Lecture Notes - Chapter 5 Economic Solutions to Environmental Problems: The Market Approach PDF

Lecture Notes – Chapter 5 Economic Solutions to Environmental Problems: The Market Approach In Chapter 4, we discussed the conventional approach and focused on the Command-and- Control model of environmental regulation. In...

Lecture Notes – Chapter 5 Economic Solutions to Environmental Problems: The Market Approach In Chapter 4, we discussed the conventional approach and focused on the Command-and- Control model of environmental regulation. In contrast to the Command-and-Control approach, the Market Approach focuses on creating incentives to producers to reduce environmental pollution. The advantage of this approach is that it will achieve cost-effectiveness criterion that we discussed in the previous chapter, which would not be achieved by the Command-and-Control approach. Specifically, the market approach aims at bringing the external costs of environmental damage back into the decision making of firms and consumers, which is what we called internalizing the externality. Before we start the analysis, let’s overview the various categories of market-based instruments. The following table briefly describes each category: For each of these categories, we develop models of specific instruments, assess the results, and provide examples of how each is used in practice. Pollution Charges How do pollution charges work to internalize externalities? By definition, a pollution charge is a fee that varies with the quantity of pollutants released. It can be implemented as a product charge or as an effluent or emission charge. This approach is based on the criterion called the “polluter-pays principle”. In other words, those who pollute have to pay for the cost of environmental damage, or the cost of regaining environmental quality. 1 Modeling a Product Charge as a Per-Unit Tax The following diagram shows a competitive market where, if left alone, producers produce quantity QC, and ignore the Marginal External Costs (MEC). As we discussed before, this quantity implies too many resources are being allocated to produce it because MEC are not taken into account. Also notice that QE, where MSC equals MSB is at a lower level of production implying efficient allocation of resources. The above diagram shows how a firm can be motivated to internalize the externality by taking account of the MEC in their production decisions. This is done by the government levying a unit tax, on the pollution-generating product, that is equal to the MEC at the efficient output level (QE). This type of tax is called a Pigouvian tax, named after English economist A. C. Pigou, who initially formulated the theory. The above diagram shows how this policy shifts up the MPC curve by distance ab to MPCt , which generates an equilibrium at the efficient output level. In other words, the imposition of the tax is equivalent to increasing the cost of production or shifting the MPC upward by the amount ab. Challenges with Pigouvian Tax While the above formulation seems easy, its implementation may not be that easy for the following reasons: 1. It may not be so easy to compute the actual per unit dollar value of MEC to then use it as the basis for taxation. 2. Even if the tax can be imposed, the objective to reduce output to the level of social efficiency may not be achieved because firms are often reluctant to reduce output. 2 Therefore, rather than imposing a tax on production, the government can instead impose an emission charge, which is basically a tax levied on pollution. Modeling an Emission Charge: Single-Polluter Case An emission or effluent charge assigns a price to pollution, typically through a tax. Once implemented, this tax is practically internalized as the cost of doing business. Faced with this added cost, the polluting firm will have to make a choice to either clean up the pollution itself (which will cost the firm more as it pollutes more), or pay the pollution tax. Given these choices, the firm will take action to minimize its total cost. The following diagram shows how this is done: In this diagram, the horizonal axis shows the units of pollution abatement. MAC is marginal abatement cost. This is the cost the firm will incur to abate more pollution. As you can see, the more abatement is done by the firm, the more it costs. In other words, the line is upward sloping. The line MT is marginal tax line. The height of this line shows the amount of tax ($t) that the firm will have to pay for each unit of abatement. Now suppose the government sets an abatement standard equal to level AST. Given this structure, the firm will voluntarily choose to abate pollution up to level A0, and for any additional amount of pollution, the firm will choose to pay the marginal tax rather than continue to abate pollution itself. What is that total cost of abatement for this firm? Up to A0, the total cost is the triangular area under the MAC line (i.e. OaA0). After that (from A0 to AST) the cost is the rectangular area A0abAST, which is t*(AST – A0). 3 Assessing the Model This model has two advantages: 1) It achieves the government objective to abate up to AST. 2) It has the added advantage that the firm may decide to reduce costs even more by investing in additional abatement technologies. Consider the following diagram where the firm has adopted new technologies that reduces its MAC (the dotted line). By doing so, the firm lowers its cost by the area Oab. Modeling an Emission Charge: Multiple-Polluters Case What if there are multiple polluters in the market? Let’s assume there are two polluters for simplicity, although they can be more. Let’s also follow the same example we had in Chapter 4 where each polluter’s MAC and total abatement cost TAC is given as below: Here A1 is amount abatement done by polluter 1, and A2 is amount abatement done by polluter 2. Now suppose the government set a total abatement standard not to exceed 10 units. In other words, AST = 10. Therefore, total tax = t*(AST – A0) = t*(10 – A0). The government also sets the tax at $5 per unit of abatement, so t = $5. Therefore, the total tax collection will be $5*(10 – A0). The two diagrams we showed in the previous chapter, are presented here again: 4 Following the model for single polluter, each polluter finds it more cost effective to abate up to the point where MAC = MT. This implies that A1 = 2 and A2 = 8. 5 This approach achieves two desirable outcomes: 1) The $5 unit tax achieves the 10-unit abatement standard. 2) This objective has been achieved using the cost-effective allocation of abatement resources across polluters. Please note that most of the abating is done by the low-cost abater, Polluter 2. The high- cost polluter, Polluter 1, abates less but pays much higher emission charges in the form of taxes. Assessing the Model Even though we achieve the above efficiencies, in reality there are challenges in implementing such policies. Realistically, the government will not know the tax rate at which polluters’ abatement levels collectively meet the standard and therefore will have to adjust the tax until the environmental objective is achieved. This could take some time to achieve. Another challenge is the cost of monitoring when each polluter responds to a policy based on its own internal operations. If the government is lax in monitoring, firms may try to evade the tax by illegally disposing of pollutants. To minimize that potential, the government may have to strengthen its monitoring programs, which adds to costs. A third consideration is distributional implications: Because polluting firms pay higher taxes, part of the tax burden is shared with consumers in the form of higher prices. Job losses also may occur as firms adjust to the tax or change technologies to increase abatement. 6  Environment Subsidies An alternative market approach to reducing environmental damage is to pay polluters not to pollute. This is the opposite of tax and is called environmental subsidy. There are two major types of subsidies: 1) Abatement Equipment Subsidies 2) Pollution Reduction Subsidies Modeling an Abatement Equipment Subsidy This approach aims at reducing the costs of abatement technology. Because subsidies are “negative taxes,” they have a similar incentive mechanism to pollution charges except that they reward for not polluting as opposed to penalizing for engaging in polluting activities. In practice, abatement equipment subsidies are implemented through grants, low-interest loans, or investment tax credits, all of which give polluters an economic incentive to invest in abatement technology. From a theoretical perspective, subsidies are used to internalize the positive externality associated with the consumption of abatement activities. If a subsidy were offered for installing specific abatement equipment, such as scrubbers, quantity demanded would increase because the effective price would be lower. To achieve an efficient equilibrium, the subsidy would have to equal the marginal external benefit (MEB) of scrubber consumption measured at the efficient output level. Notice that this is analogous to a Pigouvian tax, and in fact, this type of subsidy is known as a Pigouvian subsidy. Consider this diagram: 7 Here we show the marginal private benefit of units of scrubbers (MPB). This would be similar to a firm’s demand curve for buying scrubbers, and of course the lower the price the more they may buy. The marginal social cost (MSC) is the production cost of scrubbers. However, as more scrubbers are produced and sold, more pollution is abated which increase environmental quality. If left to the private market, the equilibrium quantity of scrubbers would be at QC = 200 units. However, suppose the government has determined a specific level of environmental quality that would be achieved if QE = 210 units of scrubbers are sold and used, a level that polluters are not willing to buy because they are only willing to pay $161 for that many scrubbers and the cost of production is $175. So, the government decides to subsidize (Pigouvian subsidy) the purchase of scrubbers by the amount of ($175 - $161 = $14 per unit). This shifts the demand for scrubbers up as shown by the new MSB line. Of course, the effective price firms would pay would actually be $161 because they get $14 back from the government. These results are obtained by using the following information: The government has estimated that for every unit of scrubber installed an additional MEB is added to the value already derived by private polluters. Therefore, MSB is the sum of MPB and MEB. Practice: See if you can derive the quantities and prices shown on the graph from the above equations. Assessing the Model As in the case of Pigouvian tax, there are several challenges with this model: 1) Measurement issues: it is very difficult to measure the MEB of additional units of installed scrubber. 2) Because scrubbers are subsidies, polluters may not have any incentive to find alternative (and more cost-effective) methods of pollution abatement. 3) Where is the government getting the money to subsidize polluters? The government will have to raise taxes which redistribute money from taxpayers to polluters! 8  Deposit/Refund Systems As we had mentioned earlier, monitoring compliance with any of the previous approaches is costly, especially when polluters engage in illegal disposal of environmental contaminants. Deposit/Refund System can be considered an approach to address this problem. As the name implies, this approach requires that potential polluters deposit funds with the government for the potential occurrence of environmental damage, while they are guaranteed to receive the charges back if the polluting activities do not occur. An example of this approach is the upfront charge for plastic bottles and receiving refunds after recycling. Economics of Deposit/Refund Systems The main difference between this approach and the previous approaches is that potential polluters are forced to take both the marginal private cost (MPC) and the marginal external cost (MEC) of improper waste disposal into account, if they actually damage the environment. This approach is illustrated in the following diagram: Please note the way the horizontal axis is labeled. The arrow from left to right shows the percentage of “Improper waste disposal” (as a percentage of total waste disposal activity). The reverse of this is shown as percentage of “Proper waste disposal” from right to left. 9 The line designated as MPBIW, is the benefit private polluters save by disposing waste improperly. In a sense, this benefit to the potential polluters is exactly the same as avoiding the cost of proper disposal. In other words, as they properly dispose of waste (going from right to left on the horizontal axis), their cost of proper waste disposal goes up. Now, because they are avoiding this cost, it may also be considered as the cost of improper disposal by the potential polluters, which is shown as the upward-sloping line MPCIW. We now add MECIW, which is the cost of government monitoring and correcting such improper waste disposals. This is represented by the distance between MPCIW and MSCIW (marginal social cost of improper disposal). As you can see this distance is widening because as there are more improper disposals, it will cost more to correct it. In other words, we are adding MECIW on top of MPCIW, to get MSCIW. With this description, the private market would result in the level of improper waste disposal at QIW, where the two lines MPBIW and MPCIW intersect. The government then decides to correct the situation to where MEC is also taken into consideration. Therefore, the efficient outcome is at QE, which is the intersection of lines MPBIW and MSCIW. At that level, the distance between MPCIW and MSCIW is the dollar amount ab. Therefore, this can the amount the government demands as refundable deposit, only if the potential polluters manage to reduce their improper pollution from QIW, to QE. This is shown by the dotted line which is the deposit amount increasing (or shifting) MPCIW up, which is indicative of internalizing the externalities. Assessing the Model Please note that the deposit refund system has a more successful chance to deter. the polluters from improper polluting. Another advantage, as stated in your textbook, is that this approach “…can be used to encourage more efficient use of raw materials. An inordinate amount of used products and materials ends up in landfills or burned in incinerators, when they could be recycled. The availability of recycled products and wastes can help slow the depletion of such virgin raw materials as aluminum and timber and may result in associated price declines as well. Charging firms a deposit on raw materials acts as a tax, encouraging more efficient use of resources during the production process.” 10  Pollution Permit Trading Systems This approach basically avoids any kind of taxes or subsidies because of various limitation of the previous approaches, especially having to assess the value of environmental externalities that would be needed to implement taxes or subsidies or deposits. The pollution permit trading system is more efficient in that it determines the socially desirable quantity of pollution or abatement, and let the market establish the price. “Under a system of pollution credits, a polluter earns marketable credits only if it emits below an established standard. If instead the trading system uses pollution allowances, each permit gives the bearer the right to release some amount of pollution. These too are marketable, so that polluters can buy and sell allowances as needed, based on their access to abatement technologies and their costs.” Structure of a Pollution Permit Trading System A system of marketable pollution permits has two key components: 1. the issuance of some fixed number of permits in a region 2. a provision for trading these permits among polluting sources within that region This is also called the cap-and-trade system. Where polluters receive permits to pollute a certain amount, the sum of which is not to exceed the maximum allowable pollution (the cap). Polluters then trade these permits in a market where the low-cost polluters sell their permits to the high-cost polluters. Modeling a Pollution Permit System for Multiple Polluters Let’s illustrate this model using the same example as we had shown before: As you can see polluter 1 is the high-cost polluter and polluter 2 is the low-cost polluter. Currently each firm releases 10 units of pollution for a total of 20 units in their region. The government, then, decides that the “acceptable” level of pollution for this region is a total of 10 units. This is the concept of “Cap” that we discussed earlier. Therefore, the government issues a tradeable permit system for a total of 10 permits, each of which allows 11 the bearer to emit 1 unit of pollution. Let’s assume that these permits are divided equally among all polluters regardless of how much they pollute. Rounds of Trading Based on the initial allocation of permits, each polluter must abate 5 units of pollution. This initial condition, termed Round 1 of the permit system, is summarized as follows: This outcome is not efficient and can be improved because the combined abatement cost for both sources without trading is $39.06. Now, suppose firms are allowed to trade permits. In this case, Polluter 1 (the high-cost polluter) has an incentive to buy permits from Polluter 2 (the low-cost polluter) as long as the price of each permit is less than its MAC1. Likewise, Polluter 2 has an incentive to sell permits to Polluter 1 as long as it can obtain a price greater than its MAC2. In Round 2 the two firms agree on the purchase and sale of one permit at a price of $8.00. This could be any price the polluters agree on. At that price, Polluter 1 purchases one permit from Polluter 2, giving Polluter 1 the right to pollute 6 units and the obligation to abate 4 units. Polluter 2 now possesses the right to release 4 units of pollution, which means it must abate 6 units. Round 2 is summarized as follows: 12 This outcome is more efficient that Round 1 because the total costs of abating 10 units of pollution are now $31.25, which is $7.81 less than the costs without permit trading. This is because the low-cost polluter is allowed to pollute at a lower cost than the high-cost polluter. More specifically, trading has brought the two firms’ MAC values closer together. Polluter 1 now faces a lower MAC1 of $10 (compared to $12.50 in Round 1), and Polluter 2 now has a higher MAC2 of $3.75 (compared to $3.125 in Round 1). As a result, social costs are lowered. At the same time each firm benefits from this trade: Polluter 1 is better off, because its total expenditures have decreased. Its outlay for abating plus the cost of the added permit is $28.00 (i.e., TAC1 of $20.00 plus the cost of the additional permit, $8.00), which is $3.25 less than its TAC1 in Round 1. Similarly, Polluter 2 is better off because its net expenditures on abating and trading are $3.25 (i.e., TAC2 of $11.25 minus the revenue received from selling one permit, $8.00), which is $4.56 less than its TAC2 at the end of Round 1. Therefore, both society and each firm are better off. However, even this outcome can be improved upon (see the table below), because each polluter faces an MAC of $5, and society’s total cost to achieve the environmental objective is $25. (Notice that the $20 payment for permits is not included in society’s abatement costs, because this amount is just a transfer from one firm to another.) As predicted, the low-cost abater, Polluter 2, is doing most of the abating at 8 units, whereas the high-cost abater, Polluter 1, abates only 2 units 13 Assessing the Model As you can see, he final abatement allocation for these firms is identical to what happens if a $5 pollution charge is used. The outcome is the same because both instruments use incentives linked to the firm’s MAC. There are, however, three important advantages: 1. First, with a pollution charge, the government has to search for the price that will bring about the requisite amount of abatement. In the permit system, trading establishes the price of a right to pollute without outside intervention. 2. Second, the trading system is more flexible; the number of permits can be adjusted to change the environmental objective. If the objective is too stringent, more permits can be introduced. If it is too lenient, the government, environmental groups, or concerned citizens can buy up permits, effectively reducing the amount of pollution allowed in the affected region. 3. Third, the pollution charge generates tax revenues on all units of pollution not abated, whereas no revenues are generated from the permit system. This distinction may be critical in jurisdictions with tight fiscal budgets. However, a trading system can be designed to generate revenues if the government sells or auctions off the initial allocation of permits. 14