It is becoming increasingly clear that reliance on the command-and-control approach will not, by itself allow the EPA to achieve its mission… To maintain momentum in meeting environmental goals, we must move beyond prescriptive approaches by increasing our use of policy instruments such as economic incentives. Properly employed, economic incentives can be a powerful force for environmental protection – EPA administrator William K. Reilly
5 Introduction The issue is not whether the government should intervene, but what form government intervention should take. While economic incentives have not had dramatic success, this chapter will explore the potential for correctly structured economic incentives to achieve an improvement in environmental quality at the lowest possible cost.
6 Pigouvian Taxes A.C. Pigou (1938) argued that an externality cannot be mitigated by contractual negotiation between the affected parties. Pigou argued that direct coercion by the government or judicious use of taxes should be used against the offending party. These taxes are referred to as Pigouvian taxes.
7 Pigouvian Taxes The basic principle behind the use of externality taxes is that the tax eliminates the divergence between the Marginal Private Cost (MPC) and the Marginal Social Cost (MSC). Consider Figure 3.1. Q 1 represents the market equilibrium (where MPC=MPB), and Q* represents the optimal level of output (where MSC=MSB).
8 Figure 3.1 – An Externality Tax on Output
9 Pigouvian Taxes An externalities tax equal to the divergence between MPC and MSC would raise the steel firms’ private costs. The tax would shift the MPC curve by an amount equal to the distance from a to b in Figure 3.1. The market would arrive at an optimal equilibrium of Q*. This is known as internalizing an externality. Subsequent work has shown the tax should be placed on the externality (such as pollution emissions) rather than on output.
10 Coase Theorem Ronald Coase (1960) argued that not only is a tax unnecessary, it is often undesirable. Coase argued: The market will automatically generate the optimal level of the externality. This optimal level of the externality will be generated regardless of the initial allocation of property rights.
11 Coase Theorem Coase’s example to illustrate his theory is based on the interaction of a cattle rancher and a crop farmer. Cattle occasionally leave rancher’s property and damage farmer’s crop. Coase argued that the farmer and rancher will reach an agreement that will make them both better off. Either the rancher will accept payment to reduce the size of the herd or farmer will accept payment to cover cost of crops lost. And this will happen without government intervention.
12 Coase Theorem One critical assumption that Coase makes is that transactions costs are insignificant. Transactions costs are costs associated with arriving at an agreement (the costs of negotiation). These may be small for a 2 party agreement but would be very large for an externality such as sulfur dioxide emissions across North America.
13 Coase Theorem The number of participants makes transactions costs important. One way to reduce transactions costs is to appoint an agent who acts in behalf of a large number of people. The use of agents is associated with its own problems: Free riders – don’t share in cost, but share benefits. Often it is difficult for individuals to identify the agent that will best represent their view point.
14 Coase Theorem Another problem associated with the Coase Theorem is the need for asymmetric pricing. Maximizing social welfare requires that the generator of a negative externality be charged a price, while the victim remains uncompensated. This means that an efficient market cannot develop, as a market requires the same price for the buyer and the seller.
15 Coase Theorem Another problem associated with the Coase example is that there is only one victim. In a multiple victim/generator model, the allocation of property rights would signal entry and exit in response to those rights. If ranchers have the right to let their cattle roam without worrying about paying damages, then there will be an increase in the number of ranchers, and more damage.
16 Coase Theorem A final problem associated with the Coase Theorem is the existence of income effects. Income effects imply that the higher an individual’s standard of living, the greater his or her marginal valuation of a normal good or service. Being free from a detrimental externality raises an individual’s standard of living, the marginal valuation of the damages depends on the definition of property rights.
17 Types of Government Intervention There are five broad classes of government intervention: Moral suasion Direct prohibition of environmental quality Pollution prevention Command and control regulations Economic incentives Each of these represents a different philosophy toward the role of government in society.
18 Moral Suasion This term is used to describe government attempts to influence behavior without actually stipulating any rules. Effectiveness depends upon the extent to which individuals believe it is in their collective interest to do so. Successful programs include Woodsy Owl’s “Give a hoot, don’t pollute” and Smokey Bear’s “Only you can prevent forest fires.”
19 Direct Production of Environmental Quality Includes reforestation, breaching of dams, stocking of fish, creation of wetlands, treatment of sewage, and toxic waste site cleanup. These are largely ameliorative actions.
20 Pollution Prevention Not designed to control the externality, but to address a related market failure of imperfect information. Basic premise is that combined efforts of government agencies, national laboratories, university and private firms can lead to development of innovative and beneficial technologies. These programs emphasize being proactive in reducing pollution.
21 Command and Control Regulation These place constraints on the behavior of households and firms. Constraints generally take the form of limits on inputs or outputs in the consumption or production process. Examples include: Requiring sulfur-removing scrubbers on the smokestacks of coal-burning utilities. Prohibitions against dumping of toxic substances.
22 Economic Incentives Economic incentives simply make self interest coincide with social interest. Examples include: Pollution taxes Pollution subsidies Marketable pollution permits Deposit-refund systems Performance bonds Liability systems
23 Choosing the Correct Level of Environmental Quality Zero pollution is not possible for two reasons: The reduction of pollution will have opportunity costs. The Law of Mass Balance makes a choice of zero physically impossible. The Law of Mass Balance states that the mass of outputs of any activity are equal to the mass of inputs. Any consumption or production activity must produce waste.
24 Choosing the Correct Level of Environmental Quality The desired level of pollution will be a function of the social costs associated with pollution. The first of these is the damage that pollution creates by degrading the physical, natural, and social environment. The second is the cost of reducing pollution and includes the opportunity costs of resources used to reduce pollution and the value of foregone outputs.
25 The Marginal Damage Function The marginal damage function represents the damages that pollution generates by degrading the environment. Even if these impacts are not quantifiable, the marginal damage function is useful for thinking about the relationship between environmental change and social welfare.
26 Figure 3.3 Marginal Damage Function
27 Marginal Damage Function The marginal damage function in Figure 3.3 specifies the damages associated with an additional unit of pollution. The total damages generated by a particular level of pollution is represented by the area under the marginal damage function.
28 Marginal Damage Function The increasing slope of the marginal damage function indicates how damage changes with each additional unit of pollution. An upward sloping marginal damage function indicates that as the level of pollution becomes larger, the damages associated with the marginal unit of pollution become larger.
29 Marginal Abatement Cost Function Abatement Costs are those costs associated with reducing pollution to a lower level so that there are fewer damages. Abatement costs include: Labor Capital Energy needed to lessen emissions Opportunity costs from reducing levels of production or consumption.
30 Marginal Abatement Cost Function The marginal abatement cost function represents the costs of reducing pollution by one more unit. In the following figure, E u represents the level of pollution that would be generated in absence of any government intervention. As pollution is reduced below E u, the marginal abatement cost increases.
31 Marginal Abatement Cost Function
32 Marginal Abatement Cost Function Marginal abatement costs rise as cheaper options for reducing pollution are exhausted and more expensive steps must be taken. The decreasing slope indicates that the costs of reducing pollution increases at an increasing rate. A high vertical intercept indicates that the cost of eliminating the last few units of pollutants would be extremely high.
33 The Optimal Level of Pollution Optimal level of pollution minimizes the total social costs of pollution (the sum of total abatement costs and total damages). This level occurs at the point where marginal abatement costs are equal to marginal damages.
34 The Optimal Level of Pollution
35 The Optimal Level of Pollution If the level of emissions is less than E 1, then the marginal abatement costs are greater than the marginal damages that the unit of pollution would have caused. It doesn’t make sense to reduce pollution. If the level of emissions are greater than E 1, then the marginal damages are greater than the marginal abatement costs associated with reducing pollution by one unit. Society is better off eliminating that unit of pollution.
36 Social Costs When Pollution Level is Greater than Optimal
37 Social Costs When Pollution Level is Greater than Optimal The optimal level of pollution is E 1. The actual level of pollution is E 2. Total costs associated with pollution have been increased by the area of triangle abc. This represents marginal damages greater than marginal abatement costs for the range of pollution emissions between E 1 and E 2.
38 Social Costs When Pollution Level is Less Than the Optimal
39 Social Costs When Pollution Level is Less than Optimal The optimal level of pollution is E 1. The actual level of pollution is E 3. Total costs associated with pollution have been increased by the area of triangle ade. This represents marginal abatement costs greater than marginal damage for the range of pollution emissions between E 1 and E 3.
40 Pursuing Environmental Quality with Command and Control Policies One way to achieve an optimal level of pollution is to mandate action to achieve the desired level of pollution. Critics have argued that command and control regulations generate more abatement costs than necessary. Consider Figure 3.9 where both polluters are required to reduce pollution by 50 percent.
41 Pursuing Environmental Quality with Command and Control Policies
42 Pursuing Environmental Quality with Command and Control Policies The aggregate marginal abatement cost function (societal marginal abatement cost function) is the horizontal summation of the individual marginal abatement cost functions. With no environmental regulation, polluter 1 would emit 10 units and polluter 2 would emit 6. A requirement to reduce emissions by 50%, regardless of cost, would reduce polluter 1 to 5 units and polluter 2 to 3 units.
43 Pursuing Environmental Quality by Equating Marginal Abatement Costs When both polluters are required to reduce emissions by 50%, regardless of marginal abatement costs, polluter 2 incurs a higher cost ($3) than polluter 1 ($2). Society’s total abatement costs can be lowered by keeping total emissions constant, but reallocating level of emissions by marginal abatement costs. The optimal level of emissions will be where marginal abatement costs are equal, for a given level of emission.
44 Pursuing Environmental Quality by Equating Marginal Abatement Costs
45 Pursuing Environmental Quality by Equating Marginal Abatement Costs Since polluter 2 has higher marginal abatement costs, polluter 2 should be allowed to emit more, and polluter 1 will be required to pollute less. Polluter 1 reduces pollution by one half unit (to 4 ½) and polluter 2 increases pollution by one half unit (to 3 ½). Polluter 1’s marginal abatement costs increase and polluter 2’s marginal abatement costs decrease. Total abatement costs are minimized.
46 The Role of Command and Control Policies Despite their inability to equate marginal abatement costs across polluters, command and control policies may still be the most desirable policy instrument under the following circumstances: When monitoring costs are high. When the optimal level of emissions is at or near zero. During random events or emergencies that can change the relationship between emissions and damages.
47 The Role of Command and Control Policies While it might be possible to achieve an optimal amount of litter through the use of a tax or per person allocation, this would require the “litter police”. It is easier to make ALL littering illegal and establish a punitive fine for those caught littering. The fine multiplied by the probability of being caught would be factored into the choice to litter.
48 The Role of Command and Control Policies When the optimal level of pollution is zero or at zero, direct controls make sense. This is the case for extremely dangerous pollutants, such as heavy metals and radioactive waste. Damages associated with these pollutants are quite severe. Direct controls also make sense in other cases where initial damages are quite high compared to initial marginal abatement costs. An example is CFC’s, where accumulated amounts are dangerous but there are low cost alternatives.
49 The Role of Command and Control Policies Emergency situations may make direct controls the preferable policy instrument. These events occur in random and unpredictable fashion. Examples include smog alerts and droughts.
50 Pursuing Environmental Quality with Economic Incentives Economists advocate policies based on economic incentives for two primary reasons: Economic incentives minimize total abatement costs by equating marginal abatement costs across polluters and encouraging a broader array of abatement options. Economic incentives encourage more research and development into abatement technologies and alternatives to the activities that generate the pollution.
51 Economic Incentives and Minimized Total Abatement Costs Consider the following graph. A polluter is polluting at an unregulated level of 10 units. The government imposes a tax equal to t dollars per unit of pollution. The polluter compares the tax of t dollars to the marginal abatement cost (MAC) of reducing pollution. As long as the MAC is less than the tax, polluter will reduce level of emissions. Each polluter will chose an emission level which equates MAC and the tax.
52 Economic Incentives and Minimized Total Abatement Costs
53 Economic Incentives and the Certainty of Attaining a Target Level of Pollution If the aggregate marginal abatement cost function is know, then achieving a targeted level of pollution is easily accomplished. If the aggregate marginal abatement cost function is not known, the appropriate tax level is much harder to determine. Consider Figure 3.16, where evidence suggests that the true MAC function lies between an upper and lower bound set of MAC’s.
54 Economic Incentives and the Certainty of Attaining a Target Level of Pollution
55 Economic Incentives and the Certainty of Attaining a Target Level of Pollution Suppose policymakers believe MAC 1b is the true MAC. In an effort to achieve an emissions level of E 1, they impose a tax of t 1. However, if MAC t describes how polluters will respond, the emissions level will be E 2. E 2 is higher than the desired level of pollution. Because the choice of pollution abatement and production technologies is sensitive to specific tax structures, it may not be easy to change the tax to achieve the desired level of pollution emissions.
56 In summary: Pollution taxes are preferable to command and control techniques since pollution taxes minimize abatement costs and provide other desirable incentives. Under certain conditions, pollution taxes are less proficient than command and control techniques in achieving a desired level of pollution.
57 Marketable Pollution Permits Marketable pollution permits are permits which give a firm the right to emit a specific number of units of pollution. Polluters are free to buy and sell these rights to pollute. A marketable pollution permit system can both minimize total abatement costs, provide flexibility in the choice of mechanisms used to meet pollution goals, and achieve the desired level of pollution emissions.
58 Marketable Pollution Permits A system of marketable pollution permits begins with the determination of the target level of pollution. The next step is to allocate pollution across polluters. This allocation can be based on historic pollution levels, auctions, a lottery, or some other allocation scheme. The buying and selling of pollution permits will reallocate the emission rights.
59 Marketable Pollution Permits Marketable pollution permits equate marginal abatement costs across polluters. Each polluter compares his/her marginal abatement costs with the price of a permit. If the marginal abatement costs are higher than the price, they have an incentive to buy. If the marginal abatement costs are lower, they have an incentive to sell. Buying and selling will continue until the equilibrium price is reached which equates marginal abatement costs across all firms.
60 Marketable Pollution Permits and Geographic Considerations Geographic location of emissions can have a profound impact on the damages the pollution generates for some categories of pollution. Central to the importance of location of emissions is the manner in which the pollution disperses when it enters the environment. Pollution controls must take into consideration the geographic variation in the effect of pollution on society.
61 Marketable Pollution Permits and Geographic Considerations A pollution control system based on taxes could take variation into account by charging higher taxes in areas where emissions are more damaging. A marketable pollution permit system must divide the overall region into subregions. These subregions can account for geographic variability in one of two ways: development of a receptor-based system or development of separate markets for subregions.
62 Marketable Pollution Permits and Geographic Considerations: Ambient-based Permit System A receptor-based or ambient-based system allocates pollution receptors across the subregion. Locations relatively close to, and downwind from, the polluter may require more permits. Dispersion coefficients are used to help define the terms of trade in this type of marketable pollution permit market. In the following figure, the location of a particular polluter is denoted by a star and receptors are designed by letters. This polluter may have to buy some combination of 15 different types of permits.
63 Marketable Pollution Permits and Geographic Considerations: Ambient-based Permit System
64 Marketable Pollution Permits and Geographic Considerations: Emissions-based Permit System An alternative to the ambient-based system is to divide the subregions into separate markets. Polluters need only purchase permits for the subregion in which they are located. The inability to trade across subregions may mean that firms with lower abatement costs will not be able to trade permits with higher abatement cost firms in another subregion. A compromise would be to have one type of permit and allow trade across all regions, as long as the trade does not result in ambient quality standards being violated at any receptor point.
65 Marketable Pollution Permits and Geographic Considerations: Emissions-based Permit System
66 Other Types of Economic Incentives Deposit-refund systems are a good way of employing economic incentives when monitoring costs are high. This system is based on requiring a payment up front for undesirable acts and then building in a refund when a desirable action occurs. The most common example of this is the deposit- refund system in place for beverage containers. This system has also been used for cars and batteries in other countries.
67 Other Types of Economic Incentives Bonding systems are closely related to deposit- refund systems. A bonding system requires a potential degrader of the environment to place a large sum of money in an escrow account. This money is returned if the environment is undamaged (or returned to its original condition) and will be forfeit otherwise. Bonds need to be large enough to provide an incentive to use appropriate safeguards and/or cover the cost of clean up if damage occurs.
68 Other Types of Economic Incentives Liability systems are based on defining legal liability for the damages caused by certain types of pollution discharges and facilitating collection of these damages. The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) defines legal rights to natural resources for local, state and federal governments and defines how damages can be recovered. A related system defines legal liability and then requires potential polluters to obtain full insurance against any damages. There is a potential moral hazard problem with this option.
69 Other Types of Economic Incentives A system of pollution subsidies would pay each polluter a fixed amount of money for each unit of pollution reduced. The polluter would reduce pollution to the point where the subsidy is equal to the marginal cost of abatement. While the outcome is the same as a tax on polluters, there are distributional effects, problems with political acceptability and the possibility that strategic behavior would lead to higher initial levels of pollution in order to obtain the subsidy. In addition, the subsidy could potentially attract more polluters into the industry.
70 Conclusion Market failures associated with environmental externalities generate losses in welfare. Command and control policies are the basis of current policy but do not equate marginal abatement costs across polluters. Economic incentives, such as taxes or marketable pollution permits do equate marginal abatement costs. While there are some problems with economic incentives, they do create additional motivation for technological innovation to reduce pollution.