Uncertainty, Monitoring & Enforcement Using economic models to help inform which instruments are most effective at controlling pollution

Observed control costs If MB and MC curves known, regulator can choose efficient pollution level. Electricity MC (society) MB (firm) $ t Q 2 equivalent policies: 1)Set quota of Q 2)Set tax of t.

Unobserved control costs Think of MC as the “damage” to society of pollution. Think of MB as the “savings” to the firm from being able to pollute. Which instrument is used? “Price” instrument: pay $t per unit pollution “Quantity” instrument: emit exactly Q.

Incentives to mis-report Emissions Fee: Encourages under-reporting of private MB. So fee will be set artificially low. Emissions Permit: Encourages over-reporting of private MB. So too many permits will be distributed.

If asymmetric information Is the regulator (society as a whole) better off with: Price Instruments (I.e. TAXES)…or Quantity Instruments (I.e. QUOTAS)?

Price vs. quantity regulation MC Pollution MB L MB M MB H t $ eLeL e*eHeH If tax t is imposed: May get e L, e*, or e H

When MC is steep (rel. to MB) Pollution $ MB MC Use quantity- based regulation Q*

When MC is flat (rel. to MB) Pollution $ MC MB Use price- based regulation t*

Illegal dumping If “proper disposal” is costly… People have an incentive to “midnight dump”. If monitoring free, just impose tax on polluters when they are caught. If monitoring very expensive, could tax sale of the good (consumption tax). Want a mechanism that taxes polluters, but rewards non-polluters (but we have imperfect enforcement).

Deposit-refund [1 of 2] What happens if we place a tax on dumping equal to marginal environmental damage? Illegal dumping if monitoring no perfect. Instead, want to reward proper disposal & punish illegal disposal.

Deposit-refund [2 of 2] How it works Potential polluter pays $X on purchase of waste product Receives $Y upon return. Why is this different than simply taxing illegal dumping or subsidizing clean disposal?….It’s both.

Deposit-refund: a clever policy Remember, potential polluter effectively pays tax up front. Is reimbursed (at least) upon return. A clever disclosure mechanism: Refund is paid when potential polluter proves compliance (by returning). All polluters pay tax ($X) all non-polluters pay nothing (or make money).

Enforcement Polluter may be doing something other than what he tells regulator Regulator can audit polluter, at a cost Clear interplay between frequency and stringency of audit and fine if caught. Probability of detection vs. fine E.g. traffic laws, income tax reporting, self-reporting in RECLAIM, etc..

Auditing an emissions standard f = fine per e if caught,  = prob of detection e = emissions, C(e) = cost S = emissions standard F(e) = fine actually paid Net expected costs to firm ex ante: TC(e) = C(e) + F(e) F(e) =  *f(e - S) if e > S, = 0 if e < S

How much will firm pollute? TC(e) = C(e) + F(e) MC(e) + MF(e) = 0 at the optimum -MC(e) = MF(e): Firm pollutes where marginal savings (-MC) from polluting equal marginal expected fine. Note: If firm only cares about  f, the marginal expected fine, can adjust either.

Should regulator  fine or  ? If firm only cares about  f, regulator wants high fine, low  (this makes auditing costs very small) But assets of firm may be limited (I.e. bankruptcy) Often the case for pollution (potentially high damage from cheating) May require environmental bond Bottom line: costs of cheating must exceed costs of adhering to regulation