Public Economics PDF

Public Economics Prof. Dr. Mariana Lopes da Fonseca SIAW 1 / 33 Externalities 2 / 33 Externalities and Climate Policy Overview and Reading Overview: 1. Introduction 2. Coase Theorem 3. Pigovian Taxes...

Public Economics Prof. Dr. Mariana Lopes da Fonseca SIAW 1 / 33 Externalities 2 / 33 Externalities and Climate Policy Overview and Reading Overview: 1. Introduction 2. Coase Theorem 3. Pigovian Taxes 4. Emission Permits 5. Alternative Government Interventions (Regulation, Subsidies) 6. Global Climate Policy Textbook: I Tresch, chapters 6 and 7 3 / 33 Externalities and Climate Policy Introduction I Consumption and production can cause externalities. I Defining characteristics of externalities: 1. Direct effect on utility of other consumers or production possibilities of other firms. 2. No incentives for persons who cause the externality to take it into account in their decisions. I Examples of externalities: I Original example by Pigou: Chimney smoke in London and its effect on sunlight, clothes, and vegetables. I Further negative examples: Air pollution (e.g., CO2 or SO2 emissions), water pollution, noise pollution, congestion. I Positive examples: (Primary) education, R&D, immunizations. 4 / 33 Externalities and Climate Policy Introduction I Externalities that are sufficiently important and severe can justify government interventions. I Good government interventions “internalize the externality,” i.e., they make polluters behave as if they cared about the externality. I Example of a government intervention: Autobahnvignetten I Annual fees for highway use to address externalities from private road traffic. I What are their strengths and weaknesses? I What would be better government interventions (and why)? 5 / 33 Externalities and Climate Policy Introduction I The market failure in case of externalities: I Example: Air pollution in the manufacturing sector I Assumption: Negative externality that depends on aggregate PH production Q: MCpollution (Q) = h=1 MDh (Q), where MDh is the marginal damage of household h. I Market equilibrium: D = S priv ≡ MCpriv I Social optimum: D = S soc ≡ MCpriv + MCpollution I Market equilibrium vs. social optimum vs. zero production 6 / 33 Externalities and Climate Policy Introduction I Illustration of the market failure: 7 / 33 Externalities and Climate Policy Introduction I Main questions for today: I Should governments intervene in the presence of negative externalities? If so, what policies should they choose? I How should “we” tackle global climate change? Why isn’t it happening? 8 / 33 Externalities and Climate Policy Coase Theorem I Thought experiment: Chemical plant and fish farm on the shore of the same lake I Questions: By how much does the chemical plant reduce pollution... I in the social optimum? I if the chemical plant and the fish farm belong to the same holding company? I if it has the right to pollute, but can negotiate with the fish farm? I if the fish farm has the right to unpolluted water, but can negotiate with the chemical plant? 9 / 33 Externalities and Climate Policy Coase Theorem I Marginal benefits and marginal costs of pollution reduction: 10 / 33 Externalities and Climate Policy Coase Theorem I Coase Theorem: I If trade in an externality is possible and transaction costs are low, negotiations over externalities will lead to an efficient outcome regardless of the initial allocation of property rights. I Implications: I There may be no need for government interventions to internalize an externality. I Well-defined property rights may be sufficient. I Problems: I Negotiations are hardly possible if the externality affects many individuals (e.g., air pollution). I Transaction costs I Incentives to free-ride if firms own property rights 11 / 33 Externalities and Climate Policy Pigovian Taxes Pigovian tax: I Assumption (as before): Negative externality that depends on aggregate production: MCpollution (Q) = H P h=1 MDh (Q) I Definition: Pigovian tax is equal to the aggregate marginal damage at the social optimum. I Properties of the Pigovian tax: I Simple per-unit tax. I Same for all producers (independently of their output), because aggregate marginal damage of higher production is the same no matter who produces an additional unit. 12 / 33 Externalities and Climate Policy Pigovian Taxes I Illustration of the Pigovian tax: 13 / 33 Externalities and Climate Policy Pigovian Taxes I Problems of Pigovian taxes: I Theoretically appropriate Pigovian tax is typically unknown. It can at best be approached step by step. I Same tax across firms is suboptimal if externalities differ across firms (e.g., air pollution in California vs Maine). I Tax depending on production levels is suboptimal because externalities depend on the mix of input factors. I Gray vs. green energy I Expensive technology/low pollution vs. cheap technology/high pollution 14 / 33 Externalities and Climate Policy Pigovian Taxes Emission taxes:1 I The possibility to substitute between different input factors makes it optimal to tax the input factor that causes the externality. I Examples: Tax on electricity and fossil fuels. 1 Many economists, but not Tresch, call optimal emission taxes also Pigovian taxes, and distinguish between “simple” Pigovian taxes and Pigovian emission taxes. 15 / 33 Externalities and Climate Policy Pigovian Taxes I Theoretical argument for emission taxes: I Suppose firms have well-behaved production functions y = f (A, C , L), where A is clean air, C capital and L labor. I Profit-maximizing firms combine these inputs such that the marginal productivity-to-price ratio MPi /Pi is the same for all inputs i = A, C , L. I How can a firm reduce costs if MPC /PC > MPL /PL ? I How much clean air do firms use if its price PA is almost zero? I How do firms respond if an emission tax increases PA ? 16 / 33 Externalities and Climate Policy Pigovian Taxes I Advantages of emission taxes: 1. Achieve a given reduction in pollution at the lowest possible costs. Why? 2. Reduce pollution by affecting the input mix and by lowering aggregate production (as higher costs shift the supply curve upwards). I Larger reduction in pollution than in case of a simple Pigovian tax that would lead to the same reduction in aggregate production. 3. Ensure that the polluters (rather than the tax payers) pay the costs for reducing pollution. 17 / 33 Externalities and Climate Policy Emission permits I The “cap and trade” principle: I A cap is set on the total emissions by all participating emitters. I Emission permits are auctioned off or allocated for free, and can subsequently be traded. I Participating emitters must monitor and report their emissions to the authorities. I Firms must buy additional permits if emissions are too high. I Firms can sell some permits if emissions are low. 18 / 33 Externalities and Climate Policy Emission permits I Marketable pollution permits can internalize externalities like Pigovian taxes. I Illustration: Externality depending on aggregate production I How a simple Pigovian tax affects incentives “on the margin”: I The firm maximizes pq − C (q) − tq I FOC: p − C 0 (q) − t = 0 I How pollution permits affect incentives “on the margin”: I The firm maximizes pq − C (q) − p̃[q − q̃], where p̃ is the market price of permits and q̃ the initial stock of permits. I FOC: p − C 0 (q) − p̃ = 0 I Advantage: Easier to meet emission targets. I Disadvantage: Emission permits can be misused to hinder competitors from growing or to deter entry. 19 / 33 Externalities and Climate Policy Emission permits I European Union Emissions Trading System (EU ETS) I EU ETS was launched in 2005. I Largest ETS covering more than 11,000 power plants, factories and the like; collectively responsible for almost half of the EU’s CO2 and greenhouse gas emissions. I Auctions are the default method for allocating permits, but the manufacturing sector receives a substantial share for free. I Cap decreases by around 2% per year. I Additional emission trading scheme with separate cap for the aviation sector (for all flights from/to/within the EU). 20 / 33 Externalities and Climate Policy Alternative Government Interventions Regulation (or command and control): I Regulation is often preferred by governments. I Regulation includes prohibitions, commands, price regulations (e.g., minimum prices), quantity regulations (e.g., maximum permissible values), or acceptance standards. I Main disadvantage: High costs I Single firms may not be allowed to reduce pollution in the way that is least costly for them. I Different firms are not allowed to reduce pollution to different extents. I Most economists are thus against regulations, except in cases of very dangerous externalities. 21 / 33 Externalities and Climate Policy Alternative Government Interventions Subsidies: I Industries often propose subsidies for reduced pollution. I Subsidies can internalize externalities as well. I Illustration: Externality depending on aggregate production I How a simple Pigovian tax affects incentives “on the margin”: I The firm maximizes pq − C (q) − tq I FOC: p − C 0 (q) − t = 0 I How a subsidy affects incentives “on the margin”: I The firm maximizes pq − C (q) + s[q − q], where s is the subsidy and q the quantity threshold below which the subsidy applies. I FOC: p − C 0 (q) − s = 0 I Main disadvantages: 1. Subsidies may increase pollution in the long run. Why? 2. Subsidies are burden on the tax payers. I Most economists thus prefer taxes or emission permits. 22 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Scientific consensus: I Meta study by Cook et al. (2016): 97% of published research endorses the consensus on anthropogenic (i.e., human-caused) global warming. 23 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Source: NASA. 24 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Source: NASA. 25 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Public finance “solutions:” I Internalize negative externalities of CO2 emissions, e.g., Pigovian tax aimed at reducing CO2 emissions to the socially optimal level. I Establish property rights of CO2 emissions, e.g., by issuing CO2 certificates/pollution permits. 26 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Naive expectation: I Problem has been known for a long time. I Lyndon B. Johnson, Special Message to US Congress, 1965: “Air pollution is no longer confined to isolated places. This generation has altered the composition of the atmosphere on a global scale through [...] a steady increase in carbon dioxide from the burning of fossil fuels.” I Public finance “solutions” have been known for a long time too. I Hence, one may expect that these “solutions” have been implemented. 27 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Reality check: I Some governments have introduced policies to fight climate change, but experts largely agree that these policies are far from sufficient to avert “damage beyond repair.” I International Energy Agency estimates that in 2013 consumer subsidies for fossil fuels amounted to USD 548 billion. I Politico-economic reasons may explain this large discrepancy between naive expectations and reality. 28 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Cross-country politico-economic reasons: I International tragedy of the commons, i.e., free-rider problem. I Some countries have low incentives to fight climate change: I Countries that may benefit from climate change. I Countries that specialize in activities with high CO2 emissions. I Carbon leakages: “Dirty” firms/activities moving to countries with lower emission taxes/regulation. I Many countries for which climate change is particularly costly have no means to compensate emitters or buy pollution permits – think Bangladesh. 29 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Politico-economic reasons within countries: I Serious climate change protection would force a structural change of the energy sector. I Many established firms would lose, and they have strong incentives to fight such policies. I The “political game” is tilted in their favor: I Losers from climate change, e.g., future generations, are under-represented in democratic decision-making. I Advantage of small, well-organized groups I The seen vs the unseen (e.g., in terms of employment) I Deep pockets for lobbying (unlike firms that are not yet established/existent) 30 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Two types of lobbying: 1. Campaign spending and other goodies for politicians 2. Misinformation of the public and politicians I Case study: ExxonMobil’s climate change communications I ExxonMobil had been sued by several US states for misleading the public regarding AGW. I It decided to publish various scientific articles by their own scientists as well as internal company documents. I Supran and Oreskes (2017) analyze these documents and compare them with other publicly available documents of the company. I Their findings suggest that ExxonMobil was deliberately spreading doubt (not falsehoods). 31 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change Note: Pink bars indicate share of documents doubting that global warming is real and human-caused. Source: Supran, G., and N. Oreskes, 2017. Assessing ExxonMobil’s Climate Change Communications (1977–2014). Environmental Research Letters 12(8). 32 / 33 Externalities and Climate Policies Application: Anthropogenic Climate Change I Interesting fact: ExxonMobil’s strategy is, at least in essence, not at all new. I Tobacco and cancer, nicotine addiction, second-hand smoking, nuclear winter, SO2 emissions and acid rain. I Interestingly, the same scientists/groups of scientists have been publicly active as ‘experts’, spreading doubt in a variety of these topics. I There is a market for ‘merchants of doubt’. I Weatherall et. al (2018) call this the “Tobacco Strategy” and analyze it in an agent-based modelling framework. I Even under the assumption of benevolent policy makers who rationally update on all evidence that is available to them, the simulation studies suggest this strategy can be extremely efficient. 33 / 33