Economic Concepts. Economic Concepts and Applications to Climate Change

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1 Economic Concepts and Applications to Climate Change Economic Concepts When markets work and when they don t t work Policy Interventions to correct market failures Recent research in climate change 1

2 Part 1: Economic Concepts 2

3 First Theorem of Welfare Economics Pareto efficiency No welfare enhancing trades can be made It is impossible to make somebody else better off without making somebody else worse off First theorem of welfare economics: the equilibrium of a competitive market economy is Pareto efficient if all goods are private no difference between private and social cost Formalizes Adam Smith s s concept of an invisible hand 3

4 Invisible Hand Every individual neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own security, his own gain. And he is in this led by an invisible hand to promote an end which was no part of his intention. By pursuing his own interest he frequently promotes that of society more effectively than when he really intends to promote it. It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. 4

5 Invisible Hand Idea behind invisible hand Societal perspective: A good should be produced if the utility to the user exceeds the cost of producing it Firm perspective Can make a profit if the utility to the user (the maximum he/she is willing to pay) exceeds the cost of producing it Ina well-functioning market, note how the incentive of a firm align with that of society 5

6 Key Concepts I: Private / Public Good Public versus private goods Private good Rival: if I eat an apple, somebody else can t t eat the same apple Excludable: I can keep other people from eating my apple Public good Non-rival: if I walk in a park, my neighbor can do so at the same time Non-excludable: I can t t keep my neighbor from walking in the park Problem of free-riding: Incentive to let other people provide a good without paying for it. 6

7 Key Concepts II: Private / Social Cost Private costs (benefits) of an action accruing to the actor only Social costs (benefits) total costs of activity including those that accrue to people other than the actor Example: driving a car Private costs: fuel, maintenance Social costs include pollution, road wear 7

8 External Effects Any difference between private and social costs is referred to as an externality or external effect Recall how markets work in seeking profits firm produce a good If utility to consumer (maximum willingness to pay) exceeds the cost of producing it Problem: if private cost are different from social cost, firm doesn t t act in societies best interest 8

9 Left - social cost 15, private 10 Right - private & social cost of Costs Private-Social difference Private A B Choices Corporation will choose A as private cost is lower 9

10 Examples of Private v. Social Conserving tropical forests Private benefits: may be small for landowner some sales of non-timber forest products Eco-tourism Social benefits: carbon sequestration biodiversity conservation Avoided soil erosion 10

11 Market Failure Social benefits > private benefits Good is underprovided Provider has too little financial incentive, i.e., doesn t capture all benefits Example: rainforest Social costs > private cost good is over-provided Provider does not account for all costs it imposes on society Example: pollution, fossil fuel. 11

12 Summary Markets work very well when Assumption of first welfare theorem are met goods are private private & social costs are equal Less satisfactory otherwise market failure & rationale for intervention How best to intervene? 12

13 Part 2: Policy Responses 13

14 Policy Responses What to do if there is a difference between private and social costs Impose a tax (or subsidy) equal to difference between private and social costs Incentive to firm realigned with societal interest Introduce property rights Based on the view that an excess of social over private costs arises from the inability to own certain key resources, such as the atmosphere. Afterwards market outcome will be Pareto- efficient again 14

15 Side note: Equity & Efficiency First welfare theorem maximizes the size of the pie,, but says nothing about its distribution Pareto efficiency is separate from any concept of equity. It states that all opportunities for mutual gain are exploited. But not that the outcome is in any way fair. 15

16 Greenhouse Gases Two views on CO 2 emissions social costs of burning fuels > private costs Solution: impose a carbon tax. use of the atmosphere for waste disposal without any payment atmosphere should be someone s s property if we want to pollute it we have to obtain their permission and compensate them for damage to it Leads to tradable SO 2 /CO 2 permits Requires well-defined property rights! 16

17 Cap & Trade Systems Set a limit on allowable emissions Every party that wants to emit a unit has to buy a permit to do so If firms compete for a permit, they will bid up the price If price gets too high, it becomes cheaper to abate Demand for permits starts to decline Permits establishes property rights in environmental assets Key difference in implementation Auction off permits Grandfather permits, i.e., allocated based on historic emissions. (cheaper for firms) 17

18 Examples of Cap -&-Trade: Title IV of Clean Air Act Amendments SO 2 permit market Number of permits: 50% of historic emissions Permits are grandfathered (allocated based on historic emissions) Advantage of permit market: Firms with lowest abatement cost will abate gives firm incentive to innovate Initial cost estimates by industry > 1000 per ton SO 2 EPA: per ton SO 2 (Phase 1) per ton SO 2 (Phase 2) Permit price ~150 per ton SO 2 18

19 Examples of Cap -&-Trade: Fox River in Wisconsin Allowable firms to trade pollution rights Problem: each trade had to be approved Only 1 trade in many years Lessons: Permit market works best Clearly defined property rights Many potential buyers and sellers Low transaction cost Uniformly mixing pollutant 19

20 Examples of Cap -&-Trade: Wetlands banking Kyoto Chicago Climate Exchange 20

21 Kyoto Protocol Cap-and-trade on emissions by industrial countries and transitioning countries No significant restrictions on emissions by developing countries Clean development mechanism Develop countries can get credits for reduction in developing countries Discussion to include avoided deforestation 21

22 Kyoto Protocol Annex B Countries 22

23 Kyoto - targets European Union (15 members) US Canada, Hungary, Japan, Poland Croatia New Zealand, Russian Federation, Ukraine Norway Australia Iceland -8% -7% -6% -5% 0% +1% +8% +10% 23

- 1 World United States [5] 27,245,75 8 6,049,435 100.0 % 22.2 % 2 China 5,010,170 18.4 % - European Union 3,115,125 11.

24 - 1 World United States [5] 27,245,75 8 6,049, % 22.2 % 2 China 5,010, % - European Union 3,115, % Historic Emissions (2004) Russia India Japan Germany Canada 1,524,993 1,342,962 1,257, , , % 4.9 % 4.6 % 3.0 % 2.3 % 8 United Kingdom 587, % 9 South Korea 465, % 10 Italy [6] 449, % 11 Mexico 438, % 12 South Africa 437, % 13 Iran 433, % 14 Indonesia 378, % 15 France [7] 373, % Brazil 331, %

25 Example: Burden-sharing agreement (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% 25

26 Kyoto Protocol Doesn t t tackle India-China problem: Large fraction of world population Historically low per-capita emissions Very few grandfathered permits Problems is not theirs but of developed world Could not stabilize emissions without radically new technologies India / China has no incentive to join Without participation by China / India Kyoto Protocol will not come close to solving the problem so other countries have little incentive to join. 26

27 An Agreement on GHGs Developed world lead in development of new technologies might be sufficient to bring developing countries on board Clean coal technologies China could use all of its coal, as could India This would be of immense value to them. 27

28 An Agreement on GHGs China s s dilemma: burning coal generates terrible pollution domestic political issue. Switch away from coal will increase energy costs Development of clean coal technologies valuable to China (reduces other pollution) should encourage China and India to participate in an agreement to reduce GHGs understanding that tight standards would only apply once a new technology were in place. 28

29 Part 3: Economic Research 29

30 3a) Forecasting China s s Emissions Auffhammer and Carson Province-level approach Gives better fit than national model Model CO2 emission using Population predictions Predictions on income growth Lagged emissions growth 30

31 3a) Forecasting China s s Emissions Auffhammer and Carson 31

32 3b) Discount Rate Stern Report Advocates strong reductions in greenhouse gases Benefit outweigh cost Nordhaus Cost are much larger than benefits Key difference Interest rates Stern uses 0.1% Nordhaus argues for much larger number 32

33 3c) Impact on Agriculture Nonlinear Effect of Temperature on Agriculture Warmer temperatures are better up to a point (corn) 33

3c) Impact on Agriculture Looking at one

Capture value of land when it is put to best

34 3c) Impact on Agriculture Looking at one crop (holding crop constant) Omits crop switching as a response to climate change Idea: Look at farmland values instead Capture value of land when it is put to best (most profitable) use Link them to climatic characteristics 34

35 3d) Future Regulation - US Goulder (Stanford) Recommendations for California s s climate change regulation Use market-based approach: tax or permits Big discussion: Auction off permits or grandfather them Auctioning off is better for a societal perspective Generate government revenue Other distortionary taxes (income tax) can be lowered Grandfathering is cheaper for industry Less political resistance 35

36 3e) Future Regulation - US Stavins (Harvard) Kyoto was too little too fast Small emission reductions in short time frame Better approach Stricter goals but longer time frame to achieve Give industry time to innovate New production processes carbon capture and storage 36

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