1. Environmental and Natural Resource Economics 3rd ed. Jonathan M
Environmental and Natural Resource Economics 3rd ed. Jonathan M. Harris and Brian Roach Chapter 16 – Pollution: Analysis and Policy
Copyright © 2013 Jonathan M. Harris

2. Figure 16.1: The Optimal Level of Pollution
Marginal Cost/Damage
MCR MD B
The economic approach to pollution is to balance the marginal costs of pollution against the marginal costs of control. Since marginal damage costs typically rise with greater pollution, and marginal control costs also rise as stricter pollution control targets are adopted, there should be some optimum point, in between maximum pollution (the level that would exist with no controls) and zero pollution (a possibly unattainable goal). A Q*
Qmax
Pollution Level

3. Figure 16.2: CAFE Standards and Actual Average Fuel Economy for New Passenger Cars, 1978-2011
CAFE standards have governed the actual fuel economy achieved by the U.S. vehicle fleet. They remained unaltered from 1984 to 2010, leading to a lack of progress in fuel efficiency over this period.
Source: U.S. Department of Transportation, 2011.
Note: CAFE = Corporate Average Fuel Economy.

4. Figure 16.3: A Pollution Tax
Marginal Costs/Tax Level
MCR T2 A C T1 F
Economists often advocate a pollution tax, or per-unit emissions charge. It is profitable for business to clean up pollution rather than the pay the tax, so long as the marginal cost of cleanup is lower than the tax. Tax T1 leads to pollution reduction to level Q1, while a higher tax of T2 lead to more cleanup, to pollution level Q2. At tax T1, firms pay area E in cleanup costs rather than E+F in tax, saving area F. They still pay areas B+D in tax on the pollution that they continue to emit. At T2, firms pay an extra cleanup cost equal to areas C+D and reduce their tax bill to areas A+B. B D E Q2 Q1
Qmax
Pollution Level

5. Figure 16.4: Pollution Tax Example
Marginal Costs/Tax Level
210
MCR
110 A
The effect of a pollution tax can be shown in terms of pollution reduction. Rather than paying areas A +B +C +D in pollution reduction costs, a firm can reduce pollution by 40 tons at a cost of B + C, paying taxes of D on the remaining 60 tons of pollution. Their net cost is then B + C + D. They save area A as a result of this cleanup policy. B D 30 C 40
100
Pollution Reduction

6. D B C A Figure 16.5: A Tradable Pollution Permit System MCR2
Costs per Unit
$600
MCR1 D
$300
$200 B C A
An alternative to a pollution tax is a system of transferable (tradable) permits. In this example, two firms that are originally emitting 50 units of pollution each are issued 30 pollution permits each. Without trade, each will have to clean up 20 units, for a total control cost of $8,000. With trade, Firm 1, which has lower marginal control costs, can clean up 30 units, and sell 10 permits to Firm 2. Firm 2, having purchased an extra 10 permits, only has to clean up 10 units. The total cost is now only $6,000 for the same cleanup of 40 units total.
Units of Pollution Reduced
Firm
Firm
Initial Allocation
Allocation After Trading

7. Table 16.1: Cost Efficiency of a Tradable Permit System
Before trading
Units reduced
Reduction costs
Firm 1 20
$2,000
Firm 2
$6,000
Total 40
$8,000
After trading
Permit income or cost
Net costs 30
$4,500
+ $3,000
$1,500 10
– $3,000
The effect of a tradable permit system is to achieve the same amount of pollution reduction at lower costs. Boths firm benefit from trading, and overall cleanup efficiency is increased.

8. Figure 16.6: Linear and Nonlinear/Threshold Pollution Damage Effects
(a) Pollutant with Linear Damage Effect
(b) Pollutant with Nonlinear and Threshold Damage Effects
Damage
Quantity of Pollutant
Threshold
A complicating issue in pollution control is the shape of the marginal pollution damage curve. If this curve is linear or near-linear, determination of an “optimum” control level is easier. But if the curve is non-linear or has threshold effects, a small error in pollution control policy can lead to a large increase in damages. For some pollutants, such as heavy metals like mercury, the pollution tax or transferable permit approaches may be inappropriate, since high local concentrations of heavy metal pollution could lead to severe damage.

9. Figure 16.7: Emissions and Accumulated Concentration of a Stock Pollutant
Time (in Years)
Increasing Emissions
Emissions Freeze
Emissions Reductions
Zero Emissions
The case of a stock, or cumulative pollutant, poses a special challenge. Rather than balancing marginal costs of damage and control, it is necessary to try to limit total damage, which is based on long-term accumulation of the pollutant. A linearly increasing emissions level (years 0-20) leads to a more rapidly increasing accumulation, and even if emissions are frozen at a certain level (years 20-40) accumulations continue to rise. Even with steadily declining emissions (years 40-60), accumulations and damage continue to increase, though at a slower rate. In order to prevent greater damage, it is necessary to reduce emissions of the stock pollutant to zero.

10. Marginal Costs/Damages
Pollution Level
Qmax
MCR
Marginal Costs/Damages MD Q* Q1 T* T2 Q2 A B
Figure 16.8: Pollution Regulation under Uncertainty with Steep Marginal Damages
In general, the choice of pollution control policy should be governed by what is known about the shape of the marginal damage and marginal control cost curves. If the marginal damage costs rise steeply, as shown above, while the marginal control costs are fairly stable, the use of a pollution tax policy can lead to large errors. In the graph above, if the tax is even slightly too low (T1 rather than T0), pollution damage rises dramatically as firms choose to pay the tax rather than clean up. In this case, a quantity control mechanism such as permit allocation or direct regulation would be more likely to achieve the desired result.

11. Marginal Costs/Damages
Figure 16.9: Pollution Regulation under Uncertainty with Steep Marginal Reduction Costs
Pollution Level
Qmax
MCR
Marginal Costs/Damages MD Q* Q1 T* T2 Q2 A B T1
If marginal control costs rise steeply while the marginal damage curve is fairly flat, a tax policy is effective, with variations in the tax (between T1 and T2) leading to relatively small changes in cleanup levels (Q2 or Q3). On the other hand, an excessively strict quantity control (at Q1) can lead to soaring costs in return for relatively small benefits. Industries often argue that this situation prevails, putting them at risk of bankruptcy if regulations are too strict – but the experience of successful (and low-cost) policies such as the sulfur and nitrogen dioxide cleanup in the U.S. suggests that very high marginal control costs are the exception rather than the rule.

12. Figure 16.10: The Impact of Technological Change
Marginal Costs
MCR1
MCR2
T1,P1 A
Different policies have different effects over time, as technological progress reduced the costs of pollution cleanup. In the case of a pollution tax (T0), a reduction in marginal control costs to MC*C leads firms to do more cleanup, since the marginal cost of cleaning up from Q0 to Q1 is now less than the tax. But if a transferable permit system requires cleanup to Q1 at a permit price of P1, a technologically-driven reduction in cleanup costs will have the effect of reducing the permit price to P2. This could have the perverse effect of encouraging some firms to emit more pollution since they can buy permits for it at a lower price. In this case, regulators would need to “tighten up” the system by reducing the total number of permits available. P2 Q2 Q1
Qmax
Pollution Level

13. Technology-based approaches Tradable permit system
Table 16.2: Summary of Characteristics of Pollution Policy Approaches
Pollution standards
Technology-based approaches
Pollution taxes
Tradable permit system
Is policy economically efficient? No
Yes
Does policy create an incentive for innovation?
Only for meeting the standard
Generally no
Yes, resulting in lower pollution
Yes, resulting in lower permit price
Does policy require monitoring?
Minimal
Does policy generate public revenues?
Yes, if permits are auctioned
Does policy provide direct control over pollution levels?
Can policy eliminate hotspots?
Yes, if localized standards
Other advantages of policy?
Allows for flexibility in meeting standards
Can lead to lower costs for the best available control technology
Revenues can be used to lower other taxes
Individuals or organizations can buy and retire permits
Other disadvantages of policy?
Possibly no incentive to go beyond the standard
Doesn’t allow for flexibility
Taxes generally politically unpopular
Permit system can be difficult to understand
Different pollution control policies have different advantages and disadvantages. Economic efficiency is a desirable characteristic for a policy, but other considerations, such as eliminating pollution hotspots, make require direct controls rather than market-based policies.

14. Figure 16.11: Environmental Tax Revenues as a Percentage of GDP, Selected OECD Countries, 2004
The United States has the lowest environmental tax revenues as a percent of GDP among industrialized nations in the OECD. This does not necessarily indicate laxer environmental policies, since other policy instruments, such as standards and technology-based policies, may achieve environmental objectives without generating tax revenues.