Economics of

Pollution Control
 Environment and Economy

• Flow of mass and energy to the economic system

• Flow of waste products back to the environment
Pertinent Questions:
• What is the appropriate level of waste flow?
• How should the responsibility for achieving this
flow level be allocated among the various
sources of the pollutant when reductions are
needed?
 A Pollutant Taxonomy
• Stock pollutants: Pollutants for which the environment has little or
no absorptive capacity.
• Examples of stock pollutants include non-biodegradable bottles;
heavy metals, such as lead, and persistent synthetic chemicals etc.
• Fund pollutants: Pollutants for which the environment has some
absorptive capacity.
• Examples of fund pollutants include CO2, CH4 etc.
Taxonomy will prove useful in designing policy responses to these
various types of pollution problems. Each type of pollutant
requires a unique policy response. The failure to recognize these
distinctions leads to counterproductive policy.
 Pollutants
• Local pollutants: The damage caused is
experienced near the source of emission.
• Regional pollutants: The damage is experienced
at greater distances from the source of emission.
• Global pollutants: The damage affects the entire
planet.
The categories are not mutually exclusive; it is possible for a pollutant to
be in more than one category. Sulfur oxides and nitrogen oxides, for
example, are both local and regional pollutants.
 Efficient Allocation of Pollution:
Stock Pollutants
• Stock pollutants create an interdependency between the
present and the future, since the damage imposed in the
future depends on current actions.
• Suppose the production of commodity X that involves the
generation of a proportional amount of a stock pollutant.
• The dynamic efficient allocation is the one that maximizes
the present value of the net benefit.
• The net benefit at any point in time, t is equal to the
benefit received from the consumption of X minus the
cost of the damage caused by the presence of pollutant.
 Efficient Allocation of Pollution:
Stock Pollutants
• The efficient quantity of X (and therefore, the addition to the
accumulation of this pollutant in the environment) would
decline over time as the marginal cost of the damage rises.
• The price of X would rise over time, reflecting the rising social
cost of production.
• Why?
• To cope with the increasing marginal damage, the amount of
resources committed to controlling the pollutant would
increase over time.
• A steady state would be reached where additions to the
amount of the pollutant in the environment would cease and
the size of the pollutant stock would stabilize.
 Technology and efficient allocation
• Technological progress could modify the efficient
allocation
• Technological progress could reduce the amount
of pollutant generated per unit of X produced;
• It could create ways to recycle the stock pollutant
rather than injecting it into the environment;
• It could develop ways of rendering the pollutant
less harmful.
All of these responses would lower the marginal damage
cost associated with a given level of production of X
 Efficient Allocation of Pollution:
Fund Pollutants
• To the extent that the emission of fund pollutants exceeds the
assimilative capacity of the environment, they accumulate
and share some of the characteristics of stock pollutants.
• The link between present emissions and future damage may
be broken when discharges are assimilated by the
environment.
• When this happens, current emissions cause current damage
and future emissions cause future damage, but the level of
future damage is independent of current emissions.
• Implications?
 Approaches to examine the efficient
allocation
• Maximize the net benefit from the waste flows
• Minimization of two types of costs: damage costs and control or
avoidance costs
• To examine the efficient allocation, we need to know about how
control costs vary with the degree of control and how the
damages vary with the amount of pollution emitted.
• the marginal damage caused by a unit of pollution increases
with the amount emitted. When small amounts of the pollutant
are emitted, the incremental damage is quite small. However,
when large amounts are emitted, the marginal unit can cause
significantly more damage.
• Why?
 Marginal control costs
• It increases with the amount controlled.
• Greater degrees of control (points to the left of Q*) are
inefficient because the further increase in avoidance
costs would exceed the reduction in damages. Hence,
the total costs would rise.
• The levels of control lower than Q* would result in a
lower cost of control but the increase in damage costs
would be even larger, yielding an increase in total cost.
Increasing or decreasing the amount controlled causes
an increase in total costs. Hence, Q* must be efficient.
• Conclusion: The optimal level of pollution is not zero.
 Efficient allocation of Pollution
• In some circumstances the optimal level of
pollution may be zero, or close to it.
• It is true when the damage caused by even the
first unit of pollution is so severe that it is higher
than the marginal cost of controlling it.
• For example, the treatment of highly dangerous
radioactive pollutants such as plutonium
 Economic Reasons for Excess effluent

• Pollution is an externality that create an effect

external to the polluter.
• Lack of markets in effluent.
• Why markets are missing?
• 2 reasons
– Lack of property rights for clean environment
– Public good nature of effluents
 Property Rights
• Ability to exclude
• Legal ownership
• de jure right
• Property right may exist in the absence of
ownership.
• Ownership: Access, withdrawal, management,
Exclusion, Alienation
• Property rights Regimes: Private PRs, Common
PRs, State PRs, Open Access
 Coase Theorem and Market Based Rights
• PRs and transaction cost can mitigate
inefficiencies associated with externalities.
• How?
• Those who are affected the most, can buy or
sell PRs to arrive at the most efficient
outcome.
 Efficient Policy Response
• Why markets fail to produce an efficient level of
pollution control as well as trace out the effects of
this less-than-optimal degree of control on the
markets?
• Efficiency is achieved when the marginal cost of
control is equal to the marginal damage caused by
the pollution
• Each emitter should control its pollution until the
marginal cost of controlling the last unit is equal to
the marginal damage it causes.
 Efficient Policy Response
• How can environmental authorities allocate
pollution-control responsibility in a reasonable
manner when the information burdens are so
unrealistically large?
• Selection of specific legal levels of pollution
• Deciding how to allocate the responsibility for
meeting predetermined pollution levels
among the large numbers of emitters.
 Cost-Effective Policies for Uniformly Mixed
Fund Pollutants

• The damage caused by uniformly mixed fund

pollutants pollutants depends on the amount
entering the atmosphere.
• These are insensitive to where the emissions are
injected into the atmosphere.
• The policy can focus simply on controlling the
total amount of emissions in a manner that
minimizes the cost of control.
 Example
• Assume two emissions sources
• Emitting 15 units each
• Total emissions: 30 units
• Environment can assimilate is 15 units in total
• Reduction of 15 units is necessary
• How should this 15-unit reduction be allocated
between the two sources in order to minimize the
total cost of the reduction?
• See the Fig. Each point represents some different
combination of reduction by the two sources
• The left-hand axis represents an allocation of the entire
reduction to the second source
• Right-hand axis represents a situation in which the first
source bears the entire responsibility
• All points in between represent different degrees of
shared responsibility.
• What allocation minimizes the cost of control?
• The total variable cost of control for the reduction is
represented by area A plus area B.
• Equi-marginal principle: The cost of achieving a given
reduction in emissions will be minimized if and only if the
marginal costs of control are equalized for all emitters
 Cost-Effective Pollution-Control Policies
• The choice of policy instruments that the control
authority might use to achieve this allocation
• Government authorities responsible for meeting
pollution targets are not likely to have information
on abatement costs.
• Regulation depends on cost information.
• Plant managers would have a strong incentive to
overstate control costs in hopes of reducing their
ultimate control burden.
• Can the cost-effective allocation be found in this
dilemma?
 Emissions Standards
• An emissions standard is a legal limit on the
amount of the pollutant an individual source is
allowed to emit.
• The easiest method of pollution control would be
simply to allocate each source an equal
reduction.
• It would not be cost-effective.
• Most common approaches are known as
emissions charges and emissions trading.
 Emissions Charges
• An emissions charge is a fee, collected by the government, levied on
each unit of pollutant emitted into the air or water.
• The total payment any source would make to the government could be
found by multiplying the fee times the amount of pollution emitted.
• Emissions charges reduce pollution because paying the fees costs the
firm money.
• How much pollution control would the firm choose?
• A profit-maximizing firm would control, rather than emit, pollution
whenever it proved cheaper to do so.
• Firm will reduce emissions until the marginal cost of reduction is equal
to the emissions charge.
• the firm would pay control costs equal to area 0AD + total emissions
charge payments equal to area ABCD
 Cost-minimizing allocation
• Emissions charge T
• Both the sources will independently choose levels of
control consistent with equal marginal control costs
• This is precisely the condition that yields a cost-
minimizing allocation
• As long as the control authority imposes the same
emissions charge on all sources, the resulting
incentives are automatically compatible with
minimizing the costs of achieving that level of
control
 Appropriate level of emissions charge
• How high should the charge be set to ensure that the resulting
emissions reduction is the desired level of emissions reduction?
• In the absence of requisite information on control costs, the
control authority cannot establish the correct tax rate on the
first try.
• An iterative, trial-and-error process to find the appropriate
charge rate
• The charge system causes cost-minimizing sources to choose a
cost effective allocation of the control responsibility, and it
stimulates the development of newer, cheaper means of
controlling emissions, as well as promoting technological
progress.
 Cost saving from Technological change

• With an emissions charge system, the firm

saves money by adopting cheaper new
technologies. As long as the firm can reduce
its pollution at a marginal cost lower than T, it
pays to adopt the new technology.
• the firm saves A and B by adopting the new
technology and voluntarily increases its
emissions reduction from Q0 to Q1
 Issues with Charges
• the process for finding the appropriate rate takes some
experimenting.
• During the trial-and-error period of finding the appropriate
rate, sources would be faced with a volatile emissions
charge.
• Changing emissions charges would make planning for the
future difficult.
• Investments that would make sense under a high emissions
charge might not make sense when it falls.
• From either a policy-maker’s or business manager’s
perspective, this process leaves much to be desired.
 Cost-Effective Policies for Non-uniformly
Mixed Surface Pollutants
• For non-uniformly pollutants, the policy must be concerned with
– the weight of emissions entering the atmosphere
– the location
– timing of emissions
• For these mixed pollutants, the concentration in the air, soil, or
water counts.
• The concentration is measured as the amount of pollutant found
in a given volume of air, soil, or water at a given location and at
a given point in time.
• This is why, cities generally face more severe pollution
• problems than do rural areas.
 Continued
• We seek cost-effective policies for controlling
these pollutants to attain ambient standards.
• Ambient standards are legal ceilings placed on
the concentration level of specified pollutants in
the air, soil, or water.
• They represent the target concentration levels
that are not to be exceeded.
• A cost-effective policy results in the lowest cost
allocation of control responsibility ensuring the
ambient standards specified locations called
receptor site.
 The Single-Receptor Case
• All units of emissions from different sources do not have
the same impact on pollution at a receptor
• Assume, four sources are injecting ten units of emission
into the stream at different points in time
• We measure the pollutant concentration resulting from
each of these injections at receptor R
• the emissions from A or B would cause a larger rise in the
recorded concentration than would those from C and D
• Emissions from C and D would be substantially diluted by
the time they arrived at R
• From A and B, emissions would arrive in a more
concentrated form.
 Concentration at Receptor
• we can relate the concentration level at R to emissions from
all sources:

• Where, ai is transfer coefficient that captures the constant

amount of the concentration at the receptor if source i
emits one more unit of emission
• KR: concentration at the receptor
• Ei : emissions level of the ith source
• I : total number of sources in the region
• B: background concentration level (resulting from natural
sources or sources outside the control region)
Cost Effective Allocation of
Responsibility
 Policy Approaches for Non-uniformly
Mixed Pollutants
• The ambient charge used to produce a cost-effective
allocation of a non-uniformly mixed pollutant , takes the
form:

• where ti is the per-unit charge paid by the ith source on each

unit emitted,
• ai is the ith source’s transfer coefficient, and
• F is the marginal cost of a unit of concentration reduction
How can the cost-effective ti be found by a control authority
with insufficient information on control costs?
 Equilibrium Allocation
• F is set through an iterative process until the
desired concentration is achieved.
• If the actual pollutant concentration is below the
standard, the tax could be lowered; if it is above,
the tax could be raised.
• The correct level of F would be reached when the
resulting pollution concentration is equal to the
desired level.
• That equilibrium allocation would be the one that
meets the ambient standard at minimum cost.
• Permitted i will be

• The larger the transfer coefficient (i.e., the closer

the source is to the receptor) the smaller the
amount of emissions legitimized by the
allowances held by that firm.
 Example
Two firms can control emissions at the following marginal costs:
MC1 = $200q1, MC2 = $100q2, where q1 and q2 are, respectively, the
amount of emissions reduced by the first and second firms. Assume
that with no control at all, each firm would be emitting 20 units of
emissions or a total of 40 units for both firms.
a) Compute the cost-effective allocation of control responsibility if a
total reduction of 21 units of emissions is necessary.
b) Compute the cost-effective allocation of control responsibility if
the ambient standard is 27 ppm, and the transfer coefficients that
translate a unit of emissions into a ppm concentration at the
receptor are, respectively, a1 = 2.0 and a2 = 1.0.
 Other Policy Dimensions
• The appropriate charge can be determined only by
an iterative trial-and-error process over time,
whereas
• For the cap-and-trade approach the allowance price
can be determined immediately by the market.
• Other differences include
– The Revenue Effect
– Responses to Changes in the Regulatory Environment
– Price Volatility
– Instrument Choice under Uncertainty
– Product Charges: An Indirect Form of Environmental Taxation
 The Revenue Effect
• Environmental taxes and auctioned allowances
raise revenue
• Cap-and-trade programs that gift the allowances
to users free of charge does not raise revenues.
• This difference matters for two reasons
– Environmental taxes can be substituted for the
revenue from distortionary taxes (double dividend)
– The revenue from taxes can be used to reduce the
burden on low-income households (why? Gifting
allowances is regressive)
 Responses to Changes in the Regulatory
Environment
• The two systems react to changes in external circumstances. For example;
– Growth in the number of sources
– Inflation, and
– Technological progress.
• Bureaucratic procedures are notoriously sluggish and changes in policies
are usually rendered slowly
• If the choice is between a fixed fee and a fixed number of allowances, the
dominance of the allowance system over the fixed-fee system increases
over time (Butler and Maher, 1982).
• inflation in the cost of control would automatically result in higher
allowance prices. lower control in charge system
• technological progress in designing pollution-control equipment will make
charge system more effective
 Price Volatility
• The desirability of current abatement investment depends
not only on the level of the price associated with emitting
(either the allowance price or the emissions charge), but
also on its volatility.
• Volatility can inhibit investment incentives.
• price volatility is not an issue with charges unless the
government keeps changing the price.
• Allowances, fix the quantity and leave the price to the
market and large shifts in the demand for allowances,
coupled with the fixed supply, can cause prices to vary a lot.
• Summary: In terms of price volatility, charges have the
edge.
 Instrument Choice under Uncertainty
• Allowances offer a greater amount of certainty
about the quantity of emissions, while charges
confer more certainty about the marginal cost of
control.
• When the objective is to minimize total costs (the
sum of damage cost and control costs),
allowances would be preferred.
• Charges would be preferred when control costs is
more important.
 Product Charges: An Indirect Form of
Environmental Taxation
• tax the commodity that is most directly
responsible for the emissions, rather than the
emissions themselves, e.g. gasoline tax.
• Product charges frequently are simpler to
administer.
• Product charges are most efficient when all
purchased units of that product cause exactly
the same marginal damage.
 Summary
• Some countries (primarily in Europe) have
chosen to rely on emissions charges,
• Others (primarily the United States) have chosen
to rely on cap-and-trade.
• We can now use this framework to evaluate the
rather different policy approaches that have been
taken toward the major sources of pollution.
Assignment:
• Summarize and compare the two approaches