Presented Jan 13, 2012

By Eric Millerewmiller@yorku.ca

W2 on W3

Pricing Damages

ENVS 4510: Ecological Economics

Slide 2

Pricing Damages: Learning Objectives

• Understand price- and quantity-based solutions to correct market failure

• Understand some ways of pricing negative externalities

Slide 3

Externalities in the market model

• The consequence of a transaction that affects another person without being reflected in prices. It could be positive or negative.

• Open access resources suffer from externalities

• All goods and services involve transformation of materials/energy, using ecosystem services that are not excludable and rival negative externalities impacting the environment are widespread

• Add externalities into simple market model to see how market failure impacts efficiency, and what to do about it

Slide 4

Problem: Negative externalities affecting markets

• Negative externalities lead to inefficient market outcome where more is produced and sold than is efficient

Original (Market) Supply Curve

Demand Curve

Price ($)

QuantityQ

P

Cost of Negative externality

Social Cost Curve

Q

P

Market outcome A is inefficientEfficient outcome is at B

BA

Slide 5

Solution1: Correct market price with a special tax

• Apply a tax to cover negative externality and let market adjust the quantity supplied; called a “pigouvian” tax after Pigou (1920)

Original (Market) Supply Curve

Market Demand Curve

Price ($)

QuantityQ

P

Green Tax of Cost of Externality

New Market Supply Curve

B is new (efficient) market outcomeunder green tax

B

Q

PA

Slide 6

Solution2: Correct quantity with tradable permits

• Cap quantity of output that can be supplied with tradable permits and let the market adjust the price of permits, after Dales (1968)

Original (Market) Supply Curve

Market Demand Curve

Price ($)

QuantityQ

P

New Market Supply Curve

B is new (efficient) market outcome under tradable permit system

Maximum Permitted Output

B

Q

PA

Slide 7

Solution1 or 2? (Taxes vs. Permits)

• Ease of pricing externality or determining maximum quantity?

• Market characteristics: is externality-producing market competitive?

• Administrative burden: how to allocate initial permits? How to administer the tax?

• Durability: impact of shifting demand and supply curves?

• Political burden: is one easier to sell than another?

Slide 8

Approaches to pricing damages

Each approach is increasingly challenging, but less limiting in scope:

• Market price of the loss from externalityMethod: Market price / productivity method

• (or) Price revealed by effect of externality on another transactionMethod: Hedonic analysis of affected good/service

• (or) Price is stated by a surveyed sample contingent upon paying itMethod: Contingent valuation of willingness to pay or accept payment

Slide 9

E.g. Pricing Ontario’s alternatives to electricity from coal

Cost 3 alternatives to coal versus baseline cost of sustaining coal (DSS, 2005)

Private market cost• Construction, operating and maintenance (market prices)

+ Cost of external damages to human health• Willingness to pay to avoid minor illnesses (stated price)• Health care system costs of emergency room visits (market price)• Reduced productivity from lost work of health-impaired workers (market price)• Willingness to pay to avoid premature mortality (stated price)

+ Cost of external damages to the environment• Fixing materials corroded from pollutants (market price)• Lost agricultural productivity from pollutants (market price)• Hypothetical cost of purchasing greenhouse gas emissions permits (market price)

= Social cost of electricity

Slide 10

E.g. Pricing Ontario’s alternatives to electricity from coal

$ 0.11 $ 0.07 $ 0.10 $ 0.16 = Social cost (2005 CDN)

$ 0.01 $ 0.00 $ 0.01 $ 0.01 + External environmental cost

$ 0.04 $ 0.01 $ 0.01 $ 0.11 + External health cost

$ 0.05 $ 0.06 $ 0.08 $ 0.04 Private market cost

Replaced byClean Coal

Replaced by Gas & Nuclear

Replaced byGas

Baseline keep Coal

Slide 11

References

• Dales, J. H. 1968. "Land, water, and ownership." Canadian Journal of Economics 1(4): 791-804.

• DSS. 2005. “Cost-Benefit Analysis: Replacing Ontario’s Coal-Fired Electricity Generation.” Report for the Ontario Ministry of Energy. [online]

• Pigou, A. C. 1920. The economics of welfare. London, Macmillan.