Chapter 3

Environment
Guido Pepermans
Objectives
• Students should be able to answer questions like
• What is, from a societal point of view, the desired level of environmental
quality?
• How should emission reduction efforts be allocated across polluters in
order to minimize compliance costs?
• What are the effects, advantages and disadvantages related to different
policy instruments?

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Outline
• Optimal pollution model
• Focus on costs and benefits of pollution reduction at aggregate level

• Partial equilibrium market model

• Apply these insights in a market context

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Optimal pollution model

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Problem setting
• Focus on emission (reductions) at an aggregate level
• Assumptions
• No market power
• 2 polluters
• Initial emission levels are and
• Can reduce emissions by quantities and at a total cost and
• 2 victims
• Face a total environmental damage of and
• Pollution level reflects ‘damage effects’ rather than ‘emissions’

• Converts emissions into damage

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Cases to discuss

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Optimal pollution model
The ideal solution

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Ideal solution
• Further assumptions (no impact on insights derived from the model)
• Quasi-linear utility function
• Perfect income distribution instruments
• Fixed stock of resources
• Used to consume () or to reduce emissions (
• Linear production technology, except for the production of abatement
• Regions maximize total (joint) welfare

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Ideal solution
• Interpretation first-order conditions
1. Sum of marginal damages = Marginal
cost of reducing pollution
• Defines the optimal level of pollution
reduction
2. Marginal cost of reducing pollution is
equal between the sources and
• Condition guarantees overall cost
minimization
• Solution requires
• Perfect information and control of
polluters
• Supranational government

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Ideal solution

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Optimal pollution model
The non-cooperative solution

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Non-cooperative solution
• No supranational government that can control polluters
• How does this affect the outcome of our simple model?
• Assumptions
• 2 countries and
• Each country acts autonomously
• Reduce own emissions own cost minimization problem
• Government has perfect control over local polluters
• E.g., country

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Non-cooperative solution
• First-order condition country
• Reaction function for country
• Each country has its own reaction function
• Nash-equilibrium and
• No country wants to change its abatement effort given the abatement effort
in the other country
• Comparison with the optimal solution
• Global emission reduction efforts will be too low
• Each country only considers its own damage and not those in the other country
• Emission reduction is not performed cost-efficiently

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Optimal pollution model
The centralized government solution

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Centralized government solution
• Central government has imperfect control over polluters
• Policy instrument are needed to steer actions towards the ideal solution
• Assumptions
• 1 country
• Indirect control over polluters, through policy instruments ()
• Pollution tax, standards or tradeable permits
• 2 polluters and

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Centralized government solution: pollution tax
• Assumption
• Polluters are cost minimizing producers

• First-order condition

• Solution property
• Same tax applies to all producers cost efficient outcome

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Centralized government solution: emission standard
• Assumptions
• Emission limit set for each polluter
• Polluters minimize production costs subject to the emission limit

• Solution properties
• With a binding constraint, is directly controlled
• Typically, not cost efficient…
• …unless government has perfect information on abatement costs

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Centralized government solution: tradable
emissions
• Assumptions
• Emission rights allocated to every polluter
• Polluters can trade emission rights is net purchase of permits
• Perfectly competitive permit market
• Polluters minimize production costs subject to number of emission rights
they own
• First-order condition
• Solution properties
• Cost-efficient outcome
• Government only needs to control

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Centralized government solution: overview

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Partial equilibrium market model

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Introduction
• Change focus from costs and benefits of emission reduction to effects on
marginal cost, prices and quantity produced and consumed
• Any (environmental) policy instrument results in a combination of two effects
• “Greening” the activity
• Reducing the level of the activity
• 2 illustrations
• The market for ‘car use’ (car-km)
• Effects of a tradable emission permit scheme for airlines

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Market for car use
• Assumptions
• One producer producing car-km
• Perfect competition
• One period model
• Marginal Benefit of car use equals
• is car use (in per unit of time)
• Constant air pollution damage per unit of car
use if no abatement
• smaller than maximum WTP
• Resource (fuel) cost of car use is
• Car-km producer can reduce pollution damage
by a proportion at a cost per unit of car use of
• Total Pollution damage:
• Objective function depends on the point of view
taken

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Market for car use: no government intervention
• Optimization problem producer (label )

• Solution Total pollution damage

• Interpretation
• Market price per car-km is
• Marginal social cost per car-km is
• Car use is excessive and equals

• Total Pollution damage equals

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Market for car use: first-best solution
• Optimization problem social planner (label *)

• Solution Pollution damage

Cost of cleaner car

• Interpretation
• Using , we have

• Optimal car use

• Marginal benefit of car use =
production cost
+ marginal damage
+ marginal pollution abatement cost

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Market for car use: emission tax
• Optimization problem producer (label )

• Solution (for given level of ) Pollution damage (= tax revenue)

Cost of cleaner car

• Maximize social surplus by selecting

• Interpretation
• Decentralize optimum by setting
• Result: (first best outcome)
• Consumer price is
• Optimal consumption level

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Market for car use: emission reduction subsidy
• Optimization problem producer (label )

Pollution damage
• Solution for given level of
Cost of cleaner car

• Maximize social surplus by selecting

• Interpretation
• efficient abatement level
• Result (first-best outcome)
• Consumer price is
• Consumption level higher than socially optimal Total subsidy (clean cars and lower consumer prices)

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Market for car use: production tax
• Optimization problem producer (label )

Pollution damage (= tax revenue)

• Solution

• Interpretation
• Car manufacturers choose
• Decentralize optimal solution by setting
• Consumer price is
• Consumption level is smaller than with
emission tax

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Market for car use: technological standard
• Optimization problem producer (label )

• Solution Pollution damage

Cost of cleaner car

• set by the government
• Interpretation
• Government sets
• See cost of a cleaner car under emission tax
• Consumer price is
• Car is as clean as under , but no tax to be paid
• Production level is

• Higher than with emission tax (note that )

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Market for car use: overview
(Assuming and )

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Tradable emission permit scheme for
airlines

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Tradable emission permit scheme for airlines
• Effect of emission permit scheme on company profits?
• Depends on
• Relative efficiency of the firm in terms of environmental performance
• Demand elasticity for the product
• Extent to which tradable emission permits are received for free
• Example
• Discussion between the European Commission and the international airline
industry
• International airlines complain that, for all routes inside the EU, they must obtain tradable
carbon emission rights in proportion to their kerosene use
• However, airlines receive 80% of these rights for free
• According to the airlines this implies lower profits (or higher losses) for them
• Is this claim correct?

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Tradable emission permit scheme for airlines
• Assumptions
• Constant marginal costs
• Fixed number of permits needed per flight
• 80% of permits received for free
• Unused permits can be sold on permit
market
• Initial price
• New price
• Airlines pass on the opportunity cost
• Conclusion
• Airlines capture part of the consumer
surplus and increase their profit with

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Tradable emission permit scheme for airlines
• Assumptions
• Constant marginal costs
• Permits needed per flight can be reduced at a
cost
• 80% of permits rights is received for free
• Unused permits can be sold on permit market
• Initial price (including cost of efforts)
• New price
• Permit value per flight is smaller now
• Airlines pass on the opportunity cost
• Conclusion
• Profit still increases by the value of the
permits received for free ()

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Summary and conclusions

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Key Messages
• What is, from a societal point of view, the desired level of environmental quality?
• Sum of marginal damages = Marginal cost of reducing pollution
• How should emission reduction efforts be allocated across polluters in order to
minimize compliance costs?
• At the margin, all polluters should face the same cost of reducing pollution
• What are the effects, advantages and disadvantages related to different policy
instruments?
• Any policy response will imply a combination of
• Greening the ‘activity’
• Reducing the level of activity (typically, demand)
• Pollution tax or emission permits are preferred

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Exercise 1
• Market equilibrium
• € per flight 𝑝0=€100𝑝𝑒𝑟 𝑓𝑙𝑖𝑔h𝑡
• mln flights
• Demand elasticity
• Linear demand
• Linear supply:

• A share is grandfathered (given for free)

• What is the share for which the firms’ profit
is not impacted by the introduction of the
tradeable carbon emission rights?

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Exercise 2
• Air transport will be one of the major users of oil and emitters of greenhouse
gasses (GHG). The use of kerosene is at present not taxed at all. One
proposal is to force the aviation sector to use at least 20% biofuel. Biofuel
does not emit GHG but is 50% more expensive than kerosene.
• Assess this proposal in terms of social welfare, assuming that the aviation
sector in the whole world can be forced to implement this measure?

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