Economic Solutions to Environmental Problems:

The Market Approach

Chapter 5

Overview• Market approach refers to incentive-based

policy that encourages conservative practices or pollution reduction strategies

• Types of Market Instruments– Pollution charges– Subsidies– Deposit/refund systems– Pollution permit trading systems

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1. Pollution Charges

• Fees based on “Polluter-Pays Principle (polluter should bear costs of control measures)”

• Types of pollution charges –Product charge–Emission/Effluent charge

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(1) Product Charge

• A fee added to price of pollution-generating ___________, which generates negative externality

• Impose product charge as per unit tax on product, e.g., gas tax–If the tax equals the marginal external

cost (MEC) at QE, it is called a _________ _____

–How does the tax on gasoline in the US compare with that of other nations?

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Selected International Gasoline Tax Rates

Nation Tax Rate % of Price (2008)

United States 18.5

U.K. 67.8

France 67.4

Germany 70.3

Japan 45.8

Spain 56.0

5Source: International Energy Agency, November, 2008

Modeling a Pigouvian Tax

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$

Q of gasoline

MPB = MSB

MPC

MSC = MPC + MEC

0 QE QC

MPCt

b

a

Amount of tax

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Making sellers pay a tax on each unit they sell is equivalent to an increase in the cost of producing each unit. Anything that increases production costs causes the S curve to shift up: in order for sellers to be willing to supply the same quantity as before, they must receive a higher price to compensate them for the increase in their costs.

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By setting the unit tax equal to the MEC at QE, the MPC curve shifts up to MPCt. Equilibrium output is then determined by MPCt and MSB, which is QE.

Assessing the Model

• In theory, achieves an efficient outcome• In practice, difficult to identify the value of

MEC at QE

• Allows only for an output reduction to reduce pollution

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(2) Emission/Effluent Charge

• A fee imposed directly on the discharge of _____________

• Typically implemented through a tax

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Model: Single Polluter Case

• Government sets an abatement standard at AST

• A0 is actual abatement level.

• Policy options to polluter are:–Abate up to AST and incur those costs, or

–Pay a constant per unit tax, t (also called marginal tax, MT), on any abatement less than AST

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Modeling Emission ChargeSingle Polluter

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$

Abatement (A)0

MAC

MTt

A0AST

a b

c

Firm abates up to A0 sinceMAC < MT; firm pays tax between A0 and AST, sinceMAC > MT

Pollution Charges in Practice• Internationally, the pollution charge is the most

commonly used market-based instrument– Australia, Bulgaria, France, and Japan, use fees

or taxes to control noise pollution generated by aircraft

– France, Mexico, and Poland are among the nations using effluent charges to protect water resources.

– Others levy charges on products such as batteries, tires, lubricant oil, packaging, paint, paint containers, and gasoline

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2. Environmental Subsidies

• Two major types of subsidies:– Abatement equipment subsidies– Pollution reduction subsidies

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(1) Abatement Equipment Subsidy

• A payment aimed at lowering the cost of abatement technology

• Goal is to internalize the positive externality associated with the consumption of abatement activities

• If the subsidy equals the marginal external benefit (MEB) at QE, it achieves an efficient equilibrium and is called a __________________

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Pigouvian SubsidyMarket for Scrubbers

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($ millions)MSC

MPB

MSB

0 QC = 200 QE = 210

PC = 170

PE = 175 Subsidy = $14 million

MPBS

Q of scrubbers

PE – s = 161

K

L

• In a competitive market, too few scrubbers are exchanged at too low a price because the MEB of a cleaner environment are not recognized by the market participants.

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(2) Pollution Reduction Subsidy

• To implement, government pays the polluter a subsidy (s) for every unit of pollution abated below some pre-established level ZST

• Per unit subsidy = s, total subsidy = s(ZST - ZO), where ZO is the actual level of pollution

– Analogous to an emission charge

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Subsidies in Practice• Environmental subsidies typically are

implemented as grants, low-interest loans, tax credits or exemptions, and rebates

• Many countries around the world use these instruments, including Belgium, Denmark, Finland, Japan, and Turkey

• In the U.S., common uses include federal funding to build publicly-owned treatment works and subsidies to encourage the development of cleaner fuels and low-emission vehicles

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3. Deposit/Refund Systems

• A market instrument that imposes an up-front charge to pay for potential damages and refunds it for returning a product for proper disposal or recycling

• The deposit is intended to capture the MEC of improper waste disposal (IW) in advance

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Modeling Deposit/Refund System improper waste (IW) disposal market

• MECIW: health damages + aesthetic impairment from litter, trash accumulation, etc.

• MPCIW: costs to disposer (e.g., trash receptacles, collection fees, plus forgone revenue from not recycling)

• MSCIW = MPCIW + MECIW

• MPBIW: demand for improper disposal

Assume MEBIW = 0, so MPBIW = MSBIW

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Deposit-Refund Model

$

Improper Waste Disposal (%)

MPBIW = MSBIW

MPCIW

MSCIW

0

QE QIW

MPCIW + Deposit

b

a

Deposit=MEC at QE

100Proper Waste Disposal (%) 0100

Deposit converts % of overall waste disposal, measured by (QIW - QE), from improper methods to proper

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Assessing the Model

• Promotes responsible behavior• Requires minimal supervision by

government• Can help slow the use of virgin raw

materials by improving availability of recycled materials

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Deposit/Refund Systems in Practice

• Deposit/refund systems are used worldwide– Many nations use these systems to

encourage proper disposal of beverage containers: in the U.S., 11 states have bottle bills

• Other applications include systems used to promote responsible disposal of used tires, car hulks, and lead-acid batteries

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4. Pollution Permit Trading Systems• A pollution permit trading system establishes a

market for rights to pollute by issuing _________ pollution credits or allowances– Credits are issued for emitting below a standard– Allowances indicate how much can be released

• Two components of the system are1. Fixed number of permits is issued based on an

“acceptable” level of pollution set by government

2. The permits are marketable

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How Permit Trading Works

• There is an incentive to trade as long as polluters face different ________ levels

• Suppose a firm has 50 permits but normally emits 75 units of SO2. What must it do?– Answer

• Abate 25 units of emissions, OR• Buy 25 permits from another producer

• Which option will the firm choose?– Answer

• Whichever option is cheaper

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Result• Low-cost abaters will clean up pollution and sell

excess permits to other firms– They will _____ at any P _____ than their MAC

• High-cost abaters will buy permits rather than abate– They will _____ at any P _____ than their MAC

• Trading will continue until the incentive to do so no longer exists, at which point, the cost-effective solution is obtained, i.e., the MACs across firms are _________

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An Example (Ch4—slide 20)

Polluter 1: TAC1 = 1.25(A1)2

MAC1 = 2.5(A1)• where A1 is pollution abated by Polluter 1

Polluter 2: TAC2 = 0.3125(A2)2

MAC2 = 0.625(A2) • where A2 is pollution abated by Polluter 2

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Round 1: Government issues 5 permits to each polluter

Polluter 1: Current pollution level: 10 units # of permit held: 5 abatement required: 5MAC1 = 2.5(A1)=2.5( __ )= $12.50TAC1 = 1.25(A1)2=1.25( __) 2= $31.25

Polluter 2: Current pollution level: 10 units # of permit held: 5 abatement required: 5MAC2 = 0.625(A2)=0.625( ___)= $3.125TAC2 = 0.3125(A2)2=0.3125( ___) 2= $7.81

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Round 2: Polluter 1 purchases 1 permit ($8.00) from polluter 2

Polluter 1: Current pollution level: 10 units # of permit held: 6 abatement required: 4MAC1 = 2.5(A1)=2.5( ___)= $10.00TAC1 = 1.25(A1)2=1.25(___) 2= $20.00 (cost of 1 permit purchased=$8.00)

Polluter 2: Current pollution level: 10 units # of permit held: 4 abatement required: 6MAC2 = 0.625(A2)=0.625(___)= $3.75TAC2 = 0.3125(A2)2=0.3125(___) 2= $11.25 (revenue from 1 permit sold=$8.00)

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Final round: Polluter 1 purchases 3 permits ($8; $7; $5) from polluter 2; MAC1 = MAC2

Polluter 1: Current pollution level: 10 units # of permit held: 8 abatement required: 2MAC1 = 2.5(A1)=2.5(___)= $5.00TAC1 = 1.25(A1)2=1.25(___) 2= $5.00 (cost of 3 permits purchased=$8+$7+$5=$20.00)

Polluter 2: Current pollution level: 10 units # of permit held: 2 abatement required: 8MAC2 = 0.625(A2)=0.625(___)= $5.00TAC2 = 0.3125(A2)2=0.3125(___) 2= $20.00 (revenue from 3 permits sold =$8+$7+$5=$20.00) 31

Assessing the Model

• Trading establishes the price of a right to pollute without government trying to “search” for a price

• Trading system is flexible –Note that an emissions standard can be

adjusted by changing the number of permits issued

• Cost-effective solution is obtained32

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Pollution Trading Systems in Practice• Most of the evolution of trading is occurring in U.S.

– An important example is the allowance-based trading program to control sulfur dioxide emissions under the Clean Air Act Amendments of 1990

– More innovation has occurred at state and local levels• Ozone Transport Commission in the Northeast• California Regional Clean Air Incentives Market

(RECLAIM)• Key international example

– Trading of greenhouse gas allowances are part of the Kyoto Protocol, an international accord aimed at global warming

• Includes the European Union Greenhouse Gas Emission Trading System (EU ETS), launched in 2005

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Positive Externalities from Education• A more educated population benefits society:

– lower crime rates: educated people have more opportunities, so less likely to rob and steal

– better government: educated people make better-informed voters

• People do not consider these external benefits when deciding how much education to “purchase”

• Result: market eq’m quantity of education—too low

• How govt may improve the market outcome:– subsidize cost of education

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Other Examples of Positive Externalities

• Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce section after you.

Thank you for not contaminating the fruit supply!

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Positive Externalities

• In the presence of a positive externality, the social value of a good includes–private value – the direct value to

buyers–external benefit – the value of the

positive impact on bystanders

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AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : Analysis of a positive externalityAnalysis of a positive externality

The market for flu shots

D

S

0

10

20

30

40

50

0 10 20 30

P

Q

$External benefit

= $10/shot• Draw the social

value curve.• Find the socially

optimal Q. • What policy would

internalize this externality?

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AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : AnswersAnswers

Socially optimal Q = ___ shotsTo internalize the externality, use _______ = $10/shot.

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The market for flu shots

D

S

Social value = private value + external benefit

0

10

20

30

40

50

0 10 20 30

P

Q

$external benefit

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If negative externality market produces a larger quantity

than is socially desirableIf positive externality market produces a smaller quantity

than is socially desirableTo remedy the problem, “internalize the externality” tax goods with negative externalities subsidize goods with positive externalities

If negative externality market produces a larger quantity

than is socially desirableIf positive externality market produces a smaller quantity

than is socially desirableTo remedy the problem, “internalize the externality” tax goods with negative externalities subsidize goods with positive externalities

Effects of Externalities: Effects of Externalities: SummarySummary

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Consumption externalities Production externalities

Positive Negative Positive Negative

The benefits to the rest of society of people being vaccinated before traveling abroad

Noise pollution from using car stereos

The benefits to the environment that arise from the planting of woodland by a forestry company

Wastes being dumped into a river by a company

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