Summary: Taxes, Standards and Tradable Permits Econ 201 Externalities Summary: Taxes, Standards and Tradable Permits

Remedies for Negative Externalities Standards Permissible level of emissions for each factory in an industry (each industry gets same target), or Targets how much emissions must be reduced by each factory (again, same target for all) Taxes Direct tax on emissions Indirect on input/output if there is a direct correlation between input/output and pollution E.g., tax on gasoline, coal based on sulfur content Tradable permits Gives each firm the “right” to pollute to a certain level Firms are allowed to trade/sell permits

Two Big Questions What is the optimal level of pollution? How should it be allocated among its sources (firms)?

How Do We Set the Standard? Equate MC of damage To MC of abatement

Comparing Standards Essentially all 3 approaches can theoretically be set to achieve an optimal standard MC[damages] = MC[abatement] In practice Hard to obtain accurate data on damages Standards have been set arbitrarily in all 3 cases

Evaluating the Efficiency of Allocation? Economic Efficiency Does the policy result in meeting the standard in a least-cost manner? Administrative Cost Efficiency What are the monitoring, enforcement and other administrative costs? Flexibility: responding to changes in market dynamics, e.g., inflation, changes in demand? Self-adjusting or not?

Comparison of Approaches Standards Can produce optimal level of pollution But setting same standard for all firms (and are not productively efficient, e.g. min cost) To set individual quotas: requires knowledge of each firm’s costs Provide no incentive for firms to reduce pollution below current “authorized” levels Have higher administrative costs Not only have to monitor emissions Enforcement costs: legal proceedings (time delays and expense) Not very flexible: regulatory process for changing standards Can not respond easily to changes in market conditions Require rewriting legislation, establishing new standards

Comparison of Approaches Standards Are most useful when: Problem is short-lived (“burn” bans for high pollution days) Optimal level is zero – highly toxic with high mortality rates

Comparison of Approaches Taxes Can produce “optimal” amount of pollution at minimum costs and lower administrative costs Kneese (1977): comparing taxes versus standards found that desired quality costs half as much when using taxes Automatically allocates pollution levels among firms based on their costs Provides incentive for firms to reduce pollution levels through technological innovation Easy to adjust/”tune” to “right” level But does not respond without change to tax rate Tax revenues can be used finance admin costs

Cost Savings from Charges versus Standards Firm 2 Lower Costs

Comparison of Approaches Tradable Permits Cost efficient Firms will purchase permits from more efficient firms if permit cost < abatement (technology) costs Technological incentive to reduce pollution Marginal cost of abatement = permit cost Similar to taxes Administratively simpler Require less information about the firms’ cost Better able to handle “spatial” variation in pollution Fewer permits auctioned in bad areas Adjust “automatically” for changes in inflation and growth E.g., Ca RECLAIM experience If auctioned -> revenues for admin costs

A Webinar on Tradable Permits http://www.sightline.org/research/energy/res_pubs/cap-in-trade-2009-sightline-webinar