Policy Tools: Correcting Market Failures

What are the most serious problems we face? Climate change Agricultural production Peak oil Water supply Biodiversity loss Health care Poverty and misery Natural resource depletion

How do we solve them? Basic philosophy: the desirable ends and the physical nature of the resources determine what policies are appropriate –We need science, not ideology Policy tools and general principles, some examples Case study: health care?

Policy Tools Prescription Payments Penalties Property rights Persuasion Power

General design principles for policy 1. Every independent policy goal must have an independent policy instrument –Ecological sustainability –Just distribution –Efficient allocation 2. Attain necessary degree of macro control with minimum sacrifice of micro-level freedom and variability –Decentralized decision making –Market mechanisms

General design principles for policy 3. Uncertainty and irreversibility requires considerable safety margin –Precautionary principle –Minimize maximum regrets –Safe minimum standards 4. Start from historical conditions –Mixed economy –Property rights

General design principles for policy (cont.) 5. Adaptive management 6. Principle of subsidiarity: Institutions at the scale of the problem

Policy sequence Scale –Determines how much there is to be distributed/allocated Distribution –Pareto optimal outcome possible from any initial distribution –Decided before allocation Allocation

Policy Tool Comparison Prescription Persuasion Penalty Payments Property rights

Pollution with known cost curves

Prescription (standard setting, command and control) for negative externalities Typical approach to pollution control –Best available technology –Setting effluent level Political factors involved in setting standards Economically inefficient? –Does not lead to action on all possible frontiers –May have lower transaction costs

Command and control (cont.) Not cost effective –Different marginal abatement costs for different polluters No incentive to reduce emissions below standard –no incentive not to increase pollution in attainment areas –little incentive to develop new technologies

Marginal pollution abatement costs for three firms emitting 5000 tons of pollution each.

Persuasion Voluntary pollution reduction Green certification

Prescription or Persuasion?

Pigouvian tax tax

Marginal pollution abatement costs for three firms emitting 5000 tons of pollution each.

Pigouvian taxes and subsidies Cost effective Efficiency requires full knowledge of costs and benefits Issues with taxes –Politically difficult –May be higher cost to industry than alternatives, though cost effective for society –Not possible for international problems

Pigouvian taxes and subsidies Issues with subsidy –May lead to more entrants into industry –Ignores polluter pays principle (negative externalities) –Excellent for activities with positive public good externalities –May be most feasible alternative for some international problems Addresses allocation first, scale and distribution only indirectly

Pollution (harvest) quotas quota

Marginal pollution abatement costs for three firms emitting 5000 tons of pollution each.

Cap and trade/auction Waste absorption capacity as a market good Cost effective Distribution of permits –Grandfather –Auction –Equity based

Cap and trade/auction Purchase of permits by conservation groups –public goods problem Problems with market thinness Problems with spatial distribution –CO2 –SO2 –Mercury

Cap and trade/auction Monitoring continuous vs. periodic Input, output estimates Non-point source pollution Addresses scale first, distribution second, allocation third Actual results –SOx permits in US CBA financed by industry vs. actual costs –Kyoto protocol

Depletion tax or quota Same thing as pollution, but with resources

Tax or quota?

With a tax, you can theoretically get right amount, but amount will change with economic change. Better to let prices vary (economic) than amount of resource to be used (ecological) tax or quota on single resource leads to substitution, on all resources will not

What should quota be? Renewables –Balance between structure and function, raw materials and ecosystem services, stock-flow and fund-service –Cannot exceed rate of renewal Non-renewables with renewable substitute –set quota so that price = that of renewable substitute? Non-renewables w/o renewable substitute –ethical decision, should not harm future

Distribution issue Increasing price of resources leads to increase in price of consumer goods, so regressive. But, rich consume more than poor, so receive a higher subsidy from the future Gov’t gets more money, can get rid of more regressive taxes. If resource prices are kept low, resources must inevitably run out. Who will this affect more, the rich or poor?

Summary of taxes and quotas Both lead to same marginal cost for all participants, necessary for efficiency, sufficient for cost effectiveness Both provide incentives for innovation Taxes raise the price of undesirable activities, reducing the quantity –Undesirable activities are a drain on economic surplus. –Taxing them is efficient Quotas create a market in waste absorption capacity; fix supply of stock flow resources –Works the same as any other market –Goal is to preserve natural capital –Provide ‘efficient’ level of ecosystem fund services