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Economics of Environmental
Policy
Environmental Policies Decentralized Policies
Liability Laws and Property Rights Moral Suasion
Command and Control Emission Standards Technology Standards
Incentive-Based Policies Emission charges Subsidies Tradable discharge permits
Decentralized Policies Liability Laws and Property Rights Moral Suasion
Command and Control Emission Standards Technology Standards
Incentive-Based Policies Emission charges Subsidies Tradable discharge permits
Criteria for Evaluating Policies Efficiency Cost Effectiveness Fairness Incentives for Technological Improvements Enforceability Morality
Efficiency Cost Effectiveness Fairness Incentives for Technological Improvements Enforceability Morality
Efficiency Maximum net benefits
Requires balancing MAC and MD Decentralized……………….Centralized
Hayek’s critique
Cost Effectiveness:When damages (benefits) can’t easily be measured
Cost Effectiveness:When damages (benefits) can’t easily be measured
Rational central planning is impossible
Rational central planning is impossible
Adam Eve
12 0
9 3
5 5
4 8
0 12
Garden of Eden
Adam and Eve in the Garden of Eden, by Titian (c. 1550)
Which allocation would you choose?
1. Choice One2. Choice Two3. Choice Three4. Choice Four5. Choice Five
0% 0% 0%0%0%
Adam Eve
12 0
9 3
5 5
4 8
0 12
Tradeoff: Efficiency vs. Fairness ?
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Fairness Distribution of benefits/costs across regions,
incomes, race, etc
Distribution of Net Benefits
Program Total Cost
Total Benefits
Net Benefits
Low Income
High Income
A 50 100 50 25 25
B 50 100 50 30 20
C 50 140 90 20 70
D 50 140 90 45 45
If you could impose any of the four Programs, which would you choose?
Distribution of Net Benefits
Program Total Cost
Total Benefits
Net Benefits
Low Income
High Income
A 50 100 50 25 25
B 50 100 50 30 20
C 50 140 90 20 70
D 50 140 90 45 45
0% 0%0%0%
a) Program Ab) Program Bc) Program Cd) Program D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
If your choices were limited to Program C or Program A, which would you choose?
Distribution of Net Benefits
Program Total Cost
Total Benefits
Net Benefits
Low Income
High Income
A 50 100 50 25 25
B 50 100 50 30 20
C 50 140 90 20 70
D 50 140 90 45 45
0%0%
1. Program A2. Program C
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Incentives for Technological Improvements Shift the MAC curve down
EmissionsE0
MAC1
MAC2
MD1
E1E2
Incentives for private sector to innovate Profit motive New ideas are a public good
undersupply problem
Pollution Control industry: “envirotech” Driven by regulations and profit motive
Incentives for private sector to innovate Profit motive New ideas are a public good
undersupply problem
Pollution Control industry: “envirotech” Driven by regulations and profit motive
Incentives for Technological Improvements
Enforceability Enforcement is costly
Reliance on self-reporting Monitoring Sanctioning
Courts Fines
Enforcement is costly Reliance on self-reporting Monitoring Sanctioning
Courts Fines Paradox of the Reluctant Enforcer
Moral Considerations Right vs. wrong Taxes vs. Subsidies vs. Permits
The Animal Liberation Front (ALF) carries out direct action against animal abuse in the form of rescuing animals and causing financial loss to animal exploiters, usually through the damage and destruction of property.
Decentralized Policies Liability Laws Property Laws Voluntary action
Liability Law Polluters must compensate those harmed
Provides incentive to make careful decisions “internalize the externality”
Which of the following situations would provide a system of liability rules the best chance for generating an efficient level of emissions?
a) b) c) d)
0% 0%0%0%
a) many people are involved, causal links are clear, and damages are difficult to measure.
b) few people are involved, causal links are clear, and damages are difficult to measure.
c) many people are involved, causal links are muddy, and damages are easy to measure.
d) few people are involved, causal links are clear, and damages are easy to measure.
a) many people are involved, causal links are clear, and damages are difficult to measure.
b) few people are involved, causal links are clear, and damages are difficult to measure.
c) many people are involved, causal links are muddy, and damages are easy to measure.
d) few people are involved, causal links are clear, and damages are easy to measure.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Liability Law…MD1MAC1
E0
$
EmissionsE*
b c
d
Suppose firm is liable for pollution damages At E0: TD = b + c + d
Reducing emissions reduces Damage Liability (saves “c+d”) Reducing emissions increases Abatement Costs (costs “c”) Threat of lawsuit could encourage optimal emissions
Legal Doctrines Strict Liability
Liable for damages regardless the circumstances Negligence
Liable only if appropriate precautions are not taken Burden of Proof?
Burden is on victims Statute of limitations
Standard of Proof? Direct causal link must be established Difficult given the probabilistic nature of many
exposures
Common Law
Smoking “causes” cancer? Exxon Valdez “caused” shoreline damages? Particular power plant “caused” SO2 damages?
Best Case Scenario for Common LawFew people involved, causal link is clear, damages
easily measured
Examples
Under a system of negligent liability, a firm disposing hazardous materials into a river would:
0% 0%0%0%
a) be liable for any damages regardless of the circumstances.
b) be liable for any damages only if the firm did not take reasonable steps to avoid damage.
c) not be liable for any damages. d) none of the above.
a) be liable for any damages regardless of the circumstances.
b) be liable for any damages only if the firm did not take reasonable steps to avoid damage.
c) not be liable for any damages. d) none of the above.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Legislative enacted laws Tax-financed victim’s fund (Netherlands) Law for the Compensation of Pollution-Related
Health Injury (Japan) CERCLA (US)
Example: #4 from Problem Set
Statutory Law
4. Accidents with trucks carrying cow renderings are fairly common in Marietta. Suppose regulators enact a rule requiring that the perpetrators of such an accident be liable for a sum equal to the average damages of all such accidents in the industry. Would this lead trucking companies to take the socially efficient amount of precaution against such accidents? Explain.
In March a small dump truck overturned in Marietta, Ohio, littering the street with cow parts. A smaller shipment fell off of a truck on the same street the following week, running the total of cow-parts spills to four within a year. Said City Councilwoman Katie McGlynn, "I would just like to know why this continues to happen. Maybe we need a stronger ordinance to make this a more serious crime." [Marietta Times, July 1993]
Property Rights
Coase Theorem If property rights are well-defined and
transactions costs low, then private bargaining will lead to an efficient allocation of resources
Corollary: efficient allocation does not depend on initial allocation of property rights
Conditions “well-defined” property rights low transactions costs complete markets
Ronald Coase1991 Nobel Prize in Economics
6. A factory's production process creates sludge which pours into a river. This sludge makes it difficult to fish in the river, increasing the costs of the local fishermen by $6000. The factory can install a water filter system for $4500, and the fishermen can utilize a weighted fishing net system (to get under the sludge) for $3750. Both systems would remedy the sludge damage to the fishermen.
a) Suppose transactions costs are zero. If the factory is not liable and can continue to produce sludge, what outcome do you predict and why?
b) Suppose transactions costs are zero. If the factory is assigned liability for sludge damage, what outcome do you predict and why?
c) Now suppose transactions costs preclude the possibility of private bargaining between the factory and fishermen. If a pollution tax is levied on the factory with the proceeds given to the fishermen, then what outcome do you predict and why?
d) How do your answers to parts (a), (b), and (c) change if the cost of the water filter system was $3500?
e) Discuss the results of parts (a), (b), (c), and (d) in terms of the Coase Theorem.
Voluntary Action Moral suasion Informal community pressure
Command and Control Policies Mandate behavior coupled with enforcement Examples
Speed limits Minimum age restrictions Minimum wage
Why are standards popular? Simple and direct Moral appeal
Ambient Standards Never exceed level of a pollutant in
ambient environment DO can not fall below 3ppm
Expressed in terms of average concentration over time SO2: 80 μg/m3 annual; 365 μg/m3 daily
Can’t be enforced directly; must monitor emissions that lead to AQ levels
Emission Standards Never exceed levels applied directly to
quantities of emissions Expressed in terms of quantity per time
Tons per week Grams per hour
Emissions Environment AQ Meteorlogical Hydrological Human decisions
Technology Standards Mandated technologies, techniques, and
practices Examples
seat belts catalytic converters Scrubbers/baghouses
Emission Standards Applicable to New Snowmobiles
Carbon Monoxideg/kw-hr
Hydrocarbonsg/kw-hr
2005 397 150
2006/2007 275 100
2010 275 75
2012 200 75
Yellowstone 2005 120 15
Yellowstone Entry Standards Number of Snowmobiles Allowed (vehicles/day)
Clinton 2003 0
Bush 720
Noise Standards for Yellowstone
Decibels
Yellowstone 73 db
Elsewhere None
Economics of Standards
Setting the standard Should EPA consider damages and abatement costs?
Zero-Risk? Reasonably small level? Efficient level?
tradeoffs made by using avg. concentration levels over time
MDMAC
E0Et E*Emissions
$
E1
Uniformity of Standards Geographic differences: MDu > MDr
Single standard can’t be efficient
tradeoff: regulatory costs vs efficiency gains
$ MDuMAC
E0
Emissions
MDr
ErEu
Incentives for Improvements Technology Standards: no incentive
All or nothing!
Emission Standards: some incentive Polluters seek to reduce abatement costs Remember: pollution control R&D carried out by
pollution-control industry rather than polluting industries themselves
MD
MAC1
MAC2
Emissions
$
a
bc
d
e
E1E2
With MAC1: cost at E1 = a + bWith MAC2: cost at E1 = b
If E1 is the standard, then the incentivefor R&D = a “cost savings”
If standard is changed to E2 as new technology is adopted, then incentiveto innovate is (a – c)
Technology Forcing: If standard is set at E2 from the start then incentive to Innovate is (a + d + e)
E0
Input Standards or Output Standards?
Total Emissions =
Total Output X
Inputs used per unit of
outputX
Emissions per unit of
input
E = [Q] x [Inputs/Q] x [E/Inputs]
Auto Emissions = [# Vehicles] x [Miles/Vehicle] x [Emissions/Mile]
Emission Standards“end of tail pipe”
Economics of Enforcement Monitoring & Sanctioning Costs
MPC = Marginal Penalty Curve = P x F x E
With MPC1, firm only cuts back to E1
To get to E*, must raise MPC1 to MPC* Raise P Raise F
E* E1
MPC1
MPC*MAC
Emissions
$
E0
P = probability of detectionF = monetary fineE = emissions
P = 0.25F = $100/EE = 10,000
MPC = (.25)(100)(10,000) = $250,000
How do Standards Hold Up? Efficiency Cost Effectiveness Fairness Incentives for Technological Improvements Enforceability Morality
Efficiency Cost Effectiveness Fairness Incentives for Technological Improvements Enforceability Morality
Incentive-Based Strategies Emission Taxes Emission Subsidies
Emission Taxes Pigouvian taxes Government sets tax = $t per unit of emissions Polluter has incentive to reduce emissions until MAC = t Standard at E1 would only cost firm area "b"; much less
than the tax
b
E0E1
MAC
t
Emissions
Tax bill
Abatement Cost
$
MD
Optimal Tax Optimal t* occurs where MD = MAC
b
c
E1
MAC
E* E0
f
ed
a
t*
Reduced damages = e + f
Remaining damages = b + d
[Tax revenues are not includedin social cost calculation]
Two-part tax?Allow E1 emissions freeApply t* to anything above E1
Tax payment = c + d If MD is unknown, use iterative process:If AQ doesn’t improve raise tIf AQ improves too much lower t
Tax cost = a + b + c + d
Suppose that society's marginal abatement cost function is given by MAC = 50 - 2E and society's marginal damage function is given by MD = 3E. What is the optimal level of pollution emissions?
50 30 20 10 5
0% 0% 0%0%0%
a) 50b) 30c) 20d) 10e) 5
a) 50b) 30c) 20d) 10e) 5
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
According to the situation above, what would be the optimal per unit pollution tax?
50 40 30 20 10
0% 0% 0%0%0%
a) $50b) $40c) $30d) $20e) $10
a) $50b) $40c) $30d) $20e) $10
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Uniform Emissions Equimarginal principle is satisfied efficiency results possible even though agencies may know nothing
about MAC at sources (unlike standards, where agencies must know MAC)
Non-Uniform Emissions single tax not fully efficient: deals with differences in MAC, but not
differences in MD 1 unit reduction by Firm B is better than 1 unit reduction by Firm A
Firm A
Firm B
Efficiency
Warning: reducing emissions through one medium may increase emissions elsewhere
Zoned Taxes?
d
E0E1E2
a bc
e
MAC1
MAC2
t*
With tax t*:
MAC1: Cost = (d + e) + (a + b + c)
MAC2: Cost = (b + e) + (a)
Cost savings = c + dRecall: cost savings for standardat E1 was only d.
Incentive to Innovate
Enforcement costs Higher monitoring requirements compared to standards Non-point sources are difficult to monitor/tax Revenues give regulators incentive to monitor
Examples CO2 taxes: Scandinavia State emission fees for criteria pollutants
Enforcement and Examples
South Coast AQMD
For emissions in Calendar Year 2008
Annual Emissions (tons/yr)
Organic Gases ($/ton)
Specific Organics ($/ton)
Nitrogen Oxides ($/ton)
Sulfur Oxides ($/ton)
Carbon Monoxide
($/ton)
Particulate Matter ($/ton)
4 – 25 $517.08 $92.52 $302.52 $358.65 -- $395.41
> 25 – 75 $839.53 $146.58 $480.53 $579.77 -- $640.70
> 75 $1,2568.68 $219.87 $723.70 $870.45 -- $959.28
> 100 -- -- -- -- $6.18 --
Source: South Coast AQMD, Rule 301, Table III. Available at http://www.aqmd.gov/rules/reg/reg03/r301.pdf
Enforcement costs Higher monitoring requirements compared to standards Non-point sources are difficult to monitor/tax Revenues give regulators incentive to monitor
Examples CO2 taxes: Scandinavia State emission fees for criteria pollutants tax on cars to control auto emissions
total emissions per year = (E/mile) x (# miles per year)
Gasoline taxes
Enforcement and Examples
Federal tax is 18.4 cents per gallonSource: http://www.factsonfuel.org/gasoline/index.html
More examples… Non-point sources
Agricultural runoff pesticides fertilizer
Distortions? Trash stickers
pack more garbage into each bag tax on house windows
Tax the input, rather than output
Regulatory costs may be passed on to consumers through higher prices to workers through reduced employment (and lower
wages)
QuantityQ1Q2
P1
P2
S1S2
D1
$
Distributional Concerns
Subsidies Types
technology subsidies abatement subsidies
while emissions per firm may go down, new firms may be attracted to the industry!
Examples: deposit refund systems:
Cars Batteries Bottles/cans
Tax credits5¢: CA, CT, DE, HI, IA, ME, MA, NY, OR, VT10¢: MI
Current Models
Make ModelEstimated Tax
Credit
Chevrolet Malibu Hybrid $1,300
Chevrolet Tahoe Hybrid $2,200
Ford Escape Hybrid (2wd) $3,000
Ford Escape Hybrid (4wd) $2,200
GMC Yukon Hybrid $2,200
Honda Civic Hybrid (auto) $2,100
Lexus RX 400h $2,200
Lexus GS 450h $1,550
Mercedes GL 320 Bluetec (clean diesel) $1,800
Mercury Mariner Hybrid (2wd) $3,000
Nissan Altima $2,350
Saturn Vue Green Line $ 650
Saturn Aura Green Line $1,300
Toyota Camry Hybrid $2,600
Toyota Highlander Hybrid $2,600
Toyota Prius $3,150
Volkswagen Jetta TDI (clean diesel) $1,300
http://www.hybridcars.com/federal-incentives.html
Pollution Worksheet Marietta-Parkersburg area emissions:
Current emissions = 90,000 units Optimal emissions = 60,000 units
Marginal Abatement Cost Cars: $5 Utilities: $10 Factories: $20
Controlling pollution through: Standards Taxes Tradable Permits
StandardsSet a maximum emissions of 20,000 units per source:
SOURCE EMISSIONS EMISSIONSABATED
ABATEMENTCOSTS
CARS
UTILITIES
FACTORIES
TOTAL
20,000
20,000
20,000
60,000
0
10,000
20,000
30,000
0
$100,000
$400,000
$500,000
StandardsRequire each source to cut emissions by 10,000 units:
SOURCE EMISSIONS EMISSIONSABATED
ABATEMENTCOSTS
CARS
UTILITIES
FACTORIES
TOTAL
10,000
20,000
30,000
60,000
10,000
10,000
10,000
30,000
$50,000
$100,000
$200,000
$350,000
StandardsRequire each source to cut emissions by 1/3:
SOURCE EMISSIONS EMISSIONSABATED
ABATEMENTCOSTS
CARS
UTILITIES
FACTORIES
TOTAL
$ 33,335
$100,000
$266,660
$399,995
13,333
20,000
26,667
60,000
6,667
10,000
13,333
30,000
StandardsCost-minimizing strategy of reducing emissions by 60,000 units.
“$200,000 Solution”
SOURCE EMISSIONS EMISSIONSABATED
ABATEMENTCOSTS
CARS
UTILITIES
FACTORIES
TOTAL
0
20,000
40,000
60,000
20,000
10,000
0
30,000
$100,000
$100,000
0
$200,000
Taxes
SOURCE EMISSIONS EMISSIONSABATED
ABATEMENTCOSTS
TAX COSTS
CARS
UTILITIES
FACTORIES
TOTAL
0
30,000
40,000
70,000
20,000
0
0
20,000
$100,000
0
0
$100,000
A tax of t = $6 per unit of pollution is imposed:
$180,000
$240,000
$420,000
0
Taxes
SOURCE EMISSIONS EMISSIONSABATED
ABATEMENTCOSTS
TAX COSTS
CARS
UTILITIES
FACTORIES
TOTAL
0
0
40,000
40,000
20,000
30,000
0
50,000
$100,000
$300,000
0
$400,000
A tax of t = $11 per unit of pollution is imposed:
0
$440,000
$440,000
0
AuctionRevenue
Tradable Permits
permits
$
$20
$10
$5
40 70 90
F
U
C
D
S
60
Abatement Cost
P = $10Q = 60,000
“$200,000 Solution”
= MAC
Tradable Discharge Permits TDPs rely on decentralized cooperation
Central authority sets aggregate # permits (CAP) Each polluter is allocated certain number of
emission permits Each permit allows 1 ton of SO2
Polluter must then make a choice: Reduce emissions to level covered by allocated
permits Reduce emissions below original permit level,
then sell excess permits Buy additional permits (to enable expanded
production)
TDPs rely on decentralized cooperation Central authority sets aggregate # permits (CAP) Each polluter is allocated certain number of
emission permits Each permit allows 1 ton of SO2
Polluter must then make a choice: Reduce emissions to level covered by allocated
permits Reduce emissions below original permit level,
then sell excess permits Buy additional permits (to enable expanded
production)
Permit Market Buyers
New firms Existing firms looking to
expand Sellers
Firms leaving area/industry Those who’ve invested in
efficient technology
D
S
Q*
P*
Permits
$
Permits flow from low MAC polluters to high MAC polluters so as to satisfy equimarginal principle
2008 Spot Auction
2008 7-yr Advance Auction
Trading Rules Should be simple and clear to minimize
uncertainty Initial Permit Allocation?
Equal allocation? Ignores differences in firm size
According to existing emissions? Ignores that some firms have already cut emissions
Give away or auction? Coase Theorem
Trading Rules… Who may participate?
Local, regional, national, international polluters?
Environmental groups? Speculators?
How will trades take place? Sealed bids for annual EPA auction Brokers are used for secondary markets Do regulators have veto power?
Urban Area
Potential Problems Market power Thin markets Permit life span Hot spots (non-uniform emissions)
Tradeoff: competitive markets vs. enviro damage
PrevailingWind
A
BC
D
“transfer coefficient”
Enforcement EPA must monitor:
Number of permits in possession of each polluter CBOT
Quantity of emissions from each source Incentive for polluters to monitor each other to prevent
cheating (reduces demand for permits)
de
75
Incentives for Innovation
Cost savings as good as emission taxes
MAC1
MAC2
MAC1 = 200 - 2E1
MAC2 = 100 – E2
10050
Permit price = $50
$50
TAC with MAC1 = d + e = $625
TAC with MAC2 = b + e = $1250
Revenue from TDP = b + c = $1250
Cost Savings =
cba
(d+e) – (b+e) + (b+c) = d + c = $625
$$200
$100
emissions
Which of the following is a criterion for evaluating environmental policies?
20% 20% 20%20%20%a) efficiency b) fairness c) incentives to improvements d) enforceabilitye) All of the above
Private bargaining can lead people to the efficient outcome if
a) b) c) d)
0% 0%0%0%
a) transactions costs are low and property rights are well defined
b) transactions costs are high and property rights are ill defined
c) transactions costs are high and property rights are well defined
d) transactions costs are low and property rights are ill defined
The two defining features of command-and-control regulation are
a) b) c) d)
0% 0%0%0%
a) cost-effectiveness and flexible standards
b) pollution taxes and marketable permits c) uniform standards and technology-
based regulations d) monitoring and compliance
Emission taxes are generally regarded as efficient since
a) b) c) d)
0% 0%0%0%
a) they raise the maximum amount of revenue possible for the IRS
b) they encourage all pollution sources to completely eliminate their emissions
c) they require environmental regulators to know the individual source marginal abatement
d) they encourage all pollution sources to adjust their emissions so that the equimarginal principle is satisfied.
Emission taxes are more likely to be effective when applied to
a) b)
0%0%
a) nonpoint sources of pollution b) point sources of pollution
Marketable pollution permits require a slightly more complex system when there are geographic differences in pollution effects. One possible approach to designing a system of permits would be to:
a) b) c) d)
0% 0%0%0%
a) use technology-based standards in conjunction with the permits
b) auction off the permits one-by-one over time until all permits have been allocated
c) simply give the permits away to polluters based on their historic emissions rate
d) establish separate markets for each subregion
