regulation on emissions vs. immissions

Emission norms: refer to emitted quantity etc.

Immission norms: refer to pollution concentration, exposition level etc.

Water protection norms in paper industry

Maximal load of organic elements (Biological Oxygen Demand – BOD):

BOD5 = 25 mg/l

Outflow of the (company) sewage works is measured

2. Taxes on the polluting activityThe Pigovian tax

Social cost should be internalised

through the introduction of a tax based on

the unit of production.

Arthur Pigou (1877-1959)

1920: Economics of Welfare

Assumptions

Perfect competition

Pollution is proportional to production

The MNPB and MEC curves are known

(by regulating authorities)

The optimum rate of the Pigovian

tax equals the amount of external

effects caused by the socially

optimum production level.

The optimum rate of the Pigovian tax

Amount of tax paid

The optimum size of the Pigovian tax

Costs,

benefits

Economic activity

MNPB

Marginal external cost, MEC

Qp0 Qs

Tax rate

Limitations of the theory of Pigou

• The identification of the MEC curve

• Asymmetric information

• Pollution is not proportionate with production

• Lack of perfect competition

• Does not motivate environmental innovation

• MEC can be several times higher than MC

Environmental taxes in practice

Regulators aim to decrease environmental loads by the taxation of polluting activities, products, raw materials etc.

PPP - „Polluter Pays Principle”

Types:‒ product fees (levied on producs)

‒ pollution/emission taxes (levied on production)

Major fields in practice:‒ Transportation taxes (on vehicles, fuel, congestion charges)

‒ Energy taxes

‒ Pollution taxes

Green taxes in the EU

Example: Environmental product fees

On products considered as environmentally harmful

Effects on competition (neutrality?):

‒ Internationally: yes

‒Among sectors: no

Examples:

‒Fuels and oil products

‒Packaging materials

‒Paper based ads

‒Tyres

‒Paints and other chemicals

‒Etc.

• Based on production relatedemissions

• Effects on competition(neutrality?):

‒ Internationally: yes

‒Among sectors: no

• Main types:

‒air pollution charges

‒water pollution charges

‒soil pollution charges

Example: Emission taxes

Exercise

A cement factory (MNPB=10-Q) is in a densely populated areaand polluting the air (MEC=1/4 Q).

How much will the slaughterhouse produce withoutregulation? How much profit will it have, and what will be the net effect for socuety in this case?

If the government wants to limit the production of theslaughterhouse to the socially desirable level using a norm, where will it set the norm and how much profit will theslaughterhouse have in this case?

If the government wants to achieve the social optimum using a tax, how high should the tax rate be? How much taxwill the slaughterhouse pay, and how much profit will it haveremaining? What is the net effect for society in this case?

Please also make a drawing showing the situation!

Homework for 12th November

The operation of a paper mill (MNPB=12-2Q) raises alsoexternal effects in the form of polluting the river nearby(MEC=Q).

How much will the paper mill produce without regulation? Howmuch profit will it have, and what will be the net effect forsociety in this case?

If the authorities want to limit the production of the paper millto the socially desirable level using a norm, where will theyset the norm and how much will it cost to the company?

If the government wants to achieve the social optimum usinga tax, how high should the tax rate be? How much does thetax-based regulation cost to the paper mill altogether?

Please also make a drawing showing the situation!

3. Enabling a bargain process The Coaseian bargain

As a result of a bargaining process the

system reaches the social optimum

independent of who ownes

the property rights.

Ronald Coase (1910-2013)

1960: The Problem of Social Cost

Assumptions

Perfect competition

Established property rights

Pollution is proportionate with production

MNPB, MEC are known

All interested parties have the necessary information

Zero transaction costs

ForestTimber processing

company

Transportation

of wood on the river

Mercury pollution

Guests leave

Hotel

The allocation of rights

1. Everyone has the right to use (pollute) the

environment

the party suffering from pollution will have to pay

the polluter so he will reduce his output

2. Everyone has the right to a clean environment

the polluter will have to pay the party suffering

from the pollution so he will allow production

The Coase-theory says that the social optimum

will be reached in both situations, if the

property rights are set.

Equilibrium the Coase-theorem

Qp

Costs,

benefits

Economic activity

MEC

0 Qs

MNPB

A

B CD

Scenario 1: everyone has the

right for a clean environment

• Starting point of bargain: 0

• End point of bargain: Qs

• Polluter pays to the sufferer

• Minimum: B

• Maximum: A+B

Scenario 2: everyone has the right

to use (pollute) the environment

• Starting point of bargain: Qp

• End point of bargain: Qs

• Sufferer pays to the polluter

• Minimum: C

• Maximum: C+D

1 2

The chance for reaching agreement

Theoretically equal in both situations

In practice, willingness to pay must be accompanied by the ability to pay

Therefore, chances for reaching agreement are smaller when the rights are with the polluter and the sufferer has to pay

Limitations of the theory of Coase

• assumes perfect competition

• the identification of the participants of the

bargaining process poses problems:

• high number of interested parties

• identification of those who cause the damage

and those who suffer from it

• interests of future generations

• transaction costs are often high

• only a few practical examples