December 2004 RFF DP DISCUSSION PAPER. Environmental Economics. Robert N. Stavins P St. NW Washington, DC

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1 DISCUSSION PAPER December 2004 RFF DP Envronmental Economcs Robert N. Stavns 1616 P St. NW Washngton, DC

2 ENVIRONMENTAL ECONOMICS Robert N. Stavns John F. Kennedy School of Government, Harvard Unversty and Resources for the Future Prepared for The New Palgrave Dctonary of Economcs, 2 nd Edton Lawrence Blume and Steven Durlauf General Edtors London: Palgrave Macmllan Ltd. December 23, 2004 Send Comments to: Prof. Robert N. Stavns John F. Kennedy School of Government Harvard Unversty 79 John F. Kennedy Street Cambrdge, Massachusetts Phone: Fax: E-Mal: robert_stavns@harvard.edu

3 ABSTRACT Ths artcle, prepared for the forthcomng second edton of the New Palgrave Dctonary of Economcs, provdes an overvew of the economcs of envronmental polcy. Included are the settng of goals and targets, notably the Kaldor-Hcks crteron, and the related method of assessment known as beneft-cost analyss. Also revewed are the means of envronmental polcy, that s, the choce of specfc polcy nstruments, featurng an examnaton of potental crtera for assessng alternatve nstruments, wth focus on cost-effectveness. The theoretcal foundatons and experental hghlghts of ndvdual nstruments are revewed, ncludng conventonal command-and-control mechansms and market-based nstruments. Keywords: envronmental economcs, effcency, cost-effectveness, beneft-cost analyss, market-based nstruments, tradable permts, polluton taxes JEL Classfcaton: K320, Q280, Q380, Q Resources for the Future. All rghts reserved. No porton of ths paper may be reproduced wthout permsson of the authors. Dscusson papers are research materals crculated by ther authors for purposes of nformaton and dscusson. They have not necessarly undergone formal peer revew.

4 ENVIRONMENTAL ECONOMICS (5,799 words; 7,812 words wth bblography) Robert N. Stavns * The fundamental theoretcal argument for government actvty n the envronmental realm s that polluton s an externalty an unntended consequence of market decsons, whch affects ndvduals other than the decson maker. Provdng ncentves for prvate actors to nternalze the full costs of ther actons was long thought to be the theoretcal soluton to the externalty problem. The prmary advocate of ths vew was Arthur Pgou, who n The Economcs of Welfare (1920) proposed that the government should mpose a tax on emssons equal to the cost of the related damages at the effcent level of control. A response to the Pgovan perspectve was provded by Ronald Coase n The Problem of Socal Cost (1960). Coase demonstrated that n a blateral barganng envronment wth no transacton costs, wealth or ncome effects, or thrd-party mpacts, two negotatng partes wll reach socally desrable agreements, and the overall amount of polluton wll be ndependent of the assgnment of property rghts. At least some of the specfed condtons are unlkely to hold for most envronmental problems. Hence, prvate negotaton wll not n general fully nternalze envronmental externaltes. Crtera for Envronmental Polcy Evaluaton More than 100 years ago, Vlfredo Pareto enuncated the well-known normatve crteron for judgng whether a socal change makes the world better off: a change s Pareto effcent f at least one person s made better off, and no one s made worse off (1896). Ths crteron has consderable normatve appeal, but vrtually no publc polces meet the test. Nearly ffty years later, Ncholas Kaldor (1939) and John Hcks (1939) postulated a more pragmatc crteron that seeks to dentfy potental Pareto mprovements: a change s welfare-mprovng f those who gan from the change could n prncple fully compensate the losers, wth (at least) one ganer stll beng better off. The Kaldor-Hcks crteron a test of whether total socal benefts exceed total socal costs s the theoretcal foundaton for the use of the analytcal devce known as beneft-cost (or net present value) analyss. If the objectve s to maxmze the dfference between benefts and costs (net benefts), then the related level of envronmental protecton (polluton abatement) s defned as the effcent level of protecton: max [ B ( q ) C ( q )] q { q } N = 1 * (1) * Albert Pratt Professor of Busness and Government at the John F. Kennedy School of Government, Drector of the Envronmental Economcs Program at Harvard Unversty, and Unversty Fellow, Resources for the Future. Ths artcle draws, n part, on Revesz and Stavns (2005). Helpful comments on a prevous verson were provded by Lor Bennear and Nathanel Keohane. 1

5 where q s abatement by source ( = 1 to N), B ( ) s the beneft functon for source, C ( ) s the cost functon for the source, and q * s the effcent level of protecton (polluton abatement). The key necessary condton that emerges from the maxmzaton problem of equaton (1) s that margnal benefts be equated wth margnal costs (assumng convexty of the respectve functons). The Kaldor-Hcks crteron s clearly more practcal than the strct Pareto crteron, but ts normatve standng s less sold, Some have argued that other factors should be consdered n a measure of socal well-beng, and that crtera such as dstrbutonal equty should trump effcency consderatons n some collectve decsons (Sagoff, 1993). Many economsts would agree wth ths asserton, and some have noted that the Kaldor-Hcks crteron should be consdered nether a necessary nor suffcent condton for publc polcy (Arrow et al., 1996). Beneft-Cost Analyss of Envronmental Regulatons The soundness of emprcal beneft-cost analyss rests upon the avalablty of relable estmates of socal benefts and costs, ncludng estmates of the socal dscount rate. The present value of net benefts (PVNB) s defned as: T t PVNB = {( B C ) (1 + r) } t = 0 t t (2) where B t are benefts at tme t, C t are costs at tme t, r s the dscount rate, and T s the termnal year of the analyss. A postve PVNB means that the polcy or project has the potental to yeld a Pareto mprovement (meets the Kaldor-Hcks crteron). Thus, carryng out beneft-cost or net present value (NPV) analyss requres dscountng to translate future mpacts nto equvalent values that can be compared. In essence, the Kaldor-Hcks crteron provdes the ratonale both for beneft-cost analyss and for dscountng (Goulder and Stavns, 2002). Choosng the dscount rate to be employed n an analyss can be dffcult, partcularly where mpacts are spread across a large number of years nvolvng more than a sngle generaton. In theory, the socal dscount rate could be derved by aggregatng the ndvdual tme preference rates of all partes affected by a polcy. Evdence from market behavor and from expermental economcs ndcates that ndvduals may employ lower dscount rates for mpacts of larger magntude, hgher dscount rates for gans than for losses, and rates that declne wth the tme span beng consdered (Cropper, Aydede, and Portney, 1994; Cropper and Labson, 1999). In partcular, there has been support for the use of hyperbolc dscountng and smlar approaches wth declnng dscount rates over tme (Ansle, 1991; Wetzman, 1994, 1998), but most of these approaches are subject to tme nconsstency. The Costs of Envronmental Regulatons In the envronment context, the economst's noton of cost, or more precsely, opportunty cost, s a measure of the value of whatever must be sacrfced to prevent or reduce the rsk of an envronmental mpact. A full taxonomy of envronmental costs ranges from the most obvous to the least drect (Jaffe et al., 1995). 2

6 Methods of drect complance cost estmaton, whch measure the costs to frms of purchasng and mantanng polluton-abatement equpment plus costs to government of admnsterng a polcy, are acceptable when behavoral responses, transtonal costs, and ndrect costs are small. Partal and general equlbrum analyss allow for the ncorporaton of behavoral responses to changes n publc polcy. Partal equlbrum analyss of complance costs ncorporates behavoral responses by modelng supply and/or demand n major affected markets, but assumes that the effects of a regulaton are confned to one or a few markets. Ths may be satsfactory f the markets affected by the polcy are small n relaton to the overall economy, but f an envronmental polcy s expected to have large consequences for the economy, general equlbrum analyss s requred, such as through the use of computable general equlbrum models (Hazlla and Kopp, 1990; Conrad, 2002). The potental nteracton of abatement costs wth pre-exstng taxes ndcates the mportance of employng general equlbrum models for comprehensve cost analyss. Revenue recyclng (usng emsson tax or auctoned permt revenues to reduce dstortonary taxes) can sgnfcantly lower the costs of polluton control, relatve to what costs would otherwse be (Goulder, 1995). In a retrospectve examnaton of 28 envronmental and occupatonal safety regulatons, Harrngton, Morgenstern, and Nelson (2000) found that fourteen cost estmaton analyses had produced ex ante cost estmates that exceeded actual ex post costs, apparently due to technologcal nnovaton stmulated by market-based nstruments (see below). The Benefts of Envronmental Regulatons Protectng the envronment usually nvolves actve employment of captal, labor, and other scarce resources. The benefts of an envronmental polcy are defned as the collecton of ndvduals wllngness to pay (WTP) for the reducton or preventon of envronmental damages or ndvduals wllngness to accept (WTA) compensaton to tolerate such envronmental damages. In theory, whch measure of value s approprate for assessng a partcular polcy depends upon the related assgnment of property rghts, the nature of the status quo, and whether the change beng measured s a gan or a loss, but under a varety of condtons, the dfference between the two measures may be expected to be relatvely small (Wllg, 1976). Emprcal evdence suggests larger than expected dfferences between wllngness to pay and wllngness to accept (Fsher, McClelland and Schulze, 1988). Theoretcal explanatons nclude psychologcal averson to loss and poor substtutes for envronmental amentes (Hanemann, 1991). The benefts people derve from envronmental protecton can be categorzed as beng related to human health (mortalty and morbdty), ecologcal mpacts (both market and non-market), or materals damage. A crtcal dstncton s between use value and non-use value. In addton to the drect benefts (use value) people receve through protecton of ther health or through use of a natural resource, people also derve passve or non-use value from envronmental qualty, partcularly n the ecologcal doman. For example, an ndvdual may value a change n an envronmental good because she wants to preserve the good for her hers (bequest value). Stll other people may envson no current or future use by themselves or ther hers, but stll wsh to protect the good because they beleve t should be protected or because they derve satsfacton from smply knowng t exsts (exstence value). 3

7 How much would ndvduals sacrfce to acheve a small reducton n the probablty of death durng a gven perod of tme? How much compensaton would ndvduals requre to accept a small ncrease n that probablty? These are reasonable economc questons, because most envronmental regulatons result n very small changes n ndvduals mortalty rsks. Hedonc wage studes, averted behavor, and contngent valuaton (all dscussed below) can provde estmates of margnal wllngness to pay or wllngness to accept for small changes n mortalty rsk, and such estmates can be normalzed as the value of a statstcal lfe (VSL). The VSL s not the value of an ndvdual lfe nether n ethcal terms, nor n techncal, economc terms. Rather t s smply a conventon: VSL = MWTP or MWTA( from hedonc wage or CV ) Small Rsk Change (3) where MWTP and MWTA, respectvely, refer to margnal wllngness to pay and margnal wllngness to accept. For example, f people are wllng, on average, to pay $12 for a rsk reducton from 5 n 500,000 to 4 n 500,000, equaton (3) would yeld: $12 VSL = = $6,000,000 (4) Thus, VSL quantfes the aggregate amount that a group of ndvduals are wllng to pay for small reductons n rsk, standardzed (extrapolated) for a rsk change of 1.0. It s not the economc value of an ndvdual lfe, because the VSL calculaton does not sgnfy that an ndvdual would pay $6 mllon to avod (certan) death ths year, or accept (certan) death ths year n exchange for $6 mllon. Revealed Preference Methods of Envronmental Beneft Estmaton The avertng behavor method, n whch values of wllngness to pay are nferred from observatons of people s behavoral responses to changes n envronmental qualty, s grounded n the household producton functon framework (Bockstael and McConnell, 1983). People sometmes take actons to reduce the rsk (avertng behavor) or lessen the mpacts (mtgatng behavor) of envronmental damages, for example, by purchasng water flters or bottled water. In theory, people s perceptons of the cost of avertng behavor and ts effectveness should be measured (Cropper and Freeman, 1991), but n practce actual expendtures on avertng and mtgatng behavors are typcally employed. An addtonal challenge s posed by the necessty of dsentanglng attrbutes of the market good or servce. Recreatonal actvtes represent a potentally large class of benefts that are mportant n assessng polces affectng the use of publc lands. The models used to estmate recreaton demand fall wthn the class of household producton models. Travel cost models (or Hotellng-Clawson- Knetsch models) use nformaton about tme and money spent vstng a ste to nfer the value of that recreatonal resource (Bockstael 1996). The smplest verson of the method nvolves one ste and uses data from surveys of users from varous geographc orgns, together wth estmates of the cost 4

8 of travel and opportunty cost of tme to nfer a demand functon relatng the number of trps to the ste as a functon of people s wllngness to pay for the experence. Random utlty models explctly model the consumer s decson to choose a partcular ste from among recreaton locatons, assessng the probablty of vstng each locaton. Such models can be used to value changes n envronmental qualty by comparng decsons to vst alternatve stes (Phaneuf and Smth 2004). All recreaton demand models share lmtatons. Frst, the valuaton of costs depends on estmates of the opportunty cost of (lesure) tme, whch s notorously dffcult to estmate. Also, most trps to a recreaton ste are part of a mult-purpose experence. In addton, random utlty models rely on people s perceptons of envronmental qualty changes. Fnally, lke all revealedpreference approaches, recreaton demand models can be used to estmate use value only; non-use value cannot be examned. An alternatve approach to assessng people s wllngness to pay for recreatonal experences s to draw on evdence from prvate optons to use publc goods. Ths approach also fts wthn the household producton framework, and s based upon the noton of estmatng the derved demand for a prvately traded opton to utlze a freely-avalable publc good. In partcular, the demand for state fshng lcenses has been used to nfer the benefts of recreatonal fshng (Bennear, Stavns, and Wagner, 2003). Usng panel data on fshng lcense sales and prces, combned wth data on substtute prces and demographc varables, a lcense demand functon was estmated, from whch the expected benefts of a recreatonal fshng day were derved. Hedonc prcng methods are founded on the proposton that people value goods n terms of the bundles of attrbutes that consttute those goods. Hedonc property value methods employ data on resdental property values and home characterstcs, ncludng structural, neghborhood, and envronmental qualty attrbutes (Palmqust, 2003). By regressng the property value on key attrbutes, the hedonc prce functon s estmated: P = f ( x, z, e) where P = housng prce (ncludes land); = vector of structural attrbutes; x = vector of neghborhood attrbutes; and z e = envronmental attrbute of concern. (5) From the estmated hedonc prce functon of equaton (5), the margnal mplct prce of any attrbute, ncludng envronmental qualty, can be calculated as the partal dervatve of the housng prce wth respect to the gven attrbute: P f () = = e e P e (6) Ths margnal mplct prce, P e, measures the aggregate margnal wllngness to pay for the attrbute n queston. For purposes of beneft estmaton, the demand functon for the attrbute s requred, and so t s necessary to examne how the margnal mplct prce of the envronmental 5

9 attrbute vares wth changes n the quantty of the attrbute and other relevant varables. If the hedonc prce equaton (5) s non-lnear, then ftted values of P e can be calculated as e s vared, and a second-stage equaton can be estmated: where ^ P e y ^ P = g( e, y) e = the ftted value of the margnal mplct prce of e from the frst-stage equaton; and = a vector of factors that affect margnal wllngness to pay for e, ncludng buyer characterstcs. (7) Equaton (7), above, has been nterpreted as the demand functon for the envronmental attrbute from whch benefts (consumers surplus) can be estmated n the ususal way but there are problems. Most mportant among these s the queston of whether a demand functon has actually been estmated, snce envronmental qualty may affect both the demand for housng and ts supply, rasng the classc dentfcaton problem. In addton, nformatonal asymmetres may dstort the analyss. Also, because the hedonc property method s based on analyss of margnal changes, t should not be appled to analyss of polces wth large antcpated effects. A related beneft-estmaton technque s the hedonc wage method, based on the realty that ndvduals n well functonng labor markets make trade-offs between wages and rsk of on-the-job njures (or death). A job s a bundle of characterstcs, ncludng ts wage, responsbltes, and rsk, among others factors. Two jobs that requre the same skll level but have dfferent rsks of on-thejob mortalty wll pay dfferent wages. On the labor supply sde, employees tend to requre extra compensaton to accept jobs wth greater rsks; and on the labor demand sde, employers are wllng to offer hgher wages to attract workers to rsker jobs. Hence, labor market data on wages and job characterstcs can be used to estmate people s margnal mplct prce of rsk, that s, ther valuaton of rsk. By regressng the wage on key attrbutes, the hedonc prce functon s estmated: W = h( x, r) where W = wage (n annual terms); = vector of worker and job characterstcs; and x r = mortalty rsk of job. (8) The margnal mplct prce of rsk s calculated as the partal dervatve of the annual wage wth respect to the measured mortalty rsk: W h() = = r r W r (9) Ths margnal mplct prce of rsk s the average annual ncome necessary to compensate a worker for a margnal change n rsk throughout the year, and t vares wth the level of rsk. 6

10 Many of the ssues that arse wth the hedonc property value method have parallels here. Frst, there s the possblty of smultanety: causalty between rsk and wages can run n both drectons. Also, f ndvduals perceptons of rsk do not correspond wth actual rsks, then the margnal mplct prce of rsk calculated from a hedonc wage study wll be based, and mperfectons n labor markets (less than perfect moblty) can cause further problems. Drect applcaton of the method n the envronmental realm s lmted to occupatonal, as opposed to envronmental exposures and rsks. Yet hedonc wage methods are of consderable mportance n the envronmental polcy realm, because the results from hedonc wage studes have frequently been used through beneft transfer to nfer the value of a statstcal lfe (VSL). In such applcatons, the hedonc wage method brngs wth t possble bas, because studes typcally focus on rsky occupatons, whch may attract workers who are systematcally less rsk-averse. Standard economc theory would suggest that younger people would have hgher values for rsk reducton because they have a longer expected lfe remanng before them and thus a hgher expected lfetme utlty (Moore and Vscus, 1988; Cropper and Sussman, 1990). On the other hand, some models and emprcal evdence suggest that older people may n fact have a hgher demand for reducng mortalty rsks than younger people, and that the value of a lfe may follow an nverted-u shape over the lfe-cycle, wth ts peak durng md-lfe (Shepard and Zeckhauser, 1982; Mrozek and Taylor, 2002; Vscus and Aldy, 2003; Albern et al., 2004). Stated Preference Methods of Envronmental Beneft Estmaton In the best known stated preference method, contngent valuaton (CV), survey respondents are presented wth scenaros that requre them to trade-off, hypothetcally, somethng for a change n an envronmental good or servce (Mtchell and Carson, 1989; Boyle, 2003). The smplest approach s to ask people for ther maxmum wllngness to pay, but there are few real markets n whch ndvduals are actually asked to generate ther reservaton prces, and so ths method s consdered unrelable. In a bddng game, the researcher begns by statng a wllngness-to-pay number, asks for a yes-no response, and then ncreases or decreases the amount untl ndfference s acheved. The problem wth ths approach s startng-pont bas. A related approach s the use of a payment card shown to the respondent, but the range of WTP on the card may ntroduce bas, and the approach cannot be used wth telephone surveys. Fnally, the referendum (dscrete choce) approach s favored by researchers. Each respondent s offered a dfferent WTP number, to whch a smple yes-no response s solcted. The prmary advantage of contngent valuaton s that t can be appled to a wde range of stuatons, ncludng use as well as non-use value, but potental problems reman. Respondents may not understand what they are beng asked to value. Ths may ntroduce greater varance, f not bas n responses. Lkewse, respondents may not take the hypothetcal market serously, because no budget constrant s mposed. Ths can ncrease varance and bas. On the other hand, f the scenaro s too realstc, strategc bas may be expected to show up n responses. Fnally, the warm glow effect may plague some stated preference surveys: people may purchase moral satsfacton wth large, but unreal statements of ther wllngness-to-pay (Andreon, 1995). 7

11 The 1989 Exxon Valdez ol spll off the coast of Alaska led to massve ltgaton, and resulted n the most promnent use ever of the concept of non-use value and the method of contngent valuaton for ts estmaton. The result was a symposum sponsored by the Exxon Corporaton attackng the CV method (Hausman, 1993), and the subsequent creaton of a government panel establshed by the Natonal Oceanc and Atmospherc Admnstraton (NOAA) and chared by two Nobel laureates n economcs to assess the scentfc valdty of the CV method. The NOAA panel concluded that CV studes can produce estmates relable enough to be the startng pont of a judcal process of damage assessment, ncludng lost passve (non-use) values (Arrow et al., 1993, p. 4610). The panel offered ts approval of CV methods subject to a set of best-practce gudelnes. It s mportant to dstngush between legtmate methods of beneft estmaton and approaches sometmes encountered n the polcy process that do not measure wllngness-to-pay or wllngness-to-accept. Frequently msused technques nclude: (1) employng as proxes for the benefts of a polcy estmates of the cost avoded by not usng the next most costly means of achevng the polcy s goals; (2) socetal revealed preference models, whch seek to nfer the benefts of a proposed polcy from the costs of prevous regulatory actons; and (3) cost-of-llness or human-captal measures whch estmate explct market costs resultng from changes n morbdty or mortalty. Because none of these approaches provde estmates of WTP or WTA, these technques do not provde vald measures of economc benefts. Choosng Instruments: The Means of Envronmental Polcy Even f the goals of envronmental polces are gven, economc analyss can brng nsghts to the assessment and desgn of envronmental polces. One mportant crteron s costeffectveness, defned as the allocaton of control among sources that results n the aggregate target beng acheved at the lowest possble cost, that s, the allocaton whch satsfes the followng costmnmzaton problem: mn C = c( r) { r } N = 1 N = 1 s.. t [ u r] E and r u 0 _ (10) (11) (12) where r = reductons n emssons (abatement or control) by source ( = 1 to N); c (r ) = cost functon for source ; C = aggregate cost of control; u = uncontrolled emssons by source ; and Ē = the aggregate emssons target mposed by the regulatory authorty. 8

12 If the cost functons are convex, then necessary and suffcent condtons for satsfacton of the constraned optmzaton problem posed by equatons (10) through (12) are the followng, among others (Kuhn and Tucker 1951): c( r) r λ 0 (13) r c( r) λ = r 0 (14) Equatons (13) and (14) together mply the crucal condton for cost-effectveness that all sources (that exercse some degree of control) experence the same margnal abatement costs (Baumol and Oates, 1988). Thus, when examnng envronmental polcy nstruments, a key queston s whether margnal abatement costs are lkely to be beng equated across sources. Command-and-Control versus Market-Based Instruments Conventonal approaches to regulatng the envronment frequently characterzed as command-and-control allow relatvely lttle flexblty n the means of achevng goals. Such polcy nstruments tend to force frms to take on equal shares of the polluton-control burden, regardless of the cost. The most prevalent form of unform command-and-control standards are technology standards that specfy the adopton of specfc polluton-control technologes, and performance standards whch specfy unform lmts on the amount of polluton a faclty can generate. In theory, non-unform performance standards could be made to be cost-effectve, but the government typcally lacks the requste nformaton (on margnal costs of ndvdual sources). Market-based nstruments encourage behavor through market sgnals, rather than through explct drectves regardng polluton control levels or methods. Market-based nstruments fall wthn four categores: polluton charges, tradeable permts, market-frcton reductons, and government subsdy reductons. Lablty rules may also be thought of as a market-based nstrument, because they provde ncentves for frms to take nto account the potental envronmental damages of ther decson. Where there s sgnfcant heterogenety of abatement costs, command-and-control methods wll not be cost-effectve. In realty, costs can vary enormously due to producton desgn, physcal confguraton, age of assets, and other factors. For example, the margnal costs of controllng lead emssons have been estmated to range from $13 to $56,000 per ton (Hartman, Wheeler, and Sngh, 1994; Morgenstern, 2000). But where costs are smlar among sources, command-and-control nstruments may perform equvalent to (or better than) market-based nstruments, dependng on transactons costs, admnstratve costs, possbltes for strategc behavor, poltcal costs, and the nature of the pollutants (Newell and Stavns, 2003). In theory, market-based nstruments allow any desred level of polluton cleanup to be realzed at the lowest overall cost, by provdng ncentves for the greatest reductons n polluton by those frms that can acheve the reductons most cheaply. Rather than equalzng polluton levels 9

13 among frms, market-based nstruments equalze ther margnal abatement costs (Montgomery, 1972). In addton, market-based nstruments have the potental to brng down abatement costs over tme by provdng ncentves for companes to adopt cheaper and better polluton-control technologes. Ths s because wth market-based nstruments, most clearly wth emsson taxes, t pays frms to clean up a bt more f a suffcently low-cost method (technology or process) of dong so can be dentfed and adopted (Downng and Whte, 1986; Maleug, 1989; Mllman and Prnce, 1989; Jaffe and Stavns, 1995). However, the rankng among polcy nstruments, n terms of ther respectve mpacts on technology nnovaton and dffuson s ambguous (Jaffe, Newell, and Stavns, 2003). Closely related to the effects of nstrument choce on technologcal change are the effects of vntage-dfferentated regulaton on the rate of captal turnover, and thereby on polluton abatement costs and envronmental performance. Vntage-dfferentated regulaton s a common feature of many envronmental polces, wheren the standard for regulated unts s fxed n terms of ther date of entry, wth later vntages facng more strngent regulaton. Such vntagedfferentated regulatons can be expected to retard turnover n the captal stock, and thereby to reduce the cost-effectveness of regulaton. Under some condtons the result can be hgher levels of pollutant emssons than would occur n the absence of regulaton. Such economc and envronmental consequences are not only predctons from theory (Maloney and Brady, 1988); both types of consequences have been valdated emprcally (Gruenspecht, 1982; Nelson, Tetenberg, Donhue, 1993). Polluton Charges Polluton charge systems assess a fee or tax on the amount of polluton that frms or sources generate (Pgou, 1920). By defnton, actual emssons are equal to unconstraned emssons mnus emssons reductons, that s, e = u - r. A source s cost mnmzaton problem n the presence of an emssons tax, t, s gven by: mn [ c ( r) + t ( u r)] { r } st.. r 0 (15) (16) The result for each source s: c( r) r t 0 (17) r c ( r) t = r 0 (18) Equatons (17) and (18) mply that each source (that exercses a postve level of control) wll carry out abatement up to the pont where ts margnal control costs are equal to the tax rate. Hence, 10

14 margnal abatement costs are equated across sources, satsfyng the condton for cost-effectveness specfed by equatons (13) and (14), at least n the smplest case of a unformly-mxed pollutant. In the non-unformly-mxed pollutant case, where hot spots can be an ssue, the respectve costeffectve nstrument s an ambent charge. A challenge wth charge systems s dentfyng the approprate tax rate. For socal effcency, t should be set equal to the margnal benefts of cleanup at the effcent level of cleanup (Pgou, 1920), but polcy makers are more lkely to thnk n terms of a desred level of cleanup, and they do not know beforehand how frms wll respond to a gven level of taxaton. An addtonal problem s that despte the fact that such systems mnmze aggregate socal costs, these systems may be more costly than comparable command-and-control nstruments for regulated frms, because frms pay both ther abatement costs plus taxes on ther resdual emssons. If charges are broadly defned, many applcatons can be dentfed (Stavns, 2003). Comng closest to true Pgovan are the ncreasngly common unt-charge systems for fnancng muncpal sold waste collecton, where households and busnesses are charged the ncremental costs of collecton and dsposal. Another mportant set of charge systems has been depost refund systems, whereby consumers pay a surcharge when purchasng potentally pollutng products, and receve a refund when returnng the product to an approved center for recyclng or dsposal. A number of countres and states have mplemented ths approach to control ltter from beverage contaners and to reduce the flow of sold waste to landflls (Bohm, 1981; Menell, 1990), and the concept has also been appled to lead-acd batteres. There has also been consderable use of envronmental user charges, through whch specfc envronmentally related servces are funded. Examples nclude nsurance premum taxes (Barthold, 1994). Another set of envronmental charges are sales taxes on motor fuels, ozone-depletng chemcals, agrcultural nputs, and low-mleage motor vehcles. Fnally, tax dfferentaton has been used to encourage the use of renewable energy sources. Tradeable Permt Systems Tradeable permts can acheve the same cost-mnmzng allocaton as a charge system, whle avodng the problems of uncertan frm responses and the dstrbutonal consequences of taxes. Under a tradable permt system, an allowed overall level of polluton, Ē, s establshed, and allocated among sources n the form of permts. Frms that keep emsson levels below allotted levels may sell surplus permts to other frms or use them to offset excess emssons n other parts of ther operatons. Let q 0 be the ntal allocaton of emsson permts to source, such that: N = 1 q 0 = E (19) Then, f p s the market-determned prce of tradeable permts, a sngle frm s cost mnmzaton problem s gven by: mn[ cr ( ) + pu ( r q )] {} r 0 (20) 11

15 st.. r 0 (21) The result for each source s: c( r) r p 0 (22) r c( r) p = r 0 (23) Equatons (22) and (23) together mply that each source (that exercses a postve level of control) wll carry out abatement up to the pont where ts margnal control costs are equal to the marketdetermned permt prce. Hence, the envronmental constrant, Ē, s satsfed, and margnal abatement costs are equated across sources, satsfyng the condton for cost-effectveness. The unque cost-effectve equlbrum s acheved ndependent of the ntal allocaton of permts (Montgomery, 1972), whch s of great poltcal sgnfcance. The performance of a tradeable permt system can be adversely affected by: concentraton n the permt market (Hahn, 1984; Msolek and Elder, 1989); concentraton n the product market (Maleug, 1990); transacton costs (Stavns, 1995); non-proft maxmzng behavor, such as sales or staff maxmzaton (Tschrhart, 1984); the preexstng regulatory envronment (Boh and Burtraw, 1992); and the degree of montorng and enforcement (Montero, 2003). Tradeable permts have been the most frequently used market-based system (U.S. Envronmental Protecton Agency, 2000). Sgnfcant applcatons nclude: the emssons tradng program (Tetenberg, 1985; Hahn, 1989); the leaded gasolne phasedown; water qualty permt tradng (Hahn, 1989; Stephenson, Norrs, and Shabman, 1998); CFC tradng (Hahn and McGartland, 1989); the sulfur doxde (SO 2 ) allowance tradng system for acd ran control (Schmalensee et al., 1998; Stavns, 1998; Carlson et al., 2000; Ellerman et al., 2000); the RECLAIM program n the Los Angeles metropoltan regon (Harrson, 1999); and tradeable development rghts for land use. Market Frcton Reducton Market frcton reducton can serve as a polcy nstrument for envronmental protecton. Market creaton establshes markets for nputs or outputs assocated wth envronmental qualty. Examples of market creaton nclude measures that facltate the voluntary exchange of water rghts and thus promote more effcent allocaton and use of scarce water supples (Howe, 1997), and polces that facltate the restructurng of electrcty generaton and transmsson. Snce wellfunctonng markets depend, n part, on the exstence of well-nformed producers and consumers, nformaton programs can help foster market-orented solutons to envronmental problems. These programs have been of two types. Product labelng requrements have been mplemented to mprove nformaton sets avalable to consumers, whle other programs have nvolved reportng requrements (Hamlton, 1995; Konar and Cohen 1997; Khanna, Qumo, and Bojlova 1998). 12

16 Government Subsdy Reducton Government subsdy reducton consttutes another category of market-based nstruments. Subsdes are the mrror mage of taxes and, n theory, can provde ncentves to address envronmental problems. Although subsdes can advance envronmental qualty (see, for example, Jaffe and Stavns, 1995), t s also true that subsdes, n general, have mportant dsadvantages relatves to taxes (Dewees and Sms, 1976; Baumol and Oates, 1988). Because subsdes ncrease profts n an ndustry, they encourage entry, and can thereby ncrease ndustry sze and polluton output (Mestelman, 1982; Kohn, 1985). In practce, rather than nternalzng externaltes, many subsdes promote economcally neffcent and envronmentally unsound practces. In such cases, reducng subsdes can ncrease effcency and mprove envronmental qualty. For example, because of concerns about global clmate change, ncreased attenton has been gven to cuttng neffcent subsdes that promote the use of fossl fuels. Implcatons of Uncertanty for Instrument Choce The dual task facng polcy makers of choosng envronmental goals and selectng polcy nstruments to acheve those goals must be carred out n the presence of the sgnfcant uncertanty that affects the benefts and the costs of envronmental protecton. Snce Wetzman's (1974) classc paper on "Prces vs. Quanttes," t has been wdely acknowledged that beneft uncertanty on ts own has no effect on the dentty of the effcent control nstrument, but that cost uncertanty can have sgnfcant effects, dependng upon the relatve slopes of the margnal beneft (damage) and margnal cost functons. In partcular, f uncertanty about margnal abatement costs s sgnfcant, and f margnal abatement costs are flat relatve to margnal benefts, then a quantty nstrument s more effcent than a prce nstrument. In the envronmental realm, beneft uncertanty and cost uncertanty are usually both present, wth beneft uncertanty of greater magntude. When margnal benefts are postvely correlated wth margnal costs (whch, t turns out, s not uncommon), then there s an addtonal argument n favor of the relatve effcency of quantty nstruments (Stavns, 1996). On the other hand, the regulaton of stock pollutants wll often favor prce nstruments, because the margnal beneft functon lnked wth the stock of polluton wll tend to be relatvely flat, compared wth the margnal cost functon lnked wth the flow of polluton (Newell and Pzer, 2003). In theory, there would be consderable effcency advantages n the presence of uncertanty of hybrd systems for example, quotas combned wth taxes or non-lnear taxes (Roberts and Spence, 1976; Wetzman, 1978; Kaplow and Shavell, 2002; Pzer, 2002), but such systems have not been adopted. Concluson The growng use of economc analyss to nform envronmental decson makng marks greater acceptance of the usefulness of these tools to mprove regulaton. But debates about the normatve standng of the Kaldor-Hcks crteron and the challenges nherent n makng beneft-cost analyss operatonal wll contnue. Nevertheless, economc analyss has assumed a sgnfcant poston n the regulatory state. At the same tme, despte the arguments made for decades by economsts, there s only lmted poltcal support for broader use of beneft-cost analyss to assess proposed or exstng envronmental regulatons. These analytcal methods reman on the perphery 13

17 of polcy formulaton. In a growng lterature (not revewed n ths artcle), economsts have examned the processes through whch poltcal decsons regardng envronmental regulaton are made (Stavns 2004). The sgnfcant changes that have taken place over the past twenty years wth regard to the means of envronmental polcy that s, acceptance of market-based envronmental nstruments may provde a model for progress wth regards to analyss of the ends the targets and goals of publc polces n ths doman. The change n the former realm has been dramatc. Marketbased nstruments have moved center stage, and polcy debates today look very dfferent from those twenty years ago, when these deas were routnely characterzed as lcenses to pollute or dsmssed as completely mpractcal. Market-based nstruments are now consdered serously for nearly every envronmental problem that s tackled, rangng from endangered speces preservaton to regonal smog to global clmate change. Of course, no ndvdual polcy nstrument whether market-based or conventonal s approprate for all envronmental problems. Whch nstrument s best n any gven stuaton depends upon a varety of characterstcs of the envronmental problem, and the socal, poltcal, and economc context n whch t s regulated. Bblography Ansle, G Dervaton of Ratonal Economc Behavor from Hyperbolc Dscount Curves. Amercan Economc Revew 81, Albern, A., M. Cropper, A. Krupnck, and N.B. Smon Does the Value of a Statstcal Lfe Vary wth Age and Health Status? Evdence from the US and Canada. Forthcomng n the Journal of Envronmental Economcs and Management. Andreon, J Warm-Glow versus Cold-Prckle: The Effects of Postve and Negatve Framng on Cooperaton n Experments. Quarterly Journal of Economcs 110(1), Arrow, K., M. Cropper, G. Eads, R. Hahn, L. Lave, R. Noll, P. Portney, M. Russell, R. Schmalensee, K. Smth, and R. Stavns Is There a Role for Beneft-Cost Analyss n Envronmental, Health, and Safety Regulaton? Scence 272, Arrow, K., R. Solow, P.R. Portney, E.E. Leamer, R. Radner, and H. Schuman Report of the NOAA Panel on Contngent Valuaton. Federal Regster 58(10), Barthold, T.A Issues n the Desgn of Envronmental Excse Taxes. Journal of Economc Perspectves 8(1), Baumol, W.J. and W.E. Oates The Theory of Envronmental Polcy. Cambrdge, U.K.: Cambrdge Unversty Press. Bennear, L.D., R.N. Stavns, and A.F. Wagner Prvate Optons to Use Publc Goods: Explotng Revealed Preferences to Estmate Envronmental Benefts. Faculty Research Workng Paper Seres, RWP Cambrdge, MA: John F. Kennedy School of Government, Harvard Unversty. Bockstael, N.E Travel Cost Methods. n: D. Bromley, ed., The Handbook of Envronmental Economcs. Oxford: Blackwell Publshers. 14

18 Bockstael, N.E. and K.E. McConnell Welfare Measurement n the Household Producton Framework. Amercan Economc Revew 73, Boh, D. and D. Burtraw Utlty Investment Behavor and the Emsson Tradng Market. Resources and Energy 14, Bohm, P Depost-Refund Systems: Theory and Applcatons to Envronmental, Conservaton, and Consumer Polcy. Baltmore, MD: Resources for the Future / Johns Hopkns Unversty Press. Boyle, K.J Contngent Valuaton n Practce. n, P.A. Champ, K.J. Boyle, and T.C. Brown, eds., A Prmer on Nonmarket Valuaton. Dordrecht: Kluwer Academc Publshers. Carlson, C., D. Burtraw, M. Cropper, and K. Palmer Sulfur Doxde Control by Electrc Utltes: What are the Gans from Trade? Journal of Poltcal Economy 108, Coase, R The Problem of Socal Cost. The Journal of Law and Economcs 3(1), Conrad, K Computable General Equlbrum Models n Envronmental and Resource Economcs. n, T.H. Tetenberg and H. Folmer, eds., The Internatonal Yearbook of Envronmental and Resource Economcs 2002/2003: A Survey of Current Issues. Northampton: Edward Elgar. Cropper, M.L., S.K. Aydede, and P.R. Portney Preferences for Lfe Savng Programs: How the Publc Dscounts Tme and Age. Journal of Rsk and Uncertanty 8, Cropper, M.L. and A.M. Freeman Envronmental Health Effects. n, J.B. Braden and C.D. Kolstad, eds., Measurng the Demand for Envronmental Qualty. Amsterdam: Elsever Scence Publcatons. Cropper, M.L. and D. Labson The Implcatons of Hyperbolc Dscountng for Project Evaluaton. n, P.R. Portney and J.P. Weyant, eds., Dscountng and Intergeneratonal Equty. Washngton, DC: Resources for the Future. Cropper, M.L. and F.G. Sussman Valung Future Rsks to Lfe. Journal of Envronmental Economcs and Management 19, Dewees, D.R. and W.A. Sms The Symmetry of Effluent Charges and Subsdes for Polluton Control. Canadan Journal of Economcs 9(2), Downng, P.B. and L.J. Whte Innovaton n Polluton Control. Journal of Envronmental Economcs and Management 13, Ellerman, D., P.L. Joskow, R. Schmalensee, J.P. Montero, and E.M. Baley Markets for Clean Ar: The U.S. Acd Ran Program. New York: Cambrdge Unversty Press. Fsher, A., G.H. McClelland, and W.D. Schulze Measures of Wllngness to Pay versus Wllngness to Accept: Evdence, Explanatons, and Potental Reconclaton. n: G.L. Peterson, B.L. Drver and R. Gregory, eds., Amenty Resource Valuaton: Integratng Economcs wth Other Dscplnes. State College, PA: Venture Goulder, L.H Envronmental Taxaton and the Double Dvdend: A Reader's Gude. Internatonal Tax and Publc Fnance 2: Goulder, L.H. and R.N. Stavns An Eye on the Future: How Economsts' Controversal Practce of Dscountng Really Affects the Evaluaton of Envronmental Polces. Nature 419(October), Gruenspecht, H.K Dfferentated Regulaton: The Case of Auto Emssons Standards. The Amercan Economc Revew Papers and Proceedngs 72(2),

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