Economics of Natural Resources and the Environment Exhaustible Resources Lecture 4 Joana Vaz Pais.
Lecture Plan II. Direct controls vs economic methods in pollution regulation A. Pollution as externality B. Environmental standards (with penalties) C. Pigovian taxes D. Subsidies E. Pollution permits
Pollution as externality Costs, benefits X MNPB MEC A Y D B C 0 Q* Qπ Level of economic activity Q
Pollution as externality Marginal net private benefits (MNPB) or marginal profit: extra net benefit (difference between revenue and cost) from changing the level of activity by one unit, i.e., P-MC Marginal external cost (MEC): value of the extra damage done by pollution; assumed increasing with output Optimal level of externality (Y): where MNPB=MEC, which corresponds to the point where the difference between the polluter s total net private benefit and total external cost is maximised. This leads to price equals marginal social cost (MSC) P- MC=MEC or P=MC+MEC=MSC Hence, A is the largest area of net benefit obtainable
Environmental standards Imply establishing particular levels of environmental concentration for the pollutant, sometimes with reference to some health-related criterion Entails having some monitoring agency which oversees polluters activity and which has the power to impose a penalty (polluters can be prosecuted or threatened with prosecution) Problem: unlikely to secure the optimal level of externality, requiring detailed information on the MNPB and MEC functions
Environmental standards Costs, benefits X S MNPB MEC P* P Penalty 0 QS Q* QB Qπ Economic activity Q WS W* WB Pollution Optimal standard: output level of Q* and certain penalty of P*
Pigovian tax Costs, benefits X MNPB MEC MNPB-t* t* Q* Qπ Level of economic activity Q
Pigovian tax The tax t* is an optimal tax (achieving the social optimum); it is equal to MEC or marginal pollution damage - at the optimum level of pollution A damage function tells us how pollution damage varies with the level of pollution emitted and what the monetary value of the damage is Finding such a function involves several steps: Economic activity pollution emissions pollution concentration in the environment pollution exposure physical damage function monetary value of damage
Pigovian tax Mathematically, net social benefits (NSB) are made up of the gross benefits of the polluting activity minus private costs (C) minus social costs (EC): NSB=PQ-C(Q)-EC(Q) Then, the FOC for maximising NSB is P=dC/dQ+dEC/dQ=dSC/dQ, i.e., the price of the polluting product must equal marginal social cost. Or, marginal net private benefits should equal marginal external costs. Then, t*=dec/dq*
Pigovian tax and abatement costs Marginal abatement cost curve (MAC) showing the extra costs of reducing the level of pollution by expenditures on abatement Usually, the lower the level of pollution, the higher the marginal cost of reducing it further The optimal level of pollution is achieved where MAC=MEC Remark: the MAC curve is an analogue of the MNPB when abatement equipment is the means of reducing pollution (so far the polluter adjusted to a tax by reducing output and the cost was the forgone profit, MNPB)
Pigovian tax and abatement costs Costs, benefits X MAC MEC MAC2 MAC1 t* W2 W1 Pollution Pollution abatement
Pigovian tax and abatement costs Costs, benefits X MAC MEC MNPB t* b Pollution Pollution abatement
Pigovian tax Problems: asymmetry of information between the polluter and the regulator: implies knowing MNPB but also MEC (and, thus, the damage function); taxes are sometimes levied on emissions or ambient concentrations measured in physical terms the polluting firm, besides being penalized by the reduction in production, also pays tax (socially desirable?) Compared to standards set without charges, taxes are a lower cost method of achieving a given standard (Baumol and Oates, 1971)
Pigovian tax costs of compliance Costs, tax MNPB MAC 1 A MAC 2 MAC 3 t* X B Y C 0 S1 S2 S3 Pollution reduction (abatement) Assumption: S1S2=S2S3
Pigovian tax costs of compliance Standard to achieve S2: each firm should abate pollution by 0S2; firm 1 stays in A, 2 in B, and 3 in C, achieving the overall standard of 3S2 Tax t* so that firm 1 goes to X, 2 to B, and 3 to Y; the same standard is achieved, but firm 1, with higher abatement costs, abates less than S2, and firm 3 abates more TAC(standard)=OAS2+OBS2+OCS2 TAC(tax)=OXS2+OBS2+OYS2 Then, TAC(standard)>TAC(tax)
Pigovian tax Advantages Leads to optimal pollution when both damage costs and abatement costs are known (Even if not known) is cost-effective Problems (Pezzey, 1988): Industry always resists taxes, which may go beyond taxing non-optimal pollution to optimal pollution Damage function difficult to estimate in practice, opening the way for disputes about the legal basis for a tax Direct regulation based on standards is the status quo in pollution control
Taxes versus standards Taxes are least-cost solutions (if a standard is to be adopted, a tax is the best way to achieve it); a mix of standards and taxes is preferable to standards alone Uncertainty
Taxes versus standards Costs, benefits MNPB (true) Standard MEC MNPB (false) c e a b d Tax t 0 Q Q* Q Tax t leads to Q ; loss equals bde Standard Q leads to Q (if rigidly enforced); loss equals acb Level of economic activity Q
Taxes versus standards Taxes are least-cost solutions (if a standard is to be adopted, a tax is the best way to achieve it); a mix of standards and taxes is preferable to standards alone Uncertainty: standard is the preferred solution when MEC is steeper than MNPB; otherwise, tax is preferred
Taxes versus standards Costs, benefits Standard MEC Tax t MNPB (false) MNPB (true) 0 Q Q* Q Standard is preferred Level of economic activity Q
Taxes versus standards Taxes are least-cost solutions (if a standard is to be adopted, a tax is the best way to achieve it); a mix of standards and taxes is preferable to standards alone Uncertainty: standard is the preferred solution when MEC is steeper than MNPB; otherwise, tax is preferred Dynamic efficiency: with a standard, up to QS, the polluter has no incentive to reduce pollution; a tax gives incentives for reducing pollution further (a tax is paid on the optimal amount of pollution) Administrative costs: it is not clear which solution is cheaper; taxes require monitoring, fees to be collected, and is open to legal wrangling; standards also require monitoring, a penalty system to be in place Outright prohibition: when MEC is vertical, there is no point in having a tax
Subsidies The idea is to give payments to firms which pollute below a certain prescribed level
Subsidies, MC+tax=MC+subsidy MC D S1 AC + tax P1 AC MC S S2 2 AC-subsidy q2 q1 q Firm output Q1 Q Q2 Industry output
Subsidies The idea is to give payments to firms which pollute below a certain prescribed level In the long run, under the tax, industry output and pollution falls; subsidies expand production and pollution
Pollution permits The authority allows only a certain level of pollutant emissions and issues permits for this amount; permits are tradeable
Pollution permits Costs, Permit, P X MAC S* MEC P* P1 0 Q* Q1 Q2 Pollution permits W* Pollution
Pollution permits The authority allows only a certain level of pollutant emissions and issues permits for this amount; permits are tradeable The MAC is the demand curve for permits Advantages of marketability: Cost minimisation: the higher cost polluters buy more permits; low-cost polluters sell permits (analogue of Baumol-Oates theorem about taxes)
Pollution permits Costs, Permit, P X MAC S* MAC2 P* MAC1 0 Q1 Q2 Q* Pollution permits W* Pollution
Pollution permits The authority allows only a certain level of pollutant emissions and issues permits for this amount; permits are tradeable The MAC is the demand curve for permits Advantages of marketability: Cost minimisation: the higher cost polluters buy more permits; low-cost polluters sell permits (analogue of Baumol-Oates theorem about taxes) New entrants: keep standard/issue new permits/buy some permits; easy to vary standards
Pollution permits Costs, Permit, P X D1 S* D P** P* 0 Q* Pollution permits W* Pollution
Pollution permits Advantages of marketability: Cost minimisation: the higher cost polluters buy more permits; low-cost polluters sell permits (analogue of Baumol-Oates theorem about taxes) New entrants: keep standard/issue new permits/buy some permits; easy to vary standards Opportunities for non-polluters, e.g., environmental pressure group Unnecessary to find the desirable standard and the tax rate, only a standard and a mechanism for issuing permits; permits respond to supply and demand and adjust automatically to inflation, entry and exit,.
To sum up Direct controls + efficacy + less expensive in administrative terms (?) + flexibility + simple dialogue with agents and decision makers - social and political restrictions - control and monitorisation - do not promote further reduction of pollution - difficult process of negotiation: high transaction costs : information and negotiation costs of political discussion and contracts.
To sum up Economic Methods + guaranties of economic optimum (?) + environmental efficiency - administrative difficulties/monitoring - high costs (time and money) in the definition/execution of the policies - social-political costs - less flexibility