1. Taxes, Standards and Tradable Permits 3-04-09
Econ 100 Lecture 9.2
Taxes, Standards
and Tradable Permits

2. Negative Externality Marginal Private Costs < Marginal Social Costs
Ideal
Actual Pi Pa

3. Negative Externalities
An Example: Pollution
Emitted by factories as a by product of the production process
Air, water, electricity
Emitted by vehicles
Typically treated as a “zero-cost” input into the production process
Source will be “over” consumed (beyond point marginal benefit = marginal cost as mc = 0)

4. What Are the Consequences?
Without Intervention
Consumers/producers will not take such costs into economic decisions
Produce too much of the good & externality (e.g., pollution)

5. Two Big Questions? What is the optimal level of pollution?
How is that amount allocated among firms/sources?

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

7. What Do We Know About the Costs of Reducing Pollution?
Additional costs of reducing pollution will be greater when level of pollution is higher
An Example:
First electrostatic precipitator reduces emissions by 80%
Second (added) EP by another 80%
Effectively 80% x 20% (remaining) = 16%
Third EP
80% x 4% = 3%

8. What Does the Cost Curve Look Like?

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

10. 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

11. Standards Emission standards
Could be set at same “optimal” amount of pollution as the tax
Two approaches
Establishes the level of pollution that can be emitted by “polluter”
Require all firms to reduce pollution by “x” amount
Typically divided up among the firms equally
Disregards technological/cost differences between firms
Therefore will not be cost efficient

12. Standards Same amount of pollution for all firms
Newer firms with newer/efficient technology able to easily meet standard and may not even reach it
Same amount of reduction
Newer firms already emitting less
Maybe increasingly more costly for them to reduce pollution by x amount then firms with older technology
Either way
Approach is not cost efficient
Provides no incentive for firms to reduce emissions below standard

13. Negative Externalities & Taxes
How to Set the Optimal tax
Set at point where MBen = MCost of Pollution
Tax: equals difference between MSC and MPC and
“internalizes” it into the consumption decision
Firm’s cost = price*quantity of inputs plus tax*emissions/output
Tax

14. EmissionTaxes Emission taxes Will be cost-efficient
Firms will adopt new technology if marginal abatement costs are less than marginal cost of tax
Otherwise will pay the tax
Consequently firms will adopt least cost approach to meeting optimal pollution goal
Taxes have lower administrative costs
Can be easily raised/lowered to fine tune meeting of the standard
Do not require litigation

15. Cost-Minimizing Control of Pollution with an Emission Charge

16. Cost Savings from Technological Change: Charges versus Standards