Economic Solutions to Environmental Problems: The Market Approach Chapter 5 Economic Solutions to Environmental Problems: The Market Approach © 2004 Thomson Learning/South-Western

Descriptive Overview Market approach – an incentive-based policy that encourages conservative practices or pollution reduction strategies Difference between market approach and command-and-control approach is how each approach attempts to achieve its objectives

Descriptive Overview Identifying Types of Market Instruments Pollution charge Subsidies Deposit/refund systems Pollution permit trading systems

Pollution Charges Pollution charge – a fee that varies with the amount of pollutants released “Polluter-pays principle” Product charge – a fee added to the price of a pollution-generating product based on its quantity or some attribute responsible for pollution

Pollution Charges Modeling a Product Charge as a Per Unit Tax Policy motivation of a product charge is to induce firms to internalize the externality by taking account of the MEC in their production decisions Pigouvian tax – a unit charge on a good whose production generates a negative externality such that the charge equals the MEC at QE Assessing the Model Difficult to identify the dollar value of MEC at QE Model implicitly allows only for an output reduction to abate pollution

Pollution Charges Figure 5.1 Implementation of a Pigouvian Tax to Achieve Efficiency

Pollution Charges Modeling an Emission Charge: Single-Polluter Case Emission or effluent charge – a fee imposed directly on the actual discharge of pollution Assessing the Model Emission charge stimulates the natural economic incentives of the polluter

Pollution Charges Figure 5.2 Modeling an Emission Charge for a Single Firm

Pollution Charges Figure 5.3 Effect of Technology Improvement on a Firm’s Least-Cost Decision Making

Pollution Charges Modeling an Emission Charge: Multi-Polluter Case Assessing the Model Emission charge exploits each polluter’s natural incentive to pursue a least-cost strategy Low-cost abaters do most of the cleaning up and high-cost abaters pay more in taxes to cover the greater damages they cost Potential increase in monitoring costs Part of tax burden is shared with consumers in form of higher prices

Pollution Charges Figure 5.4 Effect of an Emission Charge in a Two-Polluter Model

Pollution Charges Pollution Charges In Practice Internationally, pollution charge is most commonly used market-based instrument Several countries use effluent charges to control the noise pollution generated by aircraft Real-world application of the product charge is one levied on lubricant oils by Finland, Hungary, and Italy

Environmental Subsidies Two major types of subsidies: Abatement equipment subsidies Pollution reduction subsidies

Environmental Subsidies Modeling an Abatement Equipment Subsidy Abatement equipment subsidy – a payment aimed at lowering the cost of abatement technology Attempts to internalize the positive externality associated with the consumption of abatement activities Pigouvian subsidy – a per unit payment on a good whose consumption generates a positive externality such that the payment equals the MEB at QE Assessing the model Difficulty measuring the MEB May bias polluters’ decisions about how best to abate

Environmental Subsidies Modeling a Per Unit Subsidy on Pollution Reduction Per unit subsidy on pollution reduction – a payment for every unit of pollution removed below some pre-determined level Assessing the Model Might be less disruptive than an equipment subsidy Can have perverse effect of elevating pollution levels in the aggregate

Environmental Subsidies Environmental Subsidies in Practice Internationally, many countries offer environmental subsidies in the form of grants or low-interest loans In the United States, the most common use is federal funding for publicly owned treatment works

Deposit/Refund Systems Deposit/refund system – a market instrument that imposes an up-front charge to pay for potential damages and refunds it for returning a product for proper disposal or recycling Combines the incentive characteristic of a pollution charge with a built-in mechanism for controlling monitoring costs

Deposit/Refund Systems Economics of Deposit/refund Systems Intended to force the potential polluter to account for both the marginal private cost (MPC) and the marginal external cost (MEC) of improper waste disposal Targets the potential polluter instead of penalizing the actual polluter

Deposit/Refund Systems Modeling a Deposit/Refund System Deposit serves the same function as a pollution charge with the critical difference that the refund helps to deter improper waste disposal Assessing the Model Encourages environmentally responsible behavior without adding to monitoring and compliance costs Can be used to encourage more efficient use of raw materials

Deposit/Refund Systems Figure 5.5 A Pigouvian Subsidy in the Market for Scrubbers

Deposit/Refund Systems Deposit/Refund Systems in Practice Beverage container disposal Disposal of used tire, car hulks, and lead-acid batteries

Deposit/Refund Systems Figure 5.6 Modeling a Deposit/Refund System in the Market for Waste Disposal

Pollution Permit Trading Systems Pollution permit trading system – a market instrument that establishes a market for rights to pollute by issuing tradeable pollution credits or allowances Pollution credits – tradeable permits issued for emitting below an established standard Pollution allowances – tradeable permits that indicate the maximum level of pollution that may be released

Pollution Permit Trading Systems Structure of a Pollution Trading Systems Two components: The issuance of some fixed number of permits in a region A provision for trading these permits among polluting sources within that region Bargaining gives rise to a market for pollution rights

Pollution Permit Trading Systems Modeling a Pollution Permit System for Multiple Polluters Incentive to trade as long as two firms face different MAC levels Trading will continue until the incentive to do so no longer exists, at which point, the cost-effective solution is obtained Assessing the Model Trading establishes the price of a right to pollute without intervention No tax revenues are generated Trading system is more flexible

Pollution Permit Trading Systems Pollution Trading Systems in Practice Still in early stages of development Few international examples In the United States, Clean Air Act Amendments of 1990 establish an allowance-based trading program to control sulfur dioxide emissions