Economics of Environmental Protection

17.1 The Economic Rationale for Regulating Pollution

Pollution as a negative externality

The production of a good (or some activity) generates some pollution that
imposes costs on other members of society, i.e. the social marginal cost of
production exceeds its private marginal cost.

The socially optimal level of output is where the social marginal costs—private
plus external—equal the marginal benefit to society. How can this be
achieved?

If the externality can be internalized (by making the producers

bear the full external cost which they will share with consumers), allocative
efficiency can be achieved.

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Fig. 17-1 A Pollution Externality in a Competitive Market

Allocative efficiency requires

that price equal the social
marginal cost.

With a negative externality,

MCSOCIAL > MCPRIVATE

with the result that too much

gets produced in unregulated
markets, i.e.

QC > Q*.

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Switching to Pollution Emissions Abatement:

Since we don’t care about how much of a certain good is produced or

how much of an activity is engaged in, but rather the emissions that
generate the external costs, let’s recast the problem as being one of
limiting emissions.
When we talk about the abatement (limiting) of emissions, we don’t
care how they are reduced (reduced output or changing of
production methods to reduce emission per unit produced).
But if we imagine in the previous slide that the only way to reduce
emissions was to reduce output, then we are talking about moving
from QC toward Q* (ie. backwards on the “x” axis) that produces
surplus gains.
More generally and considering other possible ways of reducing
emissions (whatever is cheapest), see the next slide.

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Fig. 17-2 The Optimal Amount of Pollution Abatement

Zero environmental
damage is generally
not efficient!

MB(Q*)

= QC

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Pollution-Control Policies:

Direct Controls
Direct control is a form of environmental regulation that either:
• stipulates the use of specific technologies, or
• prohibits certain polluting behaviour altogether.
Direct controls are a practical policy instrument when the objective
is to eliminate (rather than reduce) a specific type of pollution.

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Fig. 17-3 The Inefficiency of Direct Pollution Controls

The use of direct controls is

usually economically inefficient:
MC of abatement is not equated
across different firms and hence
does not minimize the cost of a
given amount of pollution
abatement. (Recall Ch. 12.)

Monitoring and enforcement are

also often quite difficult and
generate significant costs.

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Fig. 17-4 The Efficiency of Emissions Taxes

With a tax of $t per unit of

pollution emitted the tax
becomes the firm's marginal
benefit of pollution abatement
or, more precisely, the avoided
cost of abatement if the firm
can abate at a lower cost.
Setting t = MB(Q*) is efficient.
Firms will choose how much
to abate.
And since the MC of abatement
is equated across firms,
the pollution is abated at
minimum cost (across firms).

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The Efficiency of Emissions Taxes

What is the allocatively efficient amount of pollution reduction?

As discussed, if the emissions tax is set equal to the size of the marginal external
cost at Q*, the externality will be fully internalized.
Caution: The information required to know the optimal tax rate is often
unavailable and/or costly to obtain. But so is that information crucial in designing
any optimal policy – see below.

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From Emissions Tax to Tradable Pollution Permits (“Cap and Trade”)

Whereas with an emissions tax, government must determine the optimal tax
rate, with pollution permits, the market for permits determines the
equilibrium permit price, but government needs to set the total amount of
permits in the first place and issues or sells at auction a given number of
tradable pollution permits.

The price of the permit, determined in the market for permits, becomes the
MB of abatement. Firms will abate pollution until the MB equals the MC.
Pollution is thus abated at minimum cost.

So how does the government set the optimal quantity of permits that leads to
the optimal equilibrium price—the one that fully internalizes the externality?

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Fig. 17-6 The Market for Tradable Pollution Permits

As in slide 8, firms will

compare marginal cost
of abatement to the
price of a permit: Will
abate if less costly to do
so rather than buying a
permit.

Thus, the total cost of a

given amount of
abatement is minimized.

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Technological Improvement

Improvements in abatement technology will lead to a reduction in firms'

demand for permits, and thus to a reduction in the equilibrium price.

There is therefore an incentive to innovate away from emissions to avoid

buying permits (or being able sell some you own).

This is true in the “corrective” tax case as well. Innovate away from emissions
and you pay less tax.

Either approach sets up an incentive for innovation away from emissions.

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Uncertainty and the Choice Between Emissions Taxes and “Cap and Trade”

The government does not know the firms' marginal cost curves for pollution
abatement.

• With an emissions tax, government must determine the optimal

tax rate. But the uncertainty remains as to how much firms will abate.

• With pollution permits, the market for permits determines the equilibrium
permit price, but government needs to set the total amount of permits. So
how does the government set the optimal quantity that leads to the optimal
equilibrium price—the one that fully internalizes the externality?

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Fig. 17-7 Uncertainty About
Firms' Abatement Costs

(i) Emissions taxes

Uncertainty about quantity of abatement

(ii) Cap and trade

Uncertainty about firms' per-unit costs

or the permit price emerging

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17.3 The Economic Challenge of Global Climate Change

The Basics About Greenhouse-Gas Emissions

Annual flow of GHG emissions versus accumulated stock in the atmosphere.

Likely effects of climate change:

•melting ice caps, rising sea levels

•creeping desertification, falling agricultural yields

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The Case for Global Collective Action

Pollution externality on global scale requires collective action among many

national governments.

Kyoto Protocol in 1997: Agreement among most developed countries to

reduce annual GHG emissions

Performance between 1990–2009: Some countries achieved their targets while

many did not.

Without effective policies implemented, emissions reductions are unlikely to

occur.

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Fig. 17-8 Changes in Annual GHG Emissions (1990–2009) – quite dated
Energy Use, GDP, and Greenhouse-Gas Emissions

GHG = (GHG/Energy) x (Energy/GDP) x (GDP)

Note that this equation is an identity.

Thus, three approaches to reducing GHG emissions:

1.Reducing GDP?

2.Reducing Energy use per unit of GDP?

3.Reducing GHG emissions per unit of Energy?

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Significant Policy Challenges

Two fundamental challenges:

• The difficulty of negotiating and implementing international agreements.

• The technological challenge in reducing GHG emissions while maintaining

reasonable growth in material living standards.

These suggest the need for policies which minimize the cost of any given
reduction in GHG emissions: Carbon tax or cap and trade rather than policies
based largely on voluntary measures.

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