1. Summary: Taxes, Standards and Tradable Permits
Econ 201 Chpt 10
Summary: Taxes, Standards
and Tradable Permits

2. 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

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

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

5. 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

6. 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?

7. 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

8. Comparison of Approaches
Standards
Are most useful when:
Problem is short-lived (“burn” bans for high pollution days)
Optimal level is zero

9. 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 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

10. Cost Savings from Charges versus Standards
Firm 2
Lower Costs

11. 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

12. A Webinar on Tradable Permits