ECON 487 Environmental Economics

Winter 2013 Jared C. Carbone

Incentive-Based Regulation March 22-27
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Key Concepts
Our study of externalities and public goods/bads suggested that viewed through the lens of economics the key problem with pollution is that there is no price signal that accurately reflects the full social costs and benefits of pollution
In light of this logic, the simplest remedy proposed by economic theory is for the government to establish such a price An emission fee is a price or fee paid by a polluter to a regulatory entity for every unit of emissions the polluter emits
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Model of Polluter Response to an Emission Fee

Suppose a firm produces electricity and pollution () as a byproduct.
Emission fee is charged on each unit of so total fees paid is . Thus total costs of producing a given amount of electricity as a function of is given by: = +

where is production costs.

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Model of Polluter Response to an Emission Fee

A profit-maximizing firm will choose the amount of pollution that minimizes total costs in order to get the largest profits from producing a given amount of electricity. Total costs are minimized when the change in total costs (marginal costs) with x is zero: = 0

or when the marginal costs of the different components (production, emission fees) of total cost are equalized: = = () where is the marginal change in production costs from a higher level of pollution and marginal savings (()) is the amount of money saved in reduced production costs by emitting one more unit of pollution also defined as the negative of marginal cost, or the marginal cost of abatement.

Model of Polluter Response to an Emission Fee

FIGURE 12.1 Firm choice of emissions/abatement when faced with emission fee, p.

Model of Polluter Response to an Emission Fee

So a firm will set pollution so that the fee is equal to marginal saving.
If this was not the case say marginal saving was higher then the firm could save more in reduced production costs than they would have to pay in extra emission fees by polluting a bit more.

With multiple firms, marginal cost of abatement will be equal across firms if all face the same emission fee.
This implies that they will do different amounts of abatement if they have different marginal costs.

Equimarginal Principle
Aggregate costs of pollution control must be minimized if all sources of pollution face the same fee and seek to minimize their private costs. This is another way of understanding the equimarginal principle from our past discussions Polluters with marginal costs that rise steeply will do less abatement than polluters with marginal cost curves that are shallower What factors would influence the steepness of the marginal abatement cost curve?
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Pigouvian Fees
Recall that there are really two types of efficiency in the pollution control that we focus on:
1. 2. The equimarginal principle is the first ensures that a given amount of pollution reduction is done in the most efficient (least costly) way The second principle of efficiency requires that the level of pollution (or abatement) maximizes the net benefits of pollution control (or minimizes the total costs of pollution) to society

A Pigouvian fee (named after Arthur Pigou, a British economist from the early 20th century) is an emission fee set at a level that equals the marginal social damage of pollution when the level of pollution is at efficient levels.

Pigouvian Fees: Single Polluter

Assume the same electricity-producing firm as before
There are people surrounding the factory who are exposed to the pollution (and, to keep things simple, they have no choice as to where they locate) For a person , call () the level of damages she experiences from pollution level their (negative) WTP to experience higher levels of pollution If pollution is a non-rival bad, then total damages is the sum across all people for each unit of pollution: = ()

Pigouvian Fees: Single Polluter

The efficient level of pollution minimizes the total costs including the damages to society. This level of pollution occurs where marginal abatement costs and damages are equalized: + = 0 or alternatively

( )

In words, the efficient level of pollution equates the savings to the firm of an extra unit of pollution with the damage of that extra unit to the exposed.

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Pigouvian Fees: Single Polluter

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Pigouvian Fees: Multiple Polluters

Aggregate demand for pollution (marginal savings curve) is the horizontal sum of the individual MS curves of polluters.

FIGURE 12.3 The case of two polluters. MS1 (x), marginal savings from emitting firm 1; MS2(x), marginal savings from emitting firm 2; MS(x), aggregate marginal savings from emitting; MD(x), marginal damage from emitting; p*, Pigovian fee; x*, total amount of emissions with Pigovian fee; x1*, emissions from firm 1 with Pigovian fee; x2*, emissions from firm 2 with Pigovian fee.

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Fees vs Subsidies
Subsidies are much easier to motivate politically than fees
Q: Is it possible to get the same nice properties of the emission fee from an appropriately designed emission subsidy?

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Fees vs Subsidies
Total costs are now defined as:
= ( ) where s is the subsidy per unit of abatement and is the benchmark (prereguation level of pollution of the firm. Minimizing costs within the firm requires that:

+ = 0 or = = ()
which is exactly what we found under the fee.

If = () for all polluters, then aggregate costs of pollution control must, again, be minimized.
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Fees vs Subsidies
A couple important parts of the story are missing from the preceding analysis:
If some firms are more profitable than others, then the subsidy may result in some firms that are not profitable in the absence of the subsidy continuing to operate if subsidy is designed to be contingent on operation better to keep producing then shut down. If benchmark emissions are uncertain than firms may have an incentive to overstate to get a larger subsidy
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Imperfect Competition
Monopolist in Goods Market
Electricity producers prices electricity as an unregulated monopolist: MR(Q*) = MC(Q*) Pollution is produced in proportion to electricity output

What is the effect of introducing a Pigouvian fee?

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Imperfect Competition

FIGURE 12.7 Imposing a Pigovian fee on a goods monopolist. MCU, marginal private cost of producing steel; MCT, marginal social cost of producing steel; D, demand for steel; MR, marginal revenue for steel; SU, steel output level, unregulated; ST, steel output level with 17 Pigovian tax; S*, socially optimal output of steel.

Imperfect Competition
Monopolist produces too little output and pollution ( ) relative to the efficient level ( ) in the absence of the fee.
When the fee is introduced, the under-provision becomes even worse ( )!! Ideally, we would have two instruments to correct two market failures one to correct the monopoly output problem, one to correct the pollution problem.
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Imperfect Competition
Monopolist in Bads Production
Competitive market for output (natural gas market) Monopoly producer of pollution (single shale gas developer polluting local water supply)

Again, what is the effect of introducing a Pigouvian fee?

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Imperfect Competition

FIGURE 12.8 Monopolist in provision of pollution. MS, marginal savings from polluting; MD, marginal damage from polluting; MT, marginal emission fee payments; t*, Pigovian fee; tm, monopoly emission fee level; s*, efficient amount of smoke; sm, monopoly emissions of smoke.

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Imperfect Competition
As we discussed before, the efficient level of pollution is where the marginal savings of using more pollution (MS) to the polluter is just equal to the marginal damages to society (MD), .
Because the polluter is a monopolist in pollution, it realizes that it can affect the size of the Pigouvian fee the regulator chooses through its choice of output.
Reducing emissions will provoke a lower emission fee Polluter will choose the level of pollution that minimizes its costs of compliance taking this fact into account.
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Imperfect Competition
Akin to the curve in the analysis of an output-market monopolist, let () be the marginal emission fee payments curve of the polluter. It describes the effect of a small change in S on the amount of fees the polluter must pay when fee is set at Pigouvian rate. In this face, total fees, (), is defined as = ()

Taking the derivative of we get ():

= +

So if () is upward sloping, then > ().

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Imperfect Competition
Because the polluter realizes the effect of its choice of on (), it can minimize total costs by choosing to equate () and (), resulting in pollution level . This results in an under-provision of pollution.
How could we have too little pollution? Isnt pollution bad?
Remember efficiency requires balancing competing interests too little pollution means that the cost to society in lost output by the firm is too high from an efficiency perspective.

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The Double Dividend

What happens to the revenue generated by the emission fee?
Lump sum transfer to households

Spend on new govt programs

Use revenue to replace revenue from other (distortionary) taxes
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The Double Dividend

Use revenue to replace revenue from other (distortionary) taxes
Double dividend hypothesis proposes that we can kill two birds with one stone
Correct the pollution externality
Lower the efficiency cost of raising govt revenue

Strong version of the hypothesis says that the second effect is big enough that the net cost of pollution regulation is negative.
Politically important if true because it means that we ought to be pursuing the regulation even if we think the benefits of pollution control are zero.

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The Double Dividend

Single consumer standing for many individuals in reality chooses how much labor, , to supply depending on the wage, , and how much of a polluting good, , to consume (pollution generated by production of the good). There is a tax, , on the individuals wages.
When the level of is lower, the individual takes home more of his wages for each unit of labor provided. Assume that this causes him to work more and spend less time on leisure activities than when is higher. Flipping things around can also think of it in terms of effect on leisure demand. Tax on labor supply is a subsidy to leisure demand. Demand rises with the tax a deadweight efficiency loss is created (area ABC).

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The Double Dividend

FIGURE 12.9 (a,b) Effect on leisure from environmental tax. VMPL, value of marginal product of labor; tL, tax on labor; w, wage rate; H*,L*, supply of leisure and labor with tX = 0; tX, tax on X; H+, quantity of leisure with tX > 0; BCDE, wage tax revenue loss from tX > 0.
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The Double Dividend

FIGURE 12.10 Supply and demand of polluting good. MCsocial, marginal costs of producing X, including pollution damage; MCprivate, marginal costs of producing X, excluding pollution damage; X*, production without internalizing externality; tX, product tax necessary to internalize externality; X+, production with tax tX.

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The Double Dividend

FIGURE 12.9 (a,b) Effect on leisure from environmental tax. VMPL, value of marginal product of labor; tL, tax on labor; w, wage rate; H*,L*, supply of leisure and labor with tX = 0; tX, tax on X; H+, quantity of leisure with tX > 0; BCDE, wage tax revenue loss from tX > 0.
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Double Dividend
Introduction of environmental tax causes labor supply to shrink. With smaller tax base, revenues from labor tax fall.
Implies that tax interaction effect between environmental and labor taxes means labor tax can be reduce by less in a revenue-neutral swap than in the absence of this effect, which works against the likelihood of a strong double dividend.
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Double Dividend
Three effects:
1. Pigouvian Effect emissions reduced to socially desirable levels (+) 2. Tax Interaction Effect new fee makes other taxes less effective (-) 3. Revenue-Recycling Effect other distortionary tax rates fall to hold govt revenue neutral (+)
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Marketable Emission Permits

(Discussion from Kolstad Ch. 13)
Establish aggregate emission cap
Make initial allocation of allowances to polluters Allow trade in permits to establish market-clearing price in permit market.

Widely used:
Europe carbon North American sulphur dioxide Multiple regions -- fisheries
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Marketable Emission Permits

Suppose instead of setting emission fee p, issue total permits in the amount of + in the example from before.

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Marketable Emission Permits

Allocate them half and half to the two polluters. How would they trade?

FIGURE 13.2 Illustration of trading of permits between two firms.

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Marketable Emission Permits

If permit market is competitive, then trade should lead to the point where marginal savings of each polluter is equalized the equimarginal principle just as in the case of the emission fee.
Therefore, if we issue total permits equal to the equilibrium emissions under a fee, the equilibrium permit price will be equal to the fee. The two regulations are equivalent.
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Marketable Emission Permits

How should we initially allocate the permits?
Should trade to the same point in a competitive market so distribution of rents is the only difference. In practice, permits usually handed out freely to polluters. In light of double dividend discussion, better for govt to auction off permits and used auction revenue to reduce other taxes.
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Marketable Emission Permits

Caveats:
Market power in permit market Competition in related markets and anticompetitive behavior Transaction costs

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