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

2. 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

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

4. 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

5. 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

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

7. 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

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

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

10. 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

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

12. 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

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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

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

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

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

23. 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

24. 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

25. 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

26. 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