Public Goods

&
Tax Policy

Externalities: Pollution

Cap & Trade

Using the Market
to
Respond
to
Carbon Emissions

What is Cap and Trade?

1. Limiting emissions
2. Issuing (or selling) permits to emit
3. Allowing trading of these
Essentials:
4. Comprehensive
5. Upstream idea is to prevent it not clean
it up
6. Allocation mechanism of permits
7. Use of revenues for equity corrections

Cap & Trade Steps

1. Tally Greenhouse-gas emissions
2. Set a cap
1. Initial level
2. Transition path
3. Eventual goal

3. Distribute permits
1. Equity & incentives determine how

4. Enforce cap
5. Issue progressively fewer permits

How it works:
Two markets, one abates for the other

Industries 1 and 2 are distributed E1 and E2 pollution rights Assumes that

each firm must abate the same amount to meet their quota of allowed pollution.
Industry 1 increases their abatement and sells their pollution permits to Industry 2
Industry 1 (Low MAC)

MAC

Industry 2 (High MAC)

MAC
Savings

Price

E1 Abate

MAC
MAC2

Potential
for trade

MAC

Emissions
Reduced

Cost
of
Permits

MAC1

Emissions
Reduced

Abate E2

Result: Less pollution in industry 2;

More in industry 1
Industry 1 (low cost) abates for industry 2 (high cost)
MAC = Marginal Abatement Cost

Public Goods
Some Definitions
Non-rival good
Ones consumption does not diminish anothers
ability to consume it
Ex. A national park

Non-excludable good
Difficult or costly to stop non-payers from
consuming
Ex. A pretty vista

Public Good non-rival and non-excludable

Public , Private and Hybrid goods

Most goods rival & excludable My consumption uses it up.
Goods with low excludability tend to be over-consumed
Non-rival, non-excludable goods are public goods, under-funded privately
Non-rival, excludable goods can be dealt with privately.
Rival

Low

Low

Commons good
Shared French Fries

Public Good
National defense

High

High

Private Good
Apples

Collective Good
Cable TV

Excludability

Public Goods
Q
1
2
3
4
5
6

P1

P2

10
9
8
7
6
5

7
5
3
1
0
0

P
17
14
11
8
6
5

With non-rival consumption, add

willingness to pay (prices), not
quantities

Funding Public Goods

Goal
Each pay according to their willingness to pay
There is an incentive not to report willingness

In practice
Collective action to purchase
Collection from users or citizens
Tax
Association dues

Funding Public Goods (II)

Head tax per person fixed amount
(Motor vehicle tax)

Regressive tax- % of income falls as income

increases
(Sales tax)

Proportional tax - % of income constant

(Marylands Income tax is close)

Progressive tax - % of income rises as income

increases
(Federal Income Tax)

Incidence of a Tax
Who physically pays the tax is not issue
Who has less value due to the tax is issue
If the demander is willing to pay a lot of
the tax (has LOW price elasticity),
consumer pays most of the tax
If supplier really wants to sell the product
(low supply elasticity), seller pays most of
the tax.

Effect of a Tax
on Efficiency

Tax

Added cost to Demander

Seller does not get to keep.
Seller keeps Price; Demander pays Price +
Tax.
Lower S is supplier,
Upper S faces Demander.
S + tax

Tax
Revenue

Consumer Surplus
P
S

Tax

P2+tx

Consumer Pays

Producer
Surplus

P1
P2

Producer Pays

D
Q2

Q1

Units not produced

are more valuable
than their cost.
That is, lost benefit
without saved cost.
Deadweight
Loss
Issues with tax:
1. Who pays?
Supplier (gets less)
Demander (pays more)
2. Dead Weight Loss.