Transactions costs and the optimal instrument and intensity of air pollution control

Policy Sciences 24: 315-332, 1991. �9 1991 KluwerAcademic Publishers. Printed in the Netherlands.

Transactions costs and the optimal instrument and intensity of air pollution control

ROBERT E. KOHN* Southern Illinois University, Department of Economics, School of Business, Professor Emeritus of Economics, EdwardsvilIe.

1. Introduction

The transactions costs of pollution control are the governmental costs of implementation, monitoring, and enforcement plus the costs to firms for accounting, negotiating, and filing reports. In deriving marginal conditions for the efficient intensity of pollution control, it is usually assumed that the transactions costs of implementing the solution are zero. 'This is not to deny the importance of transactions costs,' Tietenberg (1973, p. 505n) explains, 'but rather to emphasize other dimensions of choice that are logically distinct from costs of implementation, enforcement, etc.' For Coase (1960), however, the priority is reversed, because the transactions costs of implementation, enforcement, etc. determine at the outset how pollution should be controlled. Some of these 'other dimensions of choice' that Tietenberg and others address may be moot if the instrument of pollution control that makes them relevant is itself inefficient. This paper addresses the two major policy issues of pollution control that are affected by transactions costs, the choice of the optimal governmental control instrument and the efficient intensity of abatement under that instrument. For expositional convenience, these two policy issues will be considered here in reverse order.

Five alternative instruments for pollution control are considered in this paper. These are (1) Least-Cost Regulato U Standards, which are the standards that achieve targeted air quality improvement at the lowest total cost of abatement, (2) Pigouvian Taxes on emissions, equal to marginal pollution damage per unit of emissions, the revenues from which are redistributed to households in lump-sums, (3) Politically Feasible Standards that reflect political compromise as well as efficiency objectives, (4) Marketable Discharge Permits distributed at no charge to existing polluters, in quantities such that, in subsequent auctions, their equilibrium market price equals marginal pollution damage, and (5) Revenue-Raising Pigouvian Taxes to replace alternative sources of govenmaent revenue.

In Section 2 of the paper, a graphical and corresponding numerical model are proposed for determining the efficient intensity of pollution abatement under any particular control instrument. This model is used in Section 3 to examine the effect of the transactions costs of implementing Least-Cost

316

Regulatory Standards. In Section 4, the same is done for control by Pigouvian Taxes. It is arbitrarily assumed here that half of total transactions costs are the fixed annual costs of implementing a particular control instrument. The other half, which are variable transactions costs, are assumed to increase with the intensity of abatement if pollution is controlled by regulatory standards but decrease with the intensity of abatement (that is, increase with the quantity of allowable emissions) if pollution is controlled by emission taxes. It will also be assumed, to simplify the analysis, that it is the government rather than polluters that incur the transactions costs.

The implementation of a particular control instrument is likely to alter the levels of polluting activities, and this can affect the choice of an optimal instrument. These feedback effects are examined in Section 5 of the paper and ar e quantified in Section 6. In Section 7, it is recognized that regulatory standards are more likely to be Politically Feasible Standards than Least-Cost Standards, that there are special advantages to Marketable Discharge Permits, and that there is an efficiency gain when the revenue from Pigouvian Taxes is used to replace alternative sources of government revenue.

The data used in this paper are taken from my own study of pollution control in the St. Louis airshed (Kohn, 1978). Most of the numbers were calculated more than twenty years ago and many are no longer valid. The crucial estimates of total transactions costs that are contained in this study (Kohn, 1978, p. 190) are based entirely on personal communications with pollution control authorities and lack the documentation that underlies the overall study. Moreover, some simplistic assumptions are made to fill in, by interpola- tion and extrapolation, certain key gaps in the data. Despite these limitations, there is the important advantage of having a set of consistent data on the efficient control of five major air pollutants in a single airshed at a particular period of time, most of which data are available in a single volume. Although the strength of the conclusions is limited by the validity of the data, the investigation exposes a series of theoretical problems whose resolution gives rise to useful insight. Finally, it yields some broad policy conclusions on the transactions costs of air pollution control that appear likely to be upheld when more accurate data on the subject become available.

2. The model and basic data

A graphical analysis of the efficient level of pollution is presented in Figure 1, where Q0 is the flow of pollutant emissions prior to government intervention. If the transactions costs of pollution control are ignored, the efficient level of pollution is Q2, where the sum of the total cost of abatement, TCA, and total pollution damage, TPD, is a minimum. The efficient level is the less stringent Q3 if the total transactions costs of implementation decrease with the quantity of pollution, as in the case of the transactions costs of standards, TRS. The more stringent level Q1 is efficient if total transactions costs increase with the

$

317

TPD+TCA TPD+TCA+TRP

TPD+TCA+TRS

TCA I I I I I I I I I

TPD

, ,, ~ J TRP

~ T R S

Q, Q, Q~ Qo

quantity of pollution, as in the case of transactions costs of Pigouvian taxation, TRP. It is correct to represent two different control instruments by the same TCA curve, as in Figure 1, if it can be assumed that both instruments achieve successive improvements in air quality at the same total cost. This is a valid assumption when Pigouvian Taxes (which foster a least-cost solution) are compared to Least-Cost Regulatory Standards. It must also be assumed that any feedbacks of implementation on the initial level of pollution, Q0, are negligible and can be ignored.

In reality, there are many different air pollutants. In the 1960's, the focus was almost exclusively on carbon monoxide, hydrocarbons, nitrogen oxides, sulfur dioxide, and particulates. In Kohn (1978, pp. 141-144), there is a model in which these five pollutants are treated as a single pollutant by

Fig. 1. Quantities of pollution at which the sums of total pollution damage, total cost of abate-

ment, and total transactions costs are a minimum under two alternative control instruments.

318

weighting each pollutant by its shadow price (the linear programming analogue of marginal cost) and assuming that each shadow price measures both the marginal damage and the average damage of the corresponding pollutant. This procedure is subsequently referred to in Kohn (1986, p. 252) as the 'Hicksian Aggregation of Pollutants.' Although there is evidence in Kohn (1978, p. 151) that relative damage caused by the individual pollutants may vary considerably from the relative shadow prices in this study, the latter will nevertheless be used here, as they frequently are in the original study, for weighting the different pollutants. If the allowable or efficient flow of each pollutant is multiplied times its shadow price and these products are added, the aggregate allowable flow of pollution is Q* = 153.1 million unitsJ These should be interpreted as units of pollution, each of which causes (or did cause in 1975) one dollar's worth of environmental damage. In this same model, the quantities of emissions abated, that is Q0 - Q*, multiplied by their respective shadow prices, sum to an aggregate of 91.9 million units of pollution abated. 2 It follows that the initial quantity of pollution in this model is Q0 "~ 153.1 + 91.9 = 245.0 million units.

Assuming that pollution damage is a constant one dollar per unit, the pollution damage function corresponding to the curve TPD in Figure 1, but now linear, is

TPD = Q million dollars. (1)

Assuming that the elasticity of the total cost of abatement with respect to the quantity of pollution abated is a constant, there are two parameters, a and ~, that determine a proxy total cost of abatement function. These can be derived using (1) the basic premise that the solution of the St. Louis model was one in which the marginal cost of abatement equals marginal pollution damage, so that when the quantity abated, Q0 - Q*, equals 91.9 million, the marginal cost of abatement is S1.00 and (2) the result from Kohn (1978, Table 4.8, p. 126) that the total annual cost of abatement is S 35.3 million. 3 It follows that

TCA = (Qo - Q)c~/[ 3 = (Qo - Q) 2.6/3600 (2)

This total cost function implies that the elasticity of the marginal cost of abatement with respect to the quantity of pollution abated is ct minus 1, that is, 1.6. This means that a one percent increase in the quantity of pollution abated causes the marginal cost of abatement to rise 1.6 percent. Some alternative support for that numerical elasticity is suggested in Kohn (1978, Table 5.1, p. 135) by the arc-elasticity of the shadow price for abating particulates in the 160 to 170 million pound range, which is (850/8173)/ (10/165) ~ 1.7.

In the absence of transactions costs, the efficient level of pollution is calculated by substituting the previously calculated 245.0 for Q0 in (2) and then setting the derivative of

319

TPD + TCA = Q + (245.0 - 0)26/3600 (3)

with respect to Q equal to zero. The solution, which corresponds to Q2 in Figure 1, is the previously reported Q* = 153.1 million units of allowable pollution. The data for this solution are listed in row (1) of Table 1.

Table l. Total pollution costs, in millions of dollars, for alternative control instruments.

Instrument Pollution Cost of Trans- Dead- Total damage abatement actions weight costs

costs welfare loss

1. - 153.1 35.3 0.0 0.0 188.4

2. Least-cost regulatory standards 153.3 35.1 0.8 0.0 189.2

3. Feedback cffect -0.5 +0.1 +0.1 188.7

4. Revenue-neutral pigouvian taxes 151.6 36.9 7.9 0.0 196.4

5. Feedback effect -4.0 +0.9 +0.1 +0.5 191.9

6. Politically feasible standards 152.7 43.8 0.6 0.1 197.2

7. Marketable discharge permits 147.6 36.0 3.9 0.5 188.0

8. Revenue-raising pigouvian taxes 147.6 36.0 7.8 -9.8 181.6

3. The transactions costs of implementing least-cost regulatory standards

In their study of regulatory standards, Downing and Watson (1974) were the first to relate marginal transactions costs to the efficient level of pollution, concluding that the transactions costs result in less stringent standards. Their view is consistent with the assumption that transactions costs, which correspond to the curve, TRS, in Figure 1, increase with the quantity of pollution abated, which is (Q0 - Q) in Figure 1. To ignore transactions costs, Downing and Watson (1974, p. 220) advise, '... would lead to the setting of a standard which is inefficiently stringent.'

In Kohn (1978, p. 190), it is estimated that the transactions costs for administering Least-Cost Regulatory Standards in the St. Louis airshed in 1975 would have been $500,000 for stationary sources alone. The transactions costs for the excluded transportation sector is estimated by assuming that transactions costs are proportional to the quantity of emissions abated, multiplied by their respective shadow prices. Accordingly, it is estimated that the additional transactions costs for enforcing Least-Cost Regulatory Stand- ards for transportation sources would have been more than S 0.2 million per

320

year? The total transactions costs for implementing the Least-Cost Regulatory solution are therefore estimated to be S0.4 million in fixed costs plus S0.4 million in variable costs. Based on the original parameters of the St. Louis model, the latter are equivalent to $0.4/(245.0 - 153.1) = S0.004 per unit of pollution abated. The transactions cost function corresponding to the TRS curve in Figure 1 is therefore

TRS = 0.4 + 0.004 (Qo - Q) = (1.4 - 0.004Q) million dollars. (4)

The optimal solution, under Least-Cost Regulatory Standards, obtained by setting the derivative of

TPD + TCA + TRS = Q + (245.0 - Q ) 2 - 6 / 3 6 0 0 + 1.4 - .004Q, (5)

with respect to Q, equal to zero, is Q* = 153.3 million, which corresponds to Q3 in Figure 1. At this level of pollution, the marginal cost of abatement, MCA, equals constant marginal pollution damage, MPD, plus the negative marginal transactions costs of regulatory standards, MTRS, as characterized in Figure 2.

$/0

0

t MPD

MCA ~ t i II} MTRS

e ~

t MTRS

, O Qo

Fig. 2. An optimal solution in which the marginal cost of abatement equals the sum of marginal pollution damage and marginal transactions costs.

321

When the transactions costs of Least-Cost Regulatory Standards are accounted for, the efficient level of pollution, 153.3 million pounds, is only 0.1 percent larger than the original 153.1 million pounds. Even this may be an overstatement, for if total damages increase at an increasing, rather than a constant rate as Q* increases, the rising marginal damages will limit the increase in Q*. This can be seen by constructing an upward sloping MPD line in Figure 2, through the point where the currcnt horizontal lVlPD line inter- sects the MCA line. This shifts the point Q* to the left, closer to the point of intersection that is the optimum level of pollution in the absence of transactions costs. The total pollution costs associated with Least-Cost Regulatory Standards are summarized in row (2) of Table 1.

4. The transactions costs of revenue-neutral Pigouvian taxation

In the case in which pollution is controlled by Pigouvian Taxes on emissions, it is assumed that total variable costs increase as the quantity of taxable emissions increases, a relationship characterized by the curve, TRP, in Figure 1. This assumption, which can be inferred from Dahlman's (1979, p. 144) observation that the 'most common notion of transactions costs among mathematical economists is one (in) which.., a fixed proportion of whatever is being traded (in this case, taxed) is assumed to disappear in the transaction itself,' is also made by Polinsky and Shavell (1982, p. 385). 5

In Kohn (1978, p. 190), it is estimated that the total transactions costs of imposing Pigouvian Taxes on allowable emissions in the St. Louis airshed in 1975, at tax rates equal to the shadow prices, would have been $4.0 million for stationary sources other than those particular sources that appeared impossible to monitor at the time. Assuming that the transactions costs for collecting taxes from each pollution source is proportional to the Pigouvian tax revenue for which that source is liable, the annual transactions costs for the sources not counted in the above estimate of $4.0 million is another $4.0 million. 6 It is assumed that one half of the total transaction costs, or $4.0 million, would cover the fixed annual costs for the systems that must be set up to assess and collect taxes. (For an innovative example of such a system for collecting emission taxes for automobile emissions, see Collinge and Stevens (1990, pp. 57-58).) The variable costs for administering Pigouvian Taxes, based on the allowable emission flow of 153.1 million units, would be ($4.0/ 153.1) or approximately S0.026 per unit of pollution emitted.

The efficient quantity of pollution, which is calculated by setting the derivative of

TPD + TCA + TRP = Q + (245.0 - Q)Z6/3600 + 4.0 + 0.026Q, (6)

with respect to Q, equal to zero, is Q* = 151.6 million. This level of pollution corresponds to Q1 in Figure 1. In this solution, unlike that illustrated in

322

Figure 2, the marginal transactions costs of the Pigouvian solution are posi- tive (above the horizontal axis) and the equality of the marginal cost of abatement with the sum of marginal pollution damage and marginal transactions costs occurs to the left of the intersection of the MPD and MCA lines in Figure 2, where the latter is above rather than below the MPD line.

In the context of the St. Louis model, the optimum at Q* = 151.6 million is only one percent more stringent than the allowable level in the absence of transactions costs, even though the variable transactions costs are more than 10 percent of the total cost of abatement. This small increase in stringency would be even less if marginal pollution damage declines as Q declines rather than remaining constant as assumed here for computational convenience. (This result can be demonstrated in Figure 2 by tilting the MPD line upward through the same point of intersection with the MCA line.)

In the context of the present model, the total Pigouvian tax revenue collected would be Q* -~ 151.6 million dollars. It is assumed that these funds are redistributed in lump sums to households. The total costs associated with Revenue-Neutral Pigouvian Taxes are listed in row (4) of Table 1. Assuming that neither instrument, Least-Cost Regulatory Standards nor Revenue- Neutral Pigouvian Taxes, affects the level of pollution before abatement, that is Q0, the total costs of S 189.2 million for Least-Cost Regulatory Standards are lower than the S 196.4 million in total costs for Pigouvian taxes.

5. The feedback of control instruments on pollution source magnitudes

There is in Kohn (1978, pp. 14-16) a special case called 'the pure abatement model' in which only the production of intermediate goods is polluting. Each of these intermediate goods is used in the same proportion to other inputs in the production of each final good, and as a result, the magnitude of the intermediate polluting activities and the relative prices of final goods remain constant even though levels of abatement activities change. In this special case, the curves in Figure 1 correctly characterize the efficient instrument for pollution control as well as the efficient intensity of abatement. The control instrument for which the minimized sum of total pollution damage, total cost of abatement, and the corresponding total transactions costs is lower is accordingly the efficient instrument, and the level of abatement at which that minimum is attained is the efficient intensity of pollution control. Because the sum of total costs is smaller at Q3 in Figure 1, Least-Cost Regulatory Stand- ards and the intensity level, Q3, are efficient. If the sum of total costs were smaller at Q~, then Revenue-Neutral Pigouvian Taxes and the level Q~ would be efficient.

In reality, the implementation of a particular control instrument does affect the magnitude of pollution source levels. Regulatory Standards increase the costs and therefore reduce the demands for polluting activities. Pigouvian Taxes increase prices and reduce the demands for polluting activities even

$ I I a TPD

323

T P D + T C A % T R S f

TPD+TCM+TRP s

I I

I

I I ITRP t I

I f TRS i

O 0 Q~ Q~ Qo Fig. 3. Shifts in the ~otal cost of abatement curve under alternative instn~ments for controlling pollution.

more. 7 It is therefore possible, as Figure 3 demonstrates, that Pigouvian taxation could shift Q0 and the corresponding total cost of abatement curve sufficiently more to the left (to Qp and TCAP) than would the regulatory instrument (to Q~ and TCA ~) that the combined total cost curve for Pigouvian Taxes would bottom out below that for the combined costs for Least-Cost Standards. As a result, Pigou~ian Taxes would be the efficient instrument, even though the total transactions cost curve for that instrument beans, as in Figure L above the maximum point of the transactions cost curve for Least- Cost Regulatory Standards and is everywhere above it. ~

*I~e choice of the pollution control instrument that yields the smaller sum of total costs, as characterized in Figure 3, is a simplification of Coase's (1960, p. 43) partial equilibrium injunction '... to compare the total product yielded by alternative social arrangements" In effect, it is assumed that there are alternative allocations of inputs and ou!puts, each corresponding to one of the instruments for pollution control, and that these allocations represent the same market value of total product except for the deductions of total costs associated with the corresponding pollution control instruments.

Because of the feedback effects upon Q0, the revised optimal solution

324

occurs at a lower level of pollution where total damages and total costs of abatement are smaller. Although these reductions in total costs and damages can be characterized in the context of Figure 3, a more direct perspective is gained from the representation of the supply and demand curves for the output of a typical polluting industry. Figure 4 illustrates the industry demand curve, Dx, and the constant-cost supply curve, Sx, for good X. The long-run supply price of this good, in the absence of pollution control, is P0. Prior to abatement, each unit of good X causes MED 0 of marginal external pollution damage. When this industry expends A-dollars of abatement costs per unit of good X, marginal external damage declines to MED 1 per unit of output. As a consequence of the corresponding increase in price from P0 to Pa, the quantity of output demanded declines from X 0 to X v

The area under the MED 0 line from the origin to X0, added ovcr all polluting industries, is equivalent to Q0 in Figure 3. The reduction in this initial level of pollution to Q~ in Figure 3 reflects the decline of 6 + , /for industry X in Figure 4, plus corresponding declines in other polluting industries. The level of pollution after abatement, contributed by industry X, not accounting for the feedback effect of the higher price upon output, is the area under the MED 1 line from the origin to X 0. Added over all polluting industries, this gives the level of pollution Q* in Figure 2, which in this model also equals pollution damage. (Because pollution is measured in constant one-dollar damaging units, the total pollution damage curve in Figure 3 would be a straight line with slope equal to 1, so that the height of the TPD line is equivalent to the horizontal distance Q.) The feedback effect of the price increase in industry X upon total pollution after abatement is represented by the area y.

The area between PI and P0 from the origin to X 0 is the total cost of abatement, and the area ct + [3 is the reduction in the total cost of abatement due to the feedback effect. When the feedback effects of Least-Cost Reguiatory Standards upon total pollution before abatement, total pollution after abatement, and the total cost of abatement are summed over all industries, it follows (because the areas, 6 + y, ~/, and ct + 13, are in equal proportion to the respective total areas, Q0, Q*, and TCA) that

Z(6 + Y)/Qo = Z(y)/Q* = Z(a + [~)/TCA, (7)

where Y implies the summation of corresponding areas for all polluting industries. This conclusion will be checked against data flom the St. Louis airshed.

There is an offsetting deadweight loss associated with the foregone consumption of good X and represented by the area 13 in Figure 4. Given the straight line demand curve, this loss should be one half of the gain, a + 13. Finally, the area under the S x line between X 0 and X 1 represents inputs transferred from industry X to the production of other competitive, presumably nonpolluting goods; because their value to consumers is assumed to equal the

325

value of the transferred inputs, this represents neither a gain nor loss in the model.

The above analysis applies to Least-Cost Regulatory Standards. If, instead, pollution control is accomplished by Pigouvian Taxation, the efficient tax, in the context of Figure 4, is T dollars per unit of good X. Unless firms in this industry abate all of their emissions, T is necessarily greater than A. To minimize the sum of emission taxes and abatement costs, firms in this industry will expend the same A-dollars per unit of good X on abatement. (For a theoretical analysis of the effect of a Pigouvian tax on the market price of a competitive firm that abates some of its emissions, see Kohn (1988, p. 57).)

The reduction in pollution damage after abatement caused by the feedback effect of Pigouvian taxation on price and output, now Pz and X 2, is ~/+ ~t. The saving in abatement cost is ct + 13 + ~p and the deadweight welfare loss is

+ ~p + Q. Under either control instrument, the feedback effect includes a saving to the government of some of the transactions costs of implementation.

$/X

9 2

P1 Po

T

Po+T

' ~ sxSX+A

Dx

t 6 t I I I I

I i pl I

IVl I I I I

X~ X, Xo 0 X

,.IEDo

Fig. 4. Supply and demand for the output of a polluting industry and the marginal external damage before and after abatement.

326

In the following section of the paper, data from the St. Louis model are used to estimate the dollar values for the airshed that correspond to the areas defined in Figure 4. Although the feedback effects are likely to change the optimal level of pollution, Q*, these changes would be difficult to model here and are presumably too small to significantly alter the numbers which are now of primary interest, that is, the feedback effects on total pollution damage, on the total cost of abatement, on total transactions costs, and on total consumer surplus. Accordingly these adjustments in total costs are based on the original solution of the St. Louis model (see row (1) of Table 1) in which Q0 = 245.0 million units, Q* = 153.1 million units, and the total cost of abatement is (Q0 - Q*) 26/3600 = $35.3 million.

6. Least-Cost Regulatory Standards versus revenue-neutral Pigouvian Taxes

In Kohn (1972, column 2 of Table 3, p. 397), there are calculations of the feedback effect of the $35.3 million in abatement costs under Least-Cost Regulatory Standards on total pollution before abatement, on total pollution after abatement, on total abatement costs, and on consumer surplus. Aggregating the induced reduction in each emission level yields an estimate of 0.8 million units of pollution) This is the analogue of 6 + y in Figure 4, and the proportional reduction is therefore 0.8/Q0 = 0.8/245.0 = .003.

Aggregating the reductions of emissions after abatement from Kohn (1972, column (2) of Table 3, p. 397) yields an estimated aggregate of 0.5 million units of pollution, l~ This is the analogue of y in Figure 4, and the proportional reduction is therefore 0.5/Q* = 0.5/153.1 -~ 0.003. The feedback effect on total abatement costs in the St. Louis model is estimated at S0.1 million in Kohn (1978, first row of column (2) of Table 3, p. 397). This is the analogue of c~ + 13 in Figure 4, and the proportional reduction is therefore 0.1/TCA = 0.1/35.3 =- 0.003. The approximate uniformity of the three proportional reductions, as predicted by equation (7), is thus supported by data collected with no such aggregation or uniformity in mind.

The loss of consumer surplus associated with pollution abatement in the St. Louis airshed, and referred to in Kohn (1972, row (1) of column (2) of Table 3, p. 397) as the 'Inputed Cost of Shifts in Production and Consump- tion,' is reported there at S0.2 million. It is recognized in Kohn (1978, p. 178) that this estimate 'overstates loss of consumers' surplus' and should be cut in half. The resulting number, S0.1 million corresponds to the area 13 in Figure 4. The above feedback effects of abatement are listed in row (3) of Table 1 and result in an adjusted total pollution cost of S 188.7 for the Least- Cost Regulatory Standards approach to air pollution control in the St. Louis airshed.

Although no prior empirical work has been done on the feedback effects of Pigouvian taxes on the prices and outputs of polluting goods, some rough estimates can be made for the St. Louis airshed. Whereas the feedback effect

327

of abatement costs relates to the average cost of abatement, which is (Q0 - Q) 16/3600 dollars per weighted unit of pollution, the feedback effect of the Pigouvian tax is based on the marginal cost of abatement which is 2.6 (Q0 - Q ) 16/3600 dollars per unit of pollution, or 2:6 times larger. Even this is an understatement, however, because an industry-by-industry evalua- tion of the price effects of the Least-Cost Regulatory Standards in Kohn (1978, pp. 191-199) indicates that these would shift relative prices against polluting goods and services to an almost insignificant degree as compared to Pigouvian Taxes.

An alternative estimate of the feedback effects is based on data in Kohn (1978, column 2 of Table 7.3, p. 194) showing that the market value of pollution related outputs in the St. Louis airshed in 1975 in the absence of abatement was $5894 million. Pigouvian taxes equal to 5153.1 million would therefore raise the value of polluting outputs by 153.1/5894, or approximately 2.6 percent. Assuming unit-elasticity of demand with respect to price, the quantities of polluting outputs would decline by 2.6 percent and the reduction in pollution damage after abatement, caused by the feedback effect, would therefore equal (0.026) (153.1) or 54.0 million. The total cost of abatement would be (0.026) (35.3), or 50.9 million less, and the offsetting loss of consumer surplus would be half of this, or S0.5 million. In addition there would be a decline in variable transactions costs equal to (0.026) (54.0), or S0.1 million. These feedbacks are listed in row (5) of Table 1. Added to row (4), they yield a net total of S 191.9 million for the pollution costs associated with Revenue-Neutral Pigouvian Taxes.

Although the regulatory instrument presents a saving of S 3.2 million over Pigouvian Taxation, there is the offsetting advantage that the latter alone :... provides a continued incentive for polluting firms to develop cheaper forms of abatement technology' (see Terkla (1984, p. 107)). Not only would this lower the total cost of abatcment under Pigouvian taxation but it would make it profitable for firms to reduce their tax burden by emitting less. If Q* declines only 1.5 percent per year due to the technological stimulus, in less than two years the Pigouvian instrument would have the lower combined total of costs.

7. Politically Feasible Standards, Marketable Discharge Permits, and Revenue-Raising Pigouvian Taxes

Hahn (1989, 1990) observes that in practice, regulatory standards are de- signed for political expediency as well as for efficiency. It is unlikely that a set of standards would ever be adopted that meets tile 'least-cost' ideal. Kohn (1978, p. 92) estimates that the total cost of achieving the same air quality goals by means of the legal regulations in force in the St. Louis airshed in 1975 would have been approximately 25 percent higher than for Least-Cost Regulatory Standards. On the basis of the transactions cost and feedback

328

adjusted total cost of abatement of $35.1 - 0.1 = $35.0 million in rows (2) and (3) of Table 1, this implies a total cost of abatement of $43.8 million for Politically Feasible Standards. Assuming that the feedback effect on pollution damage is 25 percent higher than in row (3), somewhat smaller transactions costs, and a 25 percent higher welfare loss, the total costs of pollution associated with Politically Feasible Standards are $197.2 million.

It is assumed here that an efficient quantity of Marketable Discharge Permits are distributed without charge to existing polluters but may be subsequently sold by them during one of the mandatory., periodic auctions of all permits envisaged by Hahn and Noll (1982, pp. 141-2) and Hahn (1988). Because firms are likely to prefer such a scheme to standards or to Pigouvian taxes (see Dewees (1983, p. 70)), it is arbitrarily assumed that the transactions costs are half as much as those for Revenue-Neutral Pigouvian Taxes. Because the price effects of Marketable Discharge Permits are idential to those of Pigouvian Taxes, it is assumed that the remaining total costs and feedback effects of the two instruments are identical. The resulting sum of total costs for Marketable Discharge Permits is S 188.0 million, which is less than that for the unattainable but ideal Least-Cost Regulatory. Standards, and there is still the same potential for technological improvement of abatement as with Pigouvian Taxes.

As a result of public interest in new kinds of taxes for raising public revenue, increasing attention has been given to the taxing of pollution (see, for example, Streamers (1990)). If Pigouvian taxes are used to replace other sources of revenue, such as taxes on income or on corporate profits, then 'each dollar collected; as Terkla (1984, p. 108) explains, 'is worth more than one dollar in resources (because) it replaces an existing or future dollar raised from alternative resource distorting taxes.' Terkla (1984, pp. 114-5) assumes that 'each dollar of effluent tax revenue raised has an efficiency value of S0.35 (if) the dollar (were instead) raised by a labor income tax (or S0.56 if it were raised by a) capital income tax.' The relatively high efficiency values used by Terkla are based on a 1976 study by Edgar Browning. A more conservative estimate, based on a generalization of Browning's model by Wildasin (1984, p. 240), is that the marginal cost of raising a dollar by a proportional tax on income is S 1.07 compared to S 1.32 for a progressive tax. Using the lower of Wildasiffs estimates, it may be assumed that the deadweight loss avoided by raising S 147.6 million in Pigouvian taxes would be a gain of S 10.3 million. Deducting the welfare loss of S 0.5 million from row (5) of Table 1 leaves a net saving of $9.8 million. The remaining costs for Revenue-Raising Pigonvian Taxes are the same as those for Revenue-Neutral Pigouvian Taxes. The total costs associated with the revenue-raising alternative are the least of all the instruments examined, S 181.6 million, not including the potential benefits of enhanced abatement technology.

329

8. Conclusions

To what extent do the transactions costs of implementing alternative instruments for pollution control affect the choice of the optimal instrument and the efficient intensity of control under that instrument? In a comparison of Least-Cost Regulatory Standards and Revenue-Neutral Pigouvian Taxes, it is thc highcr transactions costs of implementing the taxes that make Pigouvian Taxes the more costly of the two instruments. However, a more practical comparison of instruments is between Politically Feasible Standards, Marketable Discharge Permits, and Revenue-Raising Pigouvian Taxes. Here, the relationship between the transactions costs of implementation and total pollution costs are in an almost linear inverse relationship. The lower the pollution costs associated with a particular instrument, and therefore the more desira- ble the instrument, the higher the transactions costs of implementation. Other factors such as political distortion and welfare gains prove to be more important than the transactions costs of implementation.

Assuming that variable transactions costs decrease with the optimal level of pollution for regulatory standards but increase with the optimal level for market oriented instruments, an accounting of transactions costs results in less stringent control in the case of regulatory standards and more stringent control in the case of market oriented instruments. However, the percentage effect is very small. Moreover, it is smaller in both cases if marginal pollution damage rises with the level of pollution, as it is usually presumed to do, rather than remain constant as assumed in this paper for purposes of aggregation.

A major conclusion of this paper is that Pigouvian Taxes are the superior instrument for pollution control when the raising of public revenues is a desired objective. However, the various conclusions of this paper should be viewed as tentative because the data on which they are based are no longer current. Moreover, the critical estimates of transactions costs are somewhat dubious. It is hoped that new data will be collected for answering the ques- tions raised in this paper. When this is done, a more powerful approach, one that obviates the need for the artificial, one-dollar-damaging, aggregate pollutant, would be an expanded linear programming model in which the transactions costs are treated as separate coefficients of the individual pollution control methods. Separate sets of such coefficients, each corresponding to a different policy instrument such as Least-Cost Regulatory Standards, Revenue-Neutral Pigouvian Taxes, etc., would enable the investigator to directly derive solutions that specifs' the optimal policy instrument as well as the optimal set of pollution control method activity levels.

Notes

* I am grateful to William Ascher, Murray Weidenbaum, and two anonymous referees for help- ful guidance on the paper.

330

1. This sum of allowable annual emission flows times respective shadow prices, taken from Kohn (1978, Table 3.3, p. 83), is 2,335 million pounds of carbon monoxide at S0.00428 per pound, plus 994 million pounds of hydrocarbons at S0.02476 per pound, plus 304 million pounds of nitrogen oxides at S0.32639 per pound, plus 400 milhon pounds of sulfur oxides at S0.02193 per pound, plus 136 million pounds of particulates at S0.07748 per pound. Perhaps the major weakness in the above data is the low shadow price of sulfur dioxide, the result of an excessive optimism in the 1960's for flue-gas desulfurization. In contrast, Terkla (1984, p. 112) estimates a much higher marginal cost of S0.15 per pound for sulfur dioxide abated. Alternatively, his estimate for the efficient marginal cost of par- ticulate abatement (1984, p. 111), which is S0.096 per pound, is only a fourth more than the shadow price reported here.

2. The quantities of pollution abated in Kohn (1978, Table 2.2, p. 68) are 1,867 million pounds of carbon monoxide, 524 million pounds of hydrocarbons, 112 million pounds of nitrogen oxides, 989 million pounds of sulfur dioxide, and 164 million pounds of particulates.

3. The $35.3 million is the cost of reducing emissions to the allowable flows. There are, in addition, Sll.2 million of voluntary abatement expenditures reported in Kohn (1978, p. 74). The total of $46.5 million for the St. Louis airshed in 1975 may be a low estimate. Assuming that the actual standards were 25 percent more costly, as estimated in Kohn (1978, p. 92), the above cost escalates to (1.25)(35.3) + 11.2 = S55.3. Weidenbaum (1981, p. 98) cites Council of Environmental Quality data indicating that the entire nation spent $14.1 billion for air pollution control in 1977. Assuming, because one percent of the U.S. population lives in the St. Louis airshed, that one percent of the national total was spent there, Weidenbanm's number implies control expenditures of S141 million for the St. Louis airshed. Converting that number, which is measured in 1977 prices, back to 1968 prices, the year in which most of the St. Louis costs were calculated, yields actual expenditures of $81.0 million, still almost 50 percent higher than the $55.3 million in control costs based on the St. Louis study. However, the discrepancy may be less because this price adjustment is based on the U.S. Bureau of Labor Statistics consumer price index for all items. This understates the inflation in pollution abatement costs which, being heavily dependent on energy and fuel substitutions (see Kohn (1978, Table 3.4, pp. 86--7)), were dramatically affected by the 1973--4 energy crisis. Weidenbaum's higher cost may also include expenditures for controlling toxic pollutants other than the five pollutants in the present study. However, it is also possible that my choice and treatment of the original data may' have been biased, for I was hopeful then that my research would show that pollution could be controlled at a reasonable cost.

4. The transportation emissions abated are derived by subtracting the allowable levels after abatement in row (1) of Table 3.5 in Kohn (1978, p. 91) from the pre-abatement levels in row (1) of Table 2.2, which yields an aggregate of 28.4 million, one-dollar damage-causing units of pollution. The extrapolated transactions costs for the transportation emissions abated are therefore (28.4)(S0.5 million)/(91.9 - 28.4) = S0.2 million. According to the data used here, the governmental transactions costs of pollution control are approximately 2 cents per dollar of annualized regulatory compliance expenditures. This estimate may be on the low side. Interpolating data in Warren and Chilton (1990, p. 4), the budget of the Environmental Protection Agency in 1977 was S 1.1 billion. On the basis of the breakdown in Weidenbaum (1981, p. 98), it is assumed that 35 percent, or S0.4 billion, are for air pollution control. Because the EPA provides approximately half of the funding for the nation's local air pollution control agencies, it may be assumed that the annual governmental cost of enforcing air pollution regulations in 1977 was S0.8 billion. Using Weidenbaum's (1981, p. 98) annualized total compliance cost figure of S 14.1 billion gives an estimate of 6 cents of governmental transactions costs per dollar of annualized regulatory compliance costs. Although this figure is almost triple the number used here, the original estimates will be retained for consistency with the estimates of abatement costs and the transactions costs of collecting Pigouvian taxes. Moreover, the 6 cents per dollar estimate implies total costs of

331

enforcement well in excess of the combined 1975 budgets of the control agencies in the St. Louis airshed.

5. An opposite point of view is held by Harford (1978) and by Lee (1983), who emphasize the costs to firms of evading pollution control and the costs to the government of detection and enforcement. In effect, they argue that the more intensive the abatement under Pigouvian Taxes, the greater the incentive of firms to conceal emissions. However, Hafford (1987, p. 49) also notes that the penalty for cheating may be made sufficiently large that any pollution control scheme '... can be perfectly enforced with an arbitrarily small monitoring expenditure;' Russell, Harrington and Vaughn (1986, p. 43) provide empirical evidence that this is true.

6. The fees that would have been collected from the excluded sources are calculated by multi- plying each emission factor for the excluded control method activity (These include transportation activities, la, 2a, 3b, 3c, 3d, 4a, 5a, 6a, 7a, 8a, 9a, 10a; residential furnaces, 15a, 33b, 34b, 47a; incinerators, 52a, 53a, 54a, 55b; open burning, 56a, 56b, 57b, 58a, 59b, 60b; coke ovens, 85a, 86e, 87b; and bulk storage tanks, 95a, 96b, 97b, from Kohn (t978, Table 2.1, pp. 38--65)) times the respective shadow price and control method activity level. These sum to $75.5 million in Pigouvian Taxes for the excluded sources. Although this seems high, it should be noted that S54.5 would have been collected from transportation sources alone. The transactions costs for collecting the Pigouvian Taxes from these excluded sources, including ma additional estimated S0.1 million for collecting taxes for hydrocarbons leaking from underground lines and refinery valves, assuming that this were feasible, are (75.5)(4.0)/(153.1-75.5) = $4.0 million. The total transactions costs, $8.0 million for collecting $153.1 in Pigouvian taxes, imply a collection cost of 5 cents per dollar of tax receipts.

7. Another mechanism whereby abatement activities affect the level of pollution source magnitudes is through the demand for inputs to abatement. This mechanism, which is only tangential to the issues examined in this paper, is discussed by Pearson (1989).

8. Figures I and 2 are traced from the equations, TPD = Q2/36, TCA = (Qa-Q)2/30, TRP = 2+(Q/15), TRS = 2-(Q/30), Q0 = 30, Q~ = 25, and Qp = 20, as plotted on graph paper with five grids to the inch, where each grid equals one unit of Q. In reality, the marginal cost of abating a given quantity of pollution may increase when there is less pollution (see Shibata and Winrich (1983, p. 428)), so that the TCA curve would become steeper as Q, becomes smaller. That possibility is ignored in this paper.

9. This reduction, referred to as the 'Decline in Production and Consumption Levels' in Kohn (1972, column (2) of Table 3, p. 397), is the sum of 23,6 million pounds of carbon monoxide, 5.0 million pounds of hydrocarbons, 1.4 million pounds of nitrogen oxides, 4.5 million pounds of sulfur dioxide, and 0.4 million pounds of particulates, each weighted by the shadow price in footnote 1 above.

10. This reduction, referred to as 'Excess Abatement' in Kohn (1972, column (2) of Table 3, p. 397), is the sum of 23.5 million pounds of carbon monoxide, 4.9 million pounds of hydrocarbons, 0.9 million pounds of nitrogen oxides, 0.5 million pounds of sulfur dioxide, and 02 million pounds of particulates, each weighted by the shadow price in foomote 1 above. This 'excess abatement' made it possible to achieve the fixed air quality goals in Kohn (1978, pp. 169--178) at a lower total cost of abatement. The corresponding total cost curve corresponds to the TCA ~ curve in Figure 3. The feedback effects that are listed in this and the preceding footnote are calculated by simply subtracting the reductions in source magnitudes from the corresponding activity levels of the original control method solution in row (t) of Table 1.

References

Coase, R. H. (October 1960). 'Tile Problem of Social Cost.' Journal of Lave and Economics 3: 1-44.

332

Collinge, Robert A. and Anne Stevens (January 1990). 'Targeting Methanol or other Alter- native Fuels: How Intrusive Should Public Policy Be?' Contemporary Policy Issues 8: 54-61.

Dahlman, Carl J. (April 1979). 'The Problem of Externality.' The Journal of Law and Economics 22: 141-162.

Dewees, Donald N. (January 1983). 'Instrument Choice in Environmental Policy.' Economic Inquiry 21: 53-71.

Downing, Paul B. and William D. Watson, Jr. (November 1974). 'The Economics of Enforcing Air Pollution Controls.' Journal of Environmental Economics and Management 1: 219-236.

Hahn, Robert W. (1988). 'Promoting Efficiency and Equity through Institutional Design.' Policy Sciences 21: 41-66.

( 1989). A Primer on Environmental Policy Design. Harwood Chur. (April 1990). 'The Political Economy of Environmental Regulation: Toward a Unifying Frame-

work.' Public Choice 65: 21-47. , and Roger G. Noll (1982). 'Designing a Market for Tradeable Emission Permits,' in Wesley A.

Magat, ed. Reform of Environmental Regulation, Ballinger, Cambridge, 119-146. Harford, Jon D. (March 1978). 'Firm Behavior Under Imperfectly Enforceable Pollution Stand-

ards and Taxes.' Journal of Environmental Economic and Management 5: 26-43. (December 1987). 'Violation-Minimizing Fine Schedules.' Atlantic Economic Journal 15:

49-56. Kohn, Robert E. (November 1972). 'Price Elasticities of Demand and Air Pollution Control.'

Review of Economics and Statistics 54: 392-400. (1978). A Linear Programming Model for Air Pollution Control, MIT Press, Cambridge. (September 1986). 'Aggregating Goods and Pollutants.' Journal of Environmental Economics

and Mangement 13: 245-254. (February 1988). 'Efficient Scale of the Pollution Abating Firm.' Land Economics 64:53-61

(pages 58 and 59 are erroneously interchanged). Lee, Dwight R. (October 1983). 'Monitoring and Budget Maximization in the Control of Pollu-

tion? Economic Inquiry 21:565-575. Pearson, E J. G. (1989). 'Proactive Energy-Environment Policy Strategies: a Role for Input-

Output Analysis?' EnvironmentandPhmningA 21: 1329-1348. Polinsky, A. Mitchell and Steven Shavell (December 1982). Pigouvian Taxation with Admin-

istrative Costs.' Journal of Public Economics 19: 385-394. Russell, Clifford S., Winston Harrington, and William J. Vaughn (1986). Enforcing Pollution

Control Laws, Resources for the Future, Washington, D.C. Shibata, Hirofumi and J. Steven Winrich (November 1983). 'Control of Pollution when the

Offended Defend Themselves.' Economicu 50: 425-437. Summers, Lawrence H. (July 23, 1990). 'A Tax Package with Social Benefits.' New York Times

A13. Terkla, David (June 1984). 'The Efficiency Value of Effluent Tax Revenues.' Journal of Environ-

mental Economics and Management 11: 107-123. Tietenberg, Thomas H. (November 1973). 'Specific Taxes and the Control of Pollution: A

General Equilibrium Analysis.' The Quarterly Journal of Economics 87: 503-522. Warren, Melinda and Kenneth Chilton (May 1990). 'Regulation's Rebound: Bush Budget Gives

Regulation a Boost.' Occasional Paper No. 81, Center for the Study of American Business, Washington University, St. Louis.

Weidenbaum, Murray L. (1981). Business, Government, and the Public, Prentice-Hall, Englewood Cliffs.

Wildasin, David E. (April 1984). 'On Public Good Provision with Distortionary Taxation.' Economic Inquiry 22: 227-243.

Documents

Transactions costs and the optimal instrument and intensity of air pollution control