Sidney Innerebner, PhD, PESidney Innerebner, PhD, PE

Indigo Water GroupIndigo Water Group

Outline for P2 EconomicsOutline for P2 EconomicsA brief introduction to economics and A brief introduction to economics and

marketsmarketsPollution as a Market FailurePollution as a Market FailureCommand and Control InstrumentsCommand and Control InstrumentsEconomic InstrumentsEconomic InstrumentsFailure of Regulatory ControlsFailure of Regulatory Controls

Law of DemandLaw of DemandConsumers are willing to buy more of a Consumers are willing to buy more of a

commodity at lower prices than at higher commodity at lower prices than at higher prices, given constant demand pressuresprices, given constant demand pressures

Law of SupplyLaw of Supply Sellers are willing to provide more of a given Sellers are willing to provide more of a given

good at higher prices than at lower prices, good at higher prices than at lower prices, given constant supply parametersgiven constant supply parameters

First Fundamental TheoremFirst Fundamental TheoremMarkets are efficient if:Markets are efficient if:

A complete set of markets exists with A complete set of markets exists with well-well-defined property rightsdefined property rights

Consumers and producers behave Consumers and producers behave competitivelycompetitively by maximizing benefits and by maximizing benefits and minimizing costs minimizing costs

Consumers and producers Consumers and producers knowknow all prices all prices Transparency!Transparency!Transaction costs are zero so that charging a Transaction costs are zero so that charging a

price does not consume resources price does not consume resources

First Fundamental TheoremFirst Fundamental TheoremIf these conditions hold, If these conditions hold, markets are said to be markets are said to be

efficientefficientEssentially, all gains from trade have been Essentially, all gains from trade have been

exhaustedexhaustedNo reallocation of resources in society could No reallocation of resources in society could

improve someone’s well being without making improve someone’s well being without making someone else worse off someone else worse off

In other words – the market pushes the most In other words – the market pushes the most efficient use of the resource…… but an individual efficient use of the resource…… but an individual might not be happy with the resultmight not be happy with the result

Property RightsProperty RightsThe first condition required that property The first condition required that property

rights be well-defined. rights be well-defined. Property rights represent a set of legal Property rights represent a set of legal

entitlements over assets. entitlements over assets. This is crucial as it allows goods to flow from This is crucial as it allows goods to flow from

low-value to high-value uses. low-value to high-value uses.

Property RightsProperty RightsProperty Rights are well-defined if:Property Rights are well-defined if:

ComprehensivelyComprehensively assignedassigned: : AllAll assets have assets have privately or collectively assigned property privately or collectively assigned property rights, and all entitlements are enforcedrights, and all entitlements are enforced

ExclusiveExclusive: All benefits and costs accrue to the : All benefits and costs accrue to the owner exclusively, and no others, either owner exclusively, and no others, either through the use or sale of the assetthrough the use or sale of the asset

Property RightsProperty RightsTransferableTransferable: All property rights must be : All property rights must be

transferable from one owner to another. The transferable from one owner to another. The possibility of resale encourages owners to possibility of resale encourages owners to consider not only their current use value, but consider not only their current use value, but also the future value to other agents also the future value to other agents

SecureSecure: All property rights should be secure : All property rights should be secure from seizure by other individuals, firms or the from seizure by other individuals, firms or the government. Provides an incentive to improve government. Provides an incentive to improve and preserve assetsand preserve assets

Incomplete MarketsIncomplete MarketsHistorically, there are many goods that lack Historically, there are many goods that lack

property rights or a marketproperty rights or a marketAir, water, fisheries, rangelands for exampleAir, water, fisheries, rangelands for exampleMany environmental problems can be traced Many environmental problems can be traced

to a lack of a market or property rightsto a lack of a market or property rights

Market Success Market Success Markets work successfully when the prices of Markets work successfully when the prices of

goods communicate their relative demands goods communicate their relative demands and scarcities to a decentralized and diffuse and scarcities to a decentralized and diffuse societysociety

Markets can organize collective information Markets can organize collective information and allocate goods and services to the and allocate goods and services to the highest-valued usehighest-valued use

Market SuccessMarket SuccessPrice signal is a powerful ‘coordination’ Price signal is a powerful ‘coordination’

mechanismmechanismWhen prices are correct, there is no need for When prices are correct, there is no need for

central planning to determine prices or central planning to determine prices or quantitiesquantities

At best they could only replicate the market At best they could only replicate the market outcome outcome

Prices are only correct when all costs of Prices are only correct when all costs of doing business have been internalizeddoing business have been internalized

Market FailuresMarket FailuresThe invisible hand pushes in such a way that The invisible hand pushes in such a way that

individual decisions do not lead to socially individual decisions do not lead to socially desirable outcomes.desirable outcomes.

What is Market Failure?What is Market Failure?Market failure occurs when freely-Market failure occurs when freely-

functioning markets, operating without functioning markets, operating without government intervention, government intervention, fail to deliver an fail to deliver an efficient or optimal allocation of resourcesefficient or optimal allocation of resources

Therefore, economic and social welfare may Therefore, economic and social welfare may not be maximizednot be maximized

This leads to a loss of economic efficiencyThis leads to a loss of economic efficiency

Definition of Market FailureDefinition of Market FailureMarket failure exists when the competitive Market failure exists when the competitive

outcome of markets is not efficient from the outcome of markets is not efficient from the point of view of the economy as a wholepoint of view of the economy as a whole

This is usually because the benefits that the This is usually because the benefits that the market confers on individuals or firms market confers on individuals or firms carrying out a particular activity diverge from carrying out a particular activity diverge from the benefits to society as a wholethe benefits to society as a whole

Definition of Market FailureDefinition of Market FailurePut another way, markets fail when the Put another way, markets fail when the

private returns which an individual or firm private returns which an individual or firm receives from carrying out a particular action receives from carrying out a particular action diverge from the returns to society as a whole diverge from the returns to society as a whole – resulting in a sub-optimal amount of it being – resulting in a sub-optimal amount of it being donedone

Markets can also fail when the individual or Markets can also fail when the individual or firm firm does not have sufficient informationdoes not have sufficient information to to recognize the returns from taking an actionrecognize the returns from taking an action

Main Causes of Market FailureMain Causes of Market FailureExternalities causing private and social costs Externalities causing private and social costs

and/or benefits to divergeand/or benefits to divergeCommon PropertyCommon PropertyPure public goods and quasi-public goodsPure public goods and quasi-public goodsImperfect informationImperfect informationMarket dominance and abuse of monopoly Market dominance and abuse of monopoly

powerpowerEquity (fairness) issues. The market can Equity (fairness) issues. The market can

generate an unacceptable distribution of generate an unacceptable distribution of income and social exclusionincome and social exclusion

ExternalitiesExternalitiesAny cost or benefit borne by an agent who Any cost or benefit borne by an agent who

receives no compensation for the cost nor receives no compensation for the cost nor pays for the benefit pays for the benefit

The absence of a market means this The absence of a market means this externality isn’t resolved through bargainingexternality isn’t resolved through bargaining

Can be negative or positiveCan be negative or positive

ExternalitiesExternalitiesIn the case of a negative externality, an agent In the case of a negative externality, an agent

fails to account for the costs he imposes on fails to account for the costs he imposes on othersothers

Pollution is a classic negative externalityPollution is a classic negative externality

Examples of Negative Examples of Negative ExternalitiesExternalitiesSmokers ignore the impact of passive Smokers ignore the impact of passive

smoking on non-smokerssmoking on non-smokersAcid rain from power stations in the UK can Acid rain from power stations in the UK can

damage the forests of Norwaydamage the forests of NorwayAir pollution from road useAir pollution from road useThe social costs of drug abuseThe social costs of drug abuseThe environmental damage caused by the The environmental damage caused by the

growing use of fertilizers in agriculturegrowing use of fertilizers in agricultureNoise pollution from aircraft taking off and Noise pollution from aircraft taking off and

landinglanding

A Negative Externality ExampleA Negative Externality ExampleMarginal social costMarginal social cost includes all the includes all the

marginal costs borne by society.marginal costs borne by society.

– It is the marginal private costs of production plus the cost of the negative externalities associated with that production.

A Negative Externality ExampleA Negative Externality ExampleWhen there are negative externalities, the When there are negative externalities, the

competitive price is too low and equilibrium competitive price is too low and equilibrium quantity too high to maximize social welfare.quantity too high to maximize social welfare.

D = Marginal social benefit

S = Marginal private cost

S1 = Marginal social costCost

Quantity0 Q0

P0

Q1

P1

Marginal cost from externality

ExternalitiesExternalitiesFirms set private marginal costs = private Firms set private marginal costs = private

marginal benefits in deciding pollution levelsmarginal benefits in deciding pollution levelsSince pollution harms other people, the Since pollution harms other people, the

marginal social costs exceed the marginal marginal social costs exceed the marginal private benefitsprivate benefits

We get an We get an overprovisionoverprovision of pollution (or any of pollution (or any other negative externality) – market failureother negative externality) – market failure

ExternalitiesExternalitiesOn the other hand, with On the other hand, with

positive externalities, we get positive externalities, we get an an underprovisionunderprovision of the of the good – market failuregood – market failure

Lighthouses for exampleLighthouses for exampleProviders of the positive Providers of the positive

externality do not account for externality do not account for the benefits of their actions the benefits of their actions that accrue to othersthat accrue to others

Marginal social benefits Marginal social benefits exceed marginal private exceed marginal private benefitsbenefits

Transferable ExternalitiesTransferable ExternalitiesRelated problem is when externalities can be Related problem is when externalities can be

transferred to others at a relatively low costtransferred to others at a relatively low costThink towns on either side of a river bank Think towns on either side of a river bank

building a levee higher and higherbuilding a levee higher and higherWe get an We get an overprovisionoverprovision of self-protection – of self-protection –

market failuremarket failure

Common PropertyCommon PropertyThere appears, then, to be some truth in the There appears, then, to be some truth in the

conservative dictum that conservative dictum that everybody's property is everybody's property is nobody's propertynobody's property. Wealth that is free for all is valued . Wealth that is free for all is valued by none because he who is foolhardy enough to wait by none because he who is foolhardy enough to wait for its proper time of use will only find that it has for its proper time of use will only find that it has been taken by another. The blade of grass that the been taken by another. The blade of grass that the manorial cowherd leaves behind is valueless to him, manorial cowherd leaves behind is valueless to him, for tomorrow it may be eaten by another's animal; for tomorrow it may be eaten by another's animal; the oil left under the earth is valueless to the driller, the oil left under the earth is valueless to the driller, for another may legally take it; the fish in the sea are for another may legally take it; the fish in the sea are valueless to the fisherman, because there is no valueless to the fisherman, because there is no assurance that they will be there for him tomorrow if assurance that they will be there for him tomorrow if they are left behind today.they are left behind today. Gordon, 1954Gordon, 1954

Common PropertyCommon PropertyIn 1968, Hardin published In 1968, Hardin published

“The Tragedy of the Commons”“The Tragedy of the Commons”Lack of property rights (open Lack of property rights (open

access) causes people to trash access) causes people to trash the resourcethe resourceEach individual thinks “what is Each individual thinks “what is

my private cost from using the my private cost from using the resource”resource”

But everyone makes that same But everyone makes that same calculation, trashing the calculation, trashing the resourceresource

Common PropertyCommon PropertyA firm polluting the “commons” has a A firm polluting the “commons” has a

private cost of emissions lower than the private cost of emissions lower than the social cost of emissions.social cost of emissions.

A cabin on a lake dumps their waste in a A cabin on a lake dumps their waste in a common lake. common lake. Pollution is diluted to all other cabins on the Pollution is diluted to all other cabins on the

lakelakePrivate cost is less than the social cost. Private cost is less than the social cost. But each cabin comes to the same conclusionBut each cabin comes to the same conclusion

Common PropertyCommon PropertyHardin’s analysis is essentially a “Prisoner’s Hardin’s analysis is essentially a “Prisoner’s

Dilemma” – Dilemma” – noncooperation is the only noncooperation is the only rational strategyrational strategy

Even if every agent recognizes that it would Even if every agent recognizes that it would be better to cooperate and preserve the be better to cooperate and preserve the commons, it’s individually rational to overuse commons, it’s individually rational to overuse it. it.

Prisoner’s DilemmaPrisoner’s Dilemma

(Defect, Defect) is the only Nash Equilibrium

Even though (Cooperate, Cooperate) would be better for both players

Public GoodsPublic GoodsIn the case of public goods, when use is In the case of public goods, when use is non-rivalnon-rival

and and non-excludablenon-excludable::Non-rivalry means that consumption of the good

by one individual does not reduce availability of the good for consumption by others; and

Non-excludability that no one can be effectively excluded from using the good

……no decentralized pricing system can serve to no decentralized pricing system can serve to determine optimally these levels of collective determine optimally these levels of collective consumptionconsumption Samuelson, 1954Samuelson, 1954

UnderprovisionUnderprovision is the result is the result

Examples of Public GoodsExamples of Public GoodsClean AirStreet LightsPublic FireworksNational Defense

Public GoodsPublic Goods

Global Public GoodsGlobal Public GoodsOne particularly challenging problem is that One particularly challenging problem is that

of global public goodsof global public goodsA global public good is one where the A global public good is one where the

impacts are indivisibly spread across the impacts are indivisibly spread across the globe (global warming, ozone, Shakespeare, globe (global warming, ozone, Shakespeare, terrorism, proliferation)terrorism, proliferation)

Public goods and market failurePublic goods and market failureFree-market economy will fail to deliver Free-market economy will fail to deliver

efficient quantity of public goods because of efficient quantity of public goods because of their characteristicstheir characteristicsA problem arising from public goods is the A problem arising from public goods is the free free

riderrider issue issuePeople take a free ride when they benefit from People take a free ride when they benefit from

consuming a good or service without paying for consuming a good or service without paying for the costs of provisionthe costs of provision

Many goods have a public element but they are Many goods have a public element but they are not pure public goods for example a congested not pure public goods for example a congested motorwaymotorway

Imperfect InformationImperfect InformationFor the market to work, agents need:For the market to work, agents need:

Perfect information about the availability of goods and services and

Complete information about prices charged by suppliers

Costs and Benefits aren’t always easily quantifiedCosts and Benefits aren’t always easily quantifiedGlobal warmingGlobal warmingIncreased cancer risk from air pollutionIncreased cancer risk from air pollution

Asymmetric information occurs when somebody knows more than somebody else in the market

Market Failure Under Market Failure Under Monopoly or MonopsonyMonopoly or MonopsonyImperfect competition can lead to a Imperfect competition can lead to a

misallocation of resourcesmisallocation of resourcesMonopoly prices will normally be above those Monopoly prices will normally be above those

in competitive marketsin competitive marketsLoss of consumer surplusLoss of consumer surplusOutput is below the competitive equilibrium levelOutput is below the competitive equilibrium levelLoss of static efficiencyLoss of static efficiency

Monopolists may waste scarce resourcesMonopolists may waste scarce resourcesHigh levels of advertising and marketing High levels of advertising and marketing

designed to increase brand loyalty and build designed to increase brand loyalty and build entry barriersentry barriers

Market Failure Under Market Failure Under MonopolyMonopolyMonopoly power can also bring economic Monopoly power can also bring economic

benefitsbenefitsExploitation of economies of scaleExploitation of economies of scaleProfits used to fund research and development Profits used to fund research and development

– leading to a faster pace of innovation and – leading to a faster pace of innovation and gains in dynamic efficiencygains in dynamic efficiency

Many monopolies face international Many monopolies face international competition and many domestic markets have competition and many domestic markets have become more contestablebecome more contestable

RecapRecapWhy do we regulate pollution?Why do we regulate pollution?

Environmental goods often suffer from market Environmental goods often suffer from market failurefailure

Allocation of environmental goods is inefficient, Allocation of environmental goods is inefficient, which provides a rationale for regulationwhich provides a rationale for regulation

Government intervention to Government intervention to correct market failurecorrect market failureThe economic rationale for government The economic rationale for government

interventioninterventionCorrection for market failure/loss of economic Correction for market failure/loss of economic

efficiencyefficiencyDesire for greater degree of equity in the Desire for greater degree of equity in the

distribution of income and wealthdistribution of income and wealthSeveral forms of government intervention are Several forms of government intervention are

possible to correct for the perceived market possible to correct for the perceived market failurefailure

Pollution Control MechanismsPollution Control MechanismsDesign standards Design standards

Quotas Quotas

Charges/Taxes/FeesCharges/Taxes/FeesSubsidiesSubsidiesCombination Combination

Fees/PermitsFees/PermitsTradable Permits Tradable Permits

Deposit-Refund Schemes Deposit-Refund Schemes

Government SolutionGovernment Solution

Market SolutionMarket Solution

CommandCommandOne approach is One approach is commandcommand—rather than —rather than

imposing a tax or offering a subsidy, the imposing a tax or offering a subsidy, the government simply requires or commands the government simply requires or commands the activity.activity.For a For a negative externalitynegative externality like pollution, the like pollution, the

government simply requires the company to government simply requires the company to stop polluting.stop polluting.

For a For a positive externalitypositive externality, like inoculation, , like inoculation, the government requires certain classes of the government requires certain classes of citizens to be inoculated. citizens to be inoculated.

Design StandardsDesign StandardsHistorically popular form of pollution control Historically popular form of pollution control

– form of – form of CommandCommand andand ControlControlGovernment determines the standards that Government determines the standards that

processes must meetprocesses must meetEx. Installation of SOEx. Installation of SO22 scrubbers, catalytic scrubbers, catalytic

convertersconvertersBenefit: clear requirements for polluting Benefit: clear requirements for polluting

firms to meetfirms to meet

Design StandardsDesign StandardsBut design standards have many issuesBut design standards have many issues

Firms have differing compliance costsFirms have differing compliance costsGovernment picks a “winning” technology that Government picks a “winning” technology that

all firms must adoptall firms must adoptTechnically costly to enforce and regulateTechnically costly to enforce and regulateLittle innovation for firms to innovate their own Little innovation for firms to innovate their own

ways to reduce pollution ways to reduce pollution Byzantine regulationsByzantine regulations

Pollution Quotas/LimitsPollution Quotas/LimitsAlso historically popular, and probably the Also historically popular, and probably the

form of pollution control most familiarform of pollution control most familiarGovernment determines the maximum level Government determines the maximum level

of each pollutant that a firm may emitof each pollutant that a firm may emitEx. Clean Water Act, CAFEEx. Clean Water Act, CAFEBenefit: If government can determine socially Benefit: If government can determine socially

optimal level of pollution, boom, they can pick optimal level of pollution, boom, they can pick itit

Pollution Quotas/LimitsPollution Quotas/LimitsThis measure allows a bit more flexibility for This measure allows a bit more flexibility for

firms – they can choose how to meet the firms – they can choose how to meet the quotaquota

If everyone complies, we get the “optimal” If everyone complies, we get the “optimal” level of pollutionlevel of pollution

Pollution Quotas/LimitsPollution Quotas/LimitsProblems:Problems:

Strong incentive for firms to shirk (moral Strong incentive for firms to shirk (moral hazard)hazard)

Short run Marginal benefits of shirking exceed Short run Marginal benefits of shirking exceed costscosts

Byzantine regulationsByzantine regulationsUniform application means we could get the Uniform application means we could get the

same reduction in pollution for less investment same reduction in pollution for less investment if high cost firms could pay low cost firms to if high cost firms could pay low cost firms to abate for themabate for them

Regulation in Fisheries ExampleRegulation in Fisheries ExampleHistorically, fisheries have been Open Access Historically, fisheries have been Open Access

– Tragedy of the Commons– Tragedy of the CommonsDespite initial optimism about our inability to Despite initial optimism about our inability to

exhaust the oceans resources, by the mid-20exhaust the oceans resources, by the mid-20thth Century fisheries were getting depletedCentury fisheries were getting depleted

In response to overexploitation, governments In response to overexploitation, governments moved to implement regulationsmoved to implement regulations

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #1: If we have too many fishermen, Thought #1: If we have too many fishermen,

we need to limit the number of boats that can we need to limit the number of boats that can fishfish

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #1: If we have too many fishermen, Thought #1: If we have too many fishermen,

we need to limit the number of boats that can we need to limit the number of boats that can fishfish

Response #1: The remaining fishermen in the Response #1: The remaining fishermen in the industry built bigger boats to catch the industry built bigger boats to catch the “extra” fish “extra” fish

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #2: If they have too big of boats, we Thought #2: If they have too big of boats, we

should limit vessel sizeshould limit vessel size

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #2: If they have too big of boats, we Thought #2: If they have too big of boats, we

should limit vessel sizeshould limit vessel sizeResponse #2: Fishermen cut off the prow of Response #2: Fishermen cut off the prow of

their boats and loaded it with lots of crewtheir boats and loaded it with lots of crew

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #3: If they have too many crew Thought #3: If they have too many crew

members, we should limit the crew sizemembers, we should limit the crew size

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #3: If they have too many crew Thought #3: If they have too many crew

members, we should limit the crew sizemembers, we should limit the crew sizeResponse #3: Fishermen loaded up their Response #3: Fishermen loaded up their

boats with tons of fishing gearboats with tons of fishing gear

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #4: This is getting ridiculous, we’ll Thought #4: This is getting ridiculous, we’ll

just close the season once a quota of fish have just close the season once a quota of fish have been caughtbeen caught

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #4: This is getting ridiculous, we’ll Thought #4: This is getting ridiculous, we’ll

just close the season once a quota of fish have just close the season once a quota of fish have been caughtbeen caught

Response #4: Fishermen set out the first day Response #4: Fishermen set out the first day of the season and catch and catch and of the season and catch and catch and catch… and seasons which used to end in 180 catch… and seasons which used to end in 180 days ended in 2 daysdays ended in 2 days

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #5: Well, we’ll just set days on Thought #5: Well, we’ll just set days on

which they can fishwhich they can fish

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #5: Well, we’ll just set days on Thought #5: Well, we’ll just set days on

which they can fishwhich they can fishResponse #5: Fishermen buy enormous Response #5: Fishermen buy enormous

motors to “race for fish” creating a very motors to “race for fish” creating a very dangerous “Fish Derby!”dangerous “Fish Derby!”

Regulation in Fisheries ExampleRegulation in Fisheries ExampleThought #5: Well, we’ll just set days on Thought #5: Well, we’ll just set days on

which they can fishwhich they can fishResponse #5: Fishermen buy enormous Response #5: Fishermen buy enormous

motors to “race for fish” creating a very motors to “race for fish” creating a very dangerous “Fish Derby!”dangerous “Fish Derby!”

Why did all these regulatory measures fail?Why did all these regulatory measures fail?

Incentives MatterIncentives MatterWe now look at alternative means of We now look at alternative means of

regulating the environmentregulating the environmentKey take away point: Incentives matter!Key take away point: Incentives matter!The preceding fishery regulations failed The preceding fishery regulations failed

because they failed to account for the because they failed to account for the fundamental incentives driving fisherman fundamental incentives driving fisherman behaviorbehavior

Ignoring incentives can lead to bad policyIgnoring incentives can lead to bad policy

Economic InstrumentsEconomic InstrumentsMany advantages over Command and ControlMany advantages over Command and ControlStatic Efficiency (cheaper now)Static Efficiency (cheaper now)Dynamic Efficiency (cheaper later)Dynamic Efficiency (cheaper later)Revenue RaisingRevenue Raising

Provide MARKET BASED incentives for Provide MARKET BASED incentives for pollution controlpollution control

Often result in lower total cost per unit of Often result in lower total cost per unit of pollution controlled AND lower total pollutionpollution controlled AND lower total pollution

Pollution TaxPollution TaxOne class of solutions to the externality One class of solutions to the externality

problems involve problems involve internalizing the costs and internalizing the costs and benefitsbenefits, so that the market can work better., so that the market can work better.

Pollution Tax: if a firm is creating a negative Pollution Tax: if a firm is creating a negative externality in the form of pollution, create a externality in the form of pollution, create a tax on the polluting firm equal to the cost of tax on the polluting firm equal to the cost of cleaning up the pollution. cleaning up the pollution.

Marginal social benefit

Marginal private cost

Marginal social costCost

Quantity0 Q0

P0

Q1

P1 Efficient tax

Emission Fees/TaxesEmission Fees/TaxesRelatively newer concept – adopted overseas Relatively newer concept – adopted overseas

in a number of contextsin a number of contextsPigouvian TaxPigouvian TaxGovernment determines a marginal fee per Government determines a marginal fee per

unit of pollution equal to the difference unit of pollution equal to the difference between social and private costsbetween social and private costs

Creates a profit incentive to reduce pollutionCreates a profit incentive to reduce pollution

Emission Fees/TaxesEmission Fees/TaxesNow firms factor in their social damages, Now firms factor in their social damages,

leading to an optimal level of pollutionleading to an optimal level of pollutionEquimarginal principle is met – on the Equimarginal principle is met – on the

margin, benefits equal costsmargin, benefits equal costsHigh cost firms will abate less, low cost firms High cost firms will abate less, low cost firms

will abate morewill abate moreAlso provides an incentive to innovate ways Also provides an incentive to innovate ways

to reduce pollutionto reduce pollution

Emission Fees/TaxesEmission Fees/TaxesStill, problems remainStill, problems remain

Regulator might not be able to determine Regulator might not be able to determine optimal tax leveloptimal tax level

Regulating joint production of multiple Regulating joint production of multiple pollutantspollutants

Equity concerns (regressive)Equity concerns (regressive)Need to be able accurately measure emissions Need to be able accurately measure emissions

to charge them (tailpipe, runoff)to charge them (tailpipe, runoff)

Tradable PermitsTradable PermitsNewest form of pollution control – very Newest form of pollution control – very

popular among economistspopular among economistsGovernment essentially creates a market for Government essentially creates a market for

the right to pollutethe right to polluteDetermine a cap on total emissions, and then Determine a cap on total emissions, and then

dole out a share of that cap (grandfather or dole out a share of that cap (grandfather or auction)auction)

Agents can then trade these rightsAgents can then trade these rights

Tradable PermitsTradable PermitsEx. US and Canada sulfur dioxide, New Ex. US and Canada sulfur dioxide, New

Zealand and Iceland fisheries, European Zealand and Iceland fisheries, European carbon marketcarbon market

Like the quota/limit system, government gets Like the quota/limit system, government gets to determine optimal social pollutionto determine optimal social pollution

But now, firms can trade permitsBut now, firms can trade permitsHigh cost firms can buy permits from low cost High cost firms can buy permits from low cost

firmsfirmsProvides incentives to innovateProvides incentives to innovate

Tradable PermitsTradable PermitsAgain, problems existAgain, problems exist

Government still needs measurement and Government still needs measurement and enforcementenforcement

Government still needs to determine “optimal” Government still needs to determine “optimal” total pollution total pollution

Hotspots and non-uniform mixing pollutantsHotspots and non-uniform mixing pollutantsMarket powerMarket powerInitial allocation process is contentiousInitial allocation process is contentious

SubsidiesSubsidiesEssentially create false demand OR falsely Essentially create false demand OR falsely

lower costslower costsCash for Clunkers – a success storyCash for Clunkers – a success storyCorn ethanolCorn ethanol

Farm subsidiesFarm subsidiesBanned import of sugar cane ethanolBanned import of sugar cane ethanolUnintended consequence: increased food Unintended consequence: increased food

pricesprices

Regulatory FailureRegulatory FailureLaws and regulations may institutionalize the Laws and regulations may institutionalize the

tragedy of the commonstragedy of the commonsRule of capture for oil and mineralsRule of capture for oil and mineralsWater rights, esp. groundwaterWater rights, esp. groundwater

Lobbyists may support regulations as a way Lobbyists may support regulations as a way of hurting their competitionof hurting their competitionClean Air Act – grandfathered plants could Clean Air Act – grandfathered plants could

operate cheaply compared to new sourcesoperate cheaply compared to new sourcesCAA – cut sulfur emissions by using low sulfur CAA – cut sulfur emissions by using low sulfur

coal OR by installing scrubberscoal OR by installing scrubbers

Regulatory FailureRegulatory FailureHard Cases Make Bad LawHard Cases Make Bad Law

1970’s Petroleum prices and lead1970’s Petroleum prices and lead2001 Power shortage in California2001 Power shortage in California

Regulations often have unintended side effectsRegulations often have unintended side effectsNew source standards in CAA have perpetuated New source standards in CAA have perpetuated

old technology and kept it in operation too longold technology and kept it in operation too longCorn ethanol and food pricesCorn ethanol and food pricesFishing boat exampleFishing boat example

Regulatory FailureRegulatory FailureRegulators don’t bear the costs of their Regulators don’t bear the costs of their

regulationsregulationsForest Service and timber roadsForest Service and timber roadsRoads paid out of US TreasuryRoads paid out of US TreasuryForest Service keeps some proceedsForest Service keeps some proceedsIncentive to build lots of roads to nowhereIncentive to build lots of roads to nowhereTimber value < road costsTimber value < road costs

More negative consequencesMore negative consequencesDeforestationDeforestationLoss of habitatLoss of habitatSoil erosionSoil erosion

Regulatory FailureRegulatory FailureCommand and Control can stifle innovationCommand and Control can stifle innovation

The existence of regulations and regulatory The existence of regulations and regulatory bodies gives people a false sense of securitybodies gives people a false sense of securityBernie Madoff?Bernie Madoff?BP Oil SpillBP Oil SpillMelamine in baby foodMelamine in baby food

Regulatory SuccessesRegulatory SuccessesPhosphorus loading in ColoradoPhosphorus loading in ColoradoCap and Trade for SOx and NOxCap and Trade for SOx and NOxRefund-Deposit schemes for bottles, Refund-Deposit schemes for bottles,

batteries, white goods, and morebatteries, white goods, and moreSafe Drinking Water ActSafe Drinking Water ActFood and Drug Administration (some failure Food and Drug Administration (some failure

here too)here too)Fuel TaxFuel Tax