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Economic Concepts Economic Concepts and Applications to Climate Changeand Applications to Climate Change

Economic ConceptsEconomic Concepts• When markets work and when they don’t workWhen markets work and when they don’t work

Policy Interventions to correct market failuresPolicy Interventions to correct market failures

Recent research in climate changeRecent research in climate change

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Part 1: Economic ConceptsPart 1: Economic Concepts

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First Theorem of Welfare EconomicsFirst Theorem of Welfare Economics

Pareto efficiencyPareto efficiency• No welfare enhancing trades can be madeNo welfare enhancing trades can be made• It is impossible to make somebody else better off without making It is impossible to make somebody else better off without making

somebody else worse offsomebody else worse off

First theorem of welfare economics: the equilibrium of a First theorem of welfare economics: the equilibrium of a competitive market economy is Pareto efficient ifcompetitive market economy is Pareto efficient if• all goods are all goods are privateprivate • no difference between no difference between private and social costprivate and social cost

Formalizes Adam Smith’s concept of an invisible handFormalizes Adam Smith’s concept of an invisible hand

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Invisible HandInvisible Hand

““Every individual … neither intends to promote the Every individual … neither intends to promote the public interest, nor knows how much he is promoting it. public interest, nor knows how much he is promoting it. He intends only his own security, his own gain. And he He intends only his own security, his own gain. And he is in this led by an invisible hand to promote an end is in this led by an invisible hand to promote an end which was no part of his intention. By pursuing his own which was no part of his intention. By pursuing his own interest he frequently promotes that of society more interest he frequently promotes that of society more effectively than when he really intends to promote it.”effectively than when he really intends to promote it.”

““It is not from the benevolence of the butcher, the brewer, It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard or the baker that we expect our dinner, but from their regard to their own interest.”to their own interest.”

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Invisible HandInvisible Hand

Idea behind invisible handIdea behind invisible hand• Societal perspective:Societal perspective:

A good should be produced if the “utility” to the user exceeds the A good should be produced if the “utility” to the user exceeds the cost of producing itcost of producing it

• Firm perspectiveFirm perspective Can make a profit if the “utility” to the user (the maximum he/she Can make a profit if the “utility” to the user (the maximum he/she

is willing to pay) exceeds the cost of producing itis willing to pay) exceeds the cost of producing it

• Ina well-functioning market, note how the incentive Ina well-functioning market, note how the incentive of a firm align with that of societyof a firm align with that of society

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Key Concepts I: Private / Public GoodKey Concepts I: Private / Public Good

Public versus private goodsPublic versus private goods• Private goodPrivate good

Rival: if I eat an apple, somebody else can’t eat the same Rival: if I eat an apple, somebody else can’t eat the same appleapple

Excludable: I can keep other people from eating my appleExcludable: I can keep other people from eating my apple

• Public goodPublic good Non-rival: if I walk in a park, my neighbor can do so at the Non-rival: if I walk in a park, my neighbor can do so at the

same timesame time Non-excludable: I can’t keep my neighbor from walking in the Non-excludable: I can’t keep my neighbor from walking in the

parkpark Problem of free-riding: Incentive to let other people “provide” Problem of free-riding: Incentive to let other people “provide”

a good without paying for it.a good without paying for it.

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Key Concepts II: Private / Social CostKey Concepts II: Private / Social Cost

Private costs (benefits) of an action Private costs (benefits) of an action • accruing to the actor only accruing to the actor only

Social costs (benefits) Social costs (benefits) • total costs of activity including those that accrue to total costs of activity including those that accrue to

people other than the actor people other than the actor

Example: driving a carExample: driving a car• Private costs: fuel, maintenance Private costs: fuel, maintenance • Social costs include pollution, road wearSocial costs include pollution, road wear

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External EffectsExternal Effects

Any difference between private and social costs Any difference between private and social costs is referred to as an “externality” or “external is referred to as an “externality” or “external effect”effect”

Recall how markets workRecall how markets work• in seeking profits firm produce a good in seeking profits firm produce a good

If “utility” to consumer (maximum willingness to pay) exceeds If “utility” to consumer (maximum willingness to pay) exceeds the cost of producing itthe cost of producing it

• Problem: if private cost are different from social cost, Problem: if private cost are different from social cost, firm doesn’t act in societies best interestfirm doesn’t act in societies best interest

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0

2

4

6

8

10

12

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A B

Choices

Co

sts

Private-Social difference

Private

Left - social cost 15, private 10 Left - social cost 15, private 10 Right - private & social cost of 12Right - private & social cost of 12

Corporation will choose A as private cost is lower

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Examples of Private v. SocialExamples of Private v. Social

Conserving tropical forests Conserving tropical forests • Private benefits: may be small for landownerPrivate benefits: may be small for landowner

some sales of non-timber forest productssome sales of non-timber forest products Eco-tourismEco-tourism

• Social benefits:Social benefits: carbon sequestrationcarbon sequestration biodiversity conservationbiodiversity conservation Avoided soil erosionAvoided soil erosion

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Market FailureMarket Failure

Social benefits > private benefitsSocial benefits > private benefits• Good is underprovidedGood is underprovided• Provider has too little financial incentive, i.e., doesn’t Provider has too little financial incentive, i.e., doesn’t

capture all benefitscapture all benefits• Example: rainforestExample: rainforest

Social costs > private costSocial costs > private cost• good is good is over-provided • Provider does not account for all costs it imposes on Provider does not account for all costs it imposes on

societysociety• Example: pollution, fossil fuel. Example: pollution, fossil fuel.

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SummarySummary

Markets work very well when Markets work very well when • Assumption of first welfare theorem are metAssumption of first welfare theorem are met

goods are private goods are private private & social costs are equalprivate & social costs are equal

Less satisfactory otherwiseLess satisfactory otherwise• ““market failure” & rationale for interventionmarket failure” & rationale for intervention• How best to intervene?How best to intervene?

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Part 2: Policy ResponsesPart 2: Policy Responses

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Policy ResponsesPolicy Responses

What to do if there is a difference between What to do if there is a difference between private and social costsprivate and social costs• Impose a tax (or subsidy) Impose a tax (or subsidy)

equal to difference between private and social costsequal to difference between private and social costs Incentive to firm realigned with societal interestIncentive to firm realigned with societal interest

• Introduce property rightsIntroduce property rights Based on the view that an excess of social over private costs Based on the view that an excess of social over private costs

arises from the inability to own certain key resources, such arises from the inability to own certain key resources, such as the atmosphere. as the atmosphere.

Afterwards market outcome will be Pareto-Afterwards market outcome will be Pareto-efficient againefficient again

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Side note: Equity & EfficiencySide note: Equity & Efficiency

First welfare theorem maximizes “the size of the First welfare theorem maximizes “the size of the pie”, but says nothing about its distributionpie”, but says nothing about its distribution

Pareto efficiency is separate from any concept of Pareto efficiency is separate from any concept of equity. equity. • It states that all opportunities for mutual gain are It states that all opportunities for mutual gain are

exploited. But not that the outcome is in any way fair. exploited. But not that the outcome is in any way fair.

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Greenhouse GasesGreenhouse Gases

Two views on COTwo views on CO22 emissions emissions• social costs of burning fuels > private costs social costs of burning fuels > private costs

Solution: impose a carbon tax.Solution: impose a carbon tax.

• use of the atmosphere for waste disposal without any use of the atmosphere for waste disposal without any paymentpayment

atmosphere should be someone’s propertyatmosphere should be someone’s property if we want to pollute it we have to obtain their permission and if we want to pollute it we have to obtain their permission and

compensate them for damage to it compensate them for damage to it Leads to tradable SOLeads to tradable SO22/CO/CO22 permits permits

• Requires well-defined property rights!Requires well-defined property rights!

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Cap & Trade SystemsCap & Trade Systems

Set a limit on allowable emissionsSet a limit on allowable emissions• Every party that wants to emit a unit has to buy a Every party that wants to emit a unit has to buy a

permit to do sopermit to do so If firms compete for a permit, they will bid up the priceIf firms compete for a permit, they will bid up the price If price gets too high, it becomes cheaper to abateIf price gets too high, it becomes cheaper to abate

• Demand for permits starts to declineDemand for permits starts to decline

• Permits establishes property rights in environmental Permits establishes property rights in environmental assetsassets

• Key difference in implementationKey difference in implementation Auction off permits Auction off permits Grandfather permits, i.e., allocated based on historic Grandfather permits, i.e., allocated based on historic

emissions. (cheaper for firms)emissions. (cheaper for firms)

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Examples of Cap -&-Trade:Examples of Cap -&-Trade:

Title IV of Clean Air Act AmendmentsTitle IV of Clean Air Act Amendments• SOSO22 permit market permit market• Number of permits: 50% of historic emissionsNumber of permits: 50% of historic emissions• Permits are grandfathered (allocated based on Permits are grandfathered (allocated based on

historic emissions)historic emissions)• Advantage of permit market: Advantage of permit market:

Firms with lowest abatement cost will abateFirms with lowest abatement cost will abate gives firm incentive to innovategives firm incentive to innovate

• Initial cost estimates by industry > 1000 per ton SOInitial cost estimates by industry > 1000 per ton SO22

• EPA: 250-350 per ton SOEPA: 250-350 per ton SO2 2 (Phase 1) (Phase 1)

500-700 per ton SO500-700 per ton SO2 2 (Phase 2)(Phase 2)• Permit price ~150 per ton SOPermit price ~150 per ton SO22

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Examples of Cap -&-Trade:Examples of Cap -&-Trade:

Fox River in WisconsinFox River in Wisconsin• Allowable firms to trade pollution rightsAllowable firms to trade pollution rights• Problem: each trade had to be approvedProblem: each trade had to be approved

Only 1 trade in many yearsOnly 1 trade in many years

Lessons: Permit market works bestLessons: Permit market works best• Clearly defined property rightsClearly defined property rights• Many potential buyers and sellersMany potential buyers and sellers• Low transaction costLow transaction cost• Uniformly mixing pollutantUniformly mixing pollutant

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Examples of Cap -&-Trade:Examples of Cap -&-Trade:

Wetlands bankingWetlands banking• www.wildlandsinc.comwww.wildlandsinc.com

KyotoKyoto• Chicago Climate ExchangeChicago Climate Exchange• www.chicagoclimatex.comwww.chicagoclimatex.com

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Kyoto ProtocolKyoto Protocol

Cap-and-trade on emissions by industrial countries Cap-and-trade on emissions by industrial countries and transitioning countriesand transitioning countries

No significant restrictions on emissions by No significant restrictions on emissions by developing countriesdeveloping countries• ““Clean development mechanism” Clean development mechanism”

Develop countries can get “credits” for reduction in developing Develop countries can get “credits” for reduction in developing countriescountries

Discussion to include “avoided” deforestationDiscussion to include “avoided” deforestation

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Kyoto Protocol – Kyoto Protocol – Annex B CountriesAnnex B Countries

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Kyoto - targetsKyoto - targets

European Union (15 members) -8%

US -7%

Canada, Hungary, Japan, Poland -6%

Croatia -5%

New Zealand, Russian Federation, Ukraine 0%

Norway +1%

Australia +8%

Iceland +10%

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-     World 27,245,758 100.0 %

1     United States [5] 6,049,435 22.2 %

2     China 5,010,170 18.4 %

-     European Union 3,115,125 11.4 %

3     Russia 1,524,993 5.6 %

4     India 1,342,962 4.9 %

5     Japan 1,257,963 4.6 %

6     Germany 808,767 3.0 %

7     Canada 639,403 2.3 %

8     United Kingdom 587,261 2.2 %

9     South Korea 465,643 1.7 %

10     Italy [6] 449,948 1.7 %

11     Mexico 438,022 1.6 %

12     South Africa 437,032 1.6 %

13     Iran 433,571 1.6 %

14     Indonesia 378,250 1.4 %

15     France [7] 373,693 1.4 %

16     Brazil 331,795 1.2 %

Historic Emissions

(2004)

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Example: Burden-sharing agreement Example: Burden-sharing agreement (Europe)(Europe)

Austria -13% Italy -6.5%

Belgium -7.5% Luxembourg -28%

Denmark -21% Netherlands -6%

Finland 0% Portugal +27%

France 0% Spain +15%

Germany -21% Sweden +4%

Greece +25% United Kingdom -12.5%

Ireland +13%

European Community

-8%

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Kyoto ProtocolKyoto Protocol

Doesn’t tackle India-China problem: Doesn’t tackle India-China problem: • Large fraction of world populationLarge fraction of world population

Historically low per-capita emissionsHistorically low per-capita emissions Very few “grandfathered” permitsVery few “grandfathered” permits Problems is not theirs but of developed worldProblems is not theirs but of developed world Could not stabilize emissions without radically new Could not stabilize emissions without radically new

technologiestechnologies India / China has no incentive to joinIndia / China has no incentive to join

• Without participation by China / IndiaWithout participation by China / India Kyoto Protocol will not come close to solving the problem so Kyoto Protocol will not come close to solving the problem so

other countries have little incentive to join.other countries have little incentive to join.

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An Agreement on GHGsAn Agreement on GHGs

Developed worldDeveloped world• lead in development of new technologieslead in development of new technologies• might be sufficient to bring developing countries on boardmight be sufficient to bring developing countries on board

Clean coal technologies Clean coal technologies • China could use all of its coal, as could IndiaChina could use all of its coal, as could India• This would be of immense value to them. This would be of immense value to them.

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An Agreement on GHGsAn Agreement on GHGs

China’s dilemma: China’s dilemma: • burning coal generates terrible pollution burning coal generates terrible pollution

domestic political issue. domestic political issue.

• Switch away from coal will increase energy costsSwitch away from coal will increase energy costs

Development of clean coal technologiesDevelopment of clean coal technologies• valuable to China (reduces other pollution)valuable to China (reduces other pollution)• should encourage China and India to participate in an should encourage China and India to participate in an

agreement to reduce GHGs agreement to reduce GHGs • understanding that tight standards would only apply understanding that tight standards would only apply

once a new technology were in place.once a new technology were in place.

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Part 3: Economic ResearchPart 3: Economic Research

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3a) Forecasting China’s Emissions3a) Forecasting China’s EmissionsAuffhammer and CarsonAuffhammer and Carson

Province-level approachProvince-level approach• Gives better fit than national modelGives better fit than national model

Model CO2 emission usingModel CO2 emission using• Population predictionsPopulation predictions• Predictions on income growthPredictions on income growth• Lagged emissions growthLagged emissions growth

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3a) Forecasting China’s Emissions3a) Forecasting China’s EmissionsAuffhammer and CarsonAuffhammer and Carson

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3b) Discount Rate3b) Discount Rate

Stern ReportStern Report• http://www.hm-treasury.gov.uk/independent_reviews/stern_review_economics_climate_change/sternreview_index.cfmhttp://www.hm-treasury.gov.uk/independent_reviews/stern_review_economics_climate_change/sternreview_index.cfm

• Advocates strong reductions in greenhouse gasesAdvocates strong reductions in greenhouse gases Benefit outweigh costBenefit outweigh cost

NordhausNordhaus• Cost are much larger than benefitsCost are much larger than benefits

Key differenceKey difference• Interest ratesInterest rates

Stern uses 0.1%Stern uses 0.1% Nordhaus argues for much larger numberNordhaus argues for much larger number

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3c) Impact on Agriculture3c) Impact on Agriculture

Nonlinear Effect of Temperature on AgricultureNonlinear Effect of Temperature on Agriculture• Warmer temperatures are better up to a point (corn)Warmer temperatures are better up to a point (corn)

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3c) Impact on Agriculture3c) Impact on Agriculture

Looking at one crop (holding crop constant)Looking at one crop (holding crop constant)• Omits crop switching as a response to climate changeOmits crop switching as a response to climate change

Idea:Idea:• Look at farmland values insteadLook at farmland values instead

Capture value of land when it is put to best (most profitable) Capture value of land when it is put to best (most profitable) useuse

Link them to climatic characteristicsLink them to climatic characteristics

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3d) Future Regulation - US3d) Future Regulation - US

Goulder (Stanford)Goulder (Stanford)• Recommendations for California’s climate change Recommendations for California’s climate change

regulationregulation Use market-based approach: tax or permitsUse market-based approach: tax or permits Big discussion:Big discussion:

• Auction off permits or grandfather themAuction off permits or grandfather them

• Auctioning off is better for a societal perspectiveAuctioning off is better for a societal perspective Generate government revenueGenerate government revenue Other distortionary taxes (income tax) can be loweredOther distortionary taxes (income tax) can be lowered

• Grandfathering is cheaper for industryGrandfathering is cheaper for industry Less political resistanceLess political resistance

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3e) Future Regulation - US3e) Future Regulation - US

Stavins (Harvard)Stavins (Harvard)• Kyoto was “too little too fast”Kyoto was “too little too fast”

““Small” emission reductions in short time frameSmall” emission reductions in short time frame

• Better approachBetter approach ““Stricter” goals but longer time frame to achieveStricter” goals but longer time frame to achieve Give industry time to innovateGive industry time to innovate

• New production processes New production processes

• carbon capture and storagecarbon capture and storage