govt intervention on market failure

7/28/2019 Govt Intervention on Market Failure

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Government Intervention in

Market Failure

Chapter 3

2004 Thomson Learning/South-Western


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Topics in Chapter 3

1. Should the Government Intervene? Arethere private solutions that will work?

2. Types of Government Intervention general

introduction3. The optimal level of environmental quality

4. Government intervention: Command andControl policies

5. Government intervention: Economicincentives


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Should the Government Intervene?

Pigouvian Taxes

A.C. Pigou (1938) argued that an externalitycannot be mitigated by contractualnegotiation between the affected parties.

Pigou argued that direct coercion by thegovernment or judicious use of taxes shouldbe used against the offending party.

These taxes are referred to as Pigouviantaxes.


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Pigouvian Taxes

The basic principle behind the use ofexternality taxes is that the tax eliminates thedivergence between the Marginal Private

Cost (MPC) and the Marginal Social Cost(MSC).

Q1 represents the market equilibrium (where

MPC=MPB), and Q* represents the optimal level of output

(where MSC=MSB).


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An Externality Tax on Output


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An Externality Tax on Output

MPC1

Demand

MSC = MPC + MDpollution

Quantity of steel

$

Q1Q*

a

b


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Pigouvian Taxes

An externalities tax equal to the divergence betweenMPC and MSC would raise the steel firms private

costs.

The tax would shift the MPC curve by an amount

equal to the distance from a to b in Figure 3.1. The market would arrive at an optimal equilibrium of

Q*.

This is known as internalizing an externality.

More precisely, the tax should be placed on theexternality itself (the amount of pollution emissions)rather than on output (amount of steel).


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Coase Theorem

Ronald Coase (1960) argued that not only isa tax unnecessary, it is often undesirable.

Coase argued:

The market will automatically generate theoptimal level of the externality.

This optimal level of the externality will be

generated regardless of the initial allocationof property rights.


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Coase Theorem

One example to illustrate his theory is based on the

interaction of a cattle rancher and a crop farmer.

Cattle occasionally leave ranchers property and

damage farmers crop.

Coase argued that the farmer and rancher will reachan agreement that will make them both better off.

Either the rancher will accept payment to reduce thesize of the herd or farmer will accept payment to

cover cost of crops lost. And this will happen without government

intervention.


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Another example: Dorm room stereos and

studying

MC loudness to you

D = MB loudness to partier

Loudness

$

QLQ*Q0


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If property rights belong to partier, where isinitial noise level? QL

But there are gains from trade until move

back to Q* If property rights belong to partier, where is

initial noise level? Q0

Again, gains from trade until get to Q* Gains to be split between two parties are

denoted A and B in diagram

Dorm room stereos and studying


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Another example: Dorm room stereos

and studying

MC loudness to you


Loudness

$

QLQ*Q0

A

B


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Coase Theorem

If there are no transaction costs and property rightsare well defined, then voluntary transactions willeliminate any distortions in resource allocationstemming from an externality and the outcome is

independent of the property rights This version of the theorem is from Baumol and

Oates text The Theory of Environmental Policy.

Emphasizes private behavior and importance of

transaction costs


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Coase Theorem

What happens if impose a Pigouvian tax on thegenerator of the externality, would this result in anefficient outcome?

Set a tax equal to marginal damage at the optimal to

shift the demand for loudness After the tax, are there still gains from trade?

Would tax be a good idea?

This is basis for Coases argument that government

intervention could make things worse


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Coase with a tax per unit of Loudness

MC loudness to you


Loudness

$

QLQ*Q0

D = MB loudness to partier - tax

QN

tax


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Criticisms: Coase Theorem

Two important assumptions: transactionscosts are insignificant and property rights welldefined.

Transactions costs are costs associated witharriving at an agreement (the costs ofnegotiation).

These may be small for a 2 party agreement

but would be very large for an externalitysuch as sulfur dioxide emissions acrossNorth America.


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Coase Theorem The number of participants makes

transactions costs important.

One way to reduce transactions costs is toappoint an agent who acts in behalf of a large

number of people. The use of agents is associated with its own

problems:

Free ridersdont share in cost, but sharebenefits.

Often it is difficult for individuals to identify theagent that will best represent their view point.


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Coase Theorem

Another problem associated with the Coaseexample can occur when the allocation ofproperty rights would signal entry and exit in

response to those rights. If ranchers have the right to let their cattle

roam without worrying about paying

damages, then there can be an increase inthe number of ranchers, and more damage.


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Bottom Line on Coase arguments

Probably are cases where privatenegotiations can be effective

In those cases, government should stay out

But, probably plenty of cases wheretransaction costs and other issues lead toneed for intervention


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Types of Government Intervention

There are five broad classes of governmentintervention: Moral suasion

Direct production of environmental quality Pollution prevention

Command and control regulations

Economic incentives

Each of these represents a differentphilosophy toward the role of government insociety.


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Moral Suasion

This term is used to describe governmentattempts to influence behavior withoutactually stipulating any rules.

Effectiveness depends upon the extent towhich individuals believe it is in theircollective interest to do so.

Successful programs include Woodsy OwlsGive a hoot, dont pollute and SmokeyBears Only you can prevent forest fires.


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Direct Production of Environmental

Quality

Includes

reforestation,

breaching of dams,

stocking of fish,

creation of wetlands,

treatment of sewage, and

toxic waste site cleanup.

These are sometimes ameliorative actions.


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Pollution Prevention

Designed to address market failure of imperfectinformation, in some cases there may betechnologies that could be developed that savefirms money and improve environment

Basic premise is that combined efforts ofgovernment agencies, national laboratories,university and private firms can lead to developmentof innovative and beneficial technologies.

These programs emphasize being proactive inreducing pollution, encourage R&D and adoption ofgreen technologies .


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Command and Control Regulation

These place constraints on the behavior ofhouseholds and firms.

Constraints generally take the form of limits

on inputs or outputs in the consumption orproduction process.

Examples include:

Requiring sulfur-removing scrubbers on thesmokestacks of coal-burning utilities.

Prohibitions against dumping of toxic substances.


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Economic Incentives

Economic incentives make self interestcoincide with social interest.

Examples include:

Pollution taxes Pollution subsidies

Marketable pollution permits

Deposit-refund systems

Performance bonds

Liability systems


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Choosing the Correct Level of

Environmental Quality

Zero pollution is not possible/desirable for tworeasons:

The reduction of pollution will have opportunity costs.

The Law of Mass Balance makes a choice of zerophysically impossible.

The Law of Mass Balance states that the mass ofoutputs of any activity are equal to the mass ofinputs.

Any consumption or production activity mustproduce waste.


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Definitions first:

Stock pollutants: pollutants for whichenvironment has little ability to absorb: non

biodegradable bottles, heavy metals, toxics Fund pollutants: environment has some

ability to absorb, pollutant doesnt accumulate

indefinitely; organic pollutants, CO2 absorbedby plants, etc.

Focus now on Fund Pollutants


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The desired level of pollution will be afunction of the social costs associated withpollution.

The first of these is the damage that pollutioncreates by degrading the physical, natural,and social environment.

The second is the cost of reducing pollution

and includes the opportunity costs ofresources used to reduce pollution and thevalue of foregone outputs.


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The Marginal Damage Function

The marginal damage function represents thedamages that pollution generates bydegrading the environment.

Even if these impacts are not quantifiable, themarginal damage function is useful for

thinking about the relationship betweenenvironmental change and social welfare.


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Figure 3.3 Marginal Damage Function


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Marginal Damage Function

The marginal damage function specifies thedamages associated with an additional unit ofpollution.

The total damages generated by a particularlevel of pollution is represented by the area

under the marginal damage function.


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Marginal Damage Function

The increasing slope of the marginal damagefunction indicates how damage changes witheach additional unit of pollution.

An upward sloping marginal damage functionindicates that as the level of pollution

becomes larger, the damages associatedwith the marginal unit of pollution becomelarger.


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Marginal Abatement Cost Function

Abatement Costs are those costs associatedwith reducing pollution to a lower level so thatthere are fewer damages.

Abatement costs include: Labor

Capital

Energy needed to lessen emissions Opportunity costs from reducing levels of

production or consumption.


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The marginal abatement cost functionrepresents the costs of reducing pollution byone more unit.

In the following figure, Eu represents the levelof pollution that would be generated inabsence of any government intervention.

As pollution is reduced below Eu, themarginal abatement cost increases.


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Marginal abatement costs rise as cheaperoptions for reducing pollution are exhaustedand more expensive steps must be taken.

The decreasing slope indicates that the costsof reducing pollution increases at anincreasing rate.

A high vertical intercept indicates that thecost of eliminating the last few units ofpollutants would be extremely high.


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The Optimal Level of Pollution

Optimal level of pollution minimizes the totalsocial costs of pollution (the sum of totalabatement costs and total damages).

This level occurs at the point where marginalabatement costs are equal to marginal

damages.


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If the level of emissions is less than E1, then themarginal abatement costs are greater than themarginal damages that the unit of pollution wouldhave caused.

It doesnt make sense to reduce pollution.

If the level of emissions are greater than E1, then themarginal damages are greater than the marginal

abatement costs associated with reducing pollutionby one unit.

Society is better off eliminating that unit of pollution.


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Social Costs When Pollution Level is

Greater than Optimal


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Social Costs When Pollution Level is

Greater than Optimal

The optimal level of pollution is E1.

The actual level of pollution is E2.

Total costs associated with pollution havebeen increased by the area of triangle abc.

This represents marginal damages greater

than marginal abatement costs for the rangeof pollution emissions between E1 and E2.


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Social Costs When Pollution Level is Less

Than the Optimal


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Social Costs When Pollution Level is Less

than Optimal

The optimal level of pollution is E1.

The actual level of pollution is E3.

Total costs associated with pollution have

been increased by the area of triangle ade.

This represents marginal abatement costsgreater than marginal damage for the range

of pollution emissions between E1 and E3.


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Optimal Level of Pollution, an alternative

graphical representation

MAC

MDF = MBabatement

Abatement

damages,costs, $

A1


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Optimal Level of Pollution, an alternative

approach

Plot functions against abatement instead of

pollution

Abatement is the amount of pollution reduced

These are analagous approaches, justsometimes more convenient to think in termsof abatement vs. pollution

Answers are the same.


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Optimal Level of Pollution, two

approaches on one graph

= MB emissions

= MB abatement

abatement


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Optimal pollution (abatement) levels and

costs of control

Two goals of environmental policy

1. Get the optimal amount of pollution

(abatement) just discussed2. Achieve that level at the lowest possible

cost

Goals are actually inter related, but helpful

to think about them in two steps, once haveidentified optimal amount of pollution, howto achieve it at least cost


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costs of control

Suppose optimal to control (abate) 100 unitsof pollution that are generated by two firms

How much control should each firm

undertake to minimize total costs Plot abatement levels by the two firms

against each other with a total of 100 units

of abatement Cost of control is at a minimum when the

marginal abatement costs are equal


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Least cost allocation of abatement

between two sources (firms)

MAC2

MAC1

Abatement firm 1

Abatement firm 2

damages,costs, $

0 10 20 30 40 50 60 70 80 90 100

100 90 80 70 60 50 40 30 20 10 0

a b


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costs of control

In this example firm 1 should control 40units and firm 2 should control 60 to achieveleast cost of control

This solution takes into account the fact thatdifferent firms have different costs of control

Can consider both goals on one graph

Can see both that optimal abatement is 100and efficient (least cost) allocation is 40, 60


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Optimal pollution and least cost

allocation of abatement

MAC2

MAC1

Abatement

damages,costs, $

0 10 20 30 40 50 60 70 80 90 100 110 120 130

MAC = MAC1

+ MAC2

MB


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Pursuing Environmental Quality with

Command and Control Policies

One way to achieve an optimal level ofpollution is to mandate action to achieve thedesired level of pollution.

Critics have argued that command andcontrol regulations generate more abatementcosts than necessary.

Suppose there is a desire to reduce pollution

by half, each firm might be required to controlhalf of its emissions, would this be the leastcost way to accomplish this reduction?


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h


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Recall, the aggregate marginal abatement costfunction is the horizontal summation of theindividual marginal abatement cost functions.

Note we are back to plotting against emissions With no environmental regulation, polluter 1

would emit 10 units and polluter 2 would emit 6.

A requirement to reduce emissions by 50%,regardless of cost, would reduce polluter 1 to 5units and polluter 2 to 3 units.

P i i l Q li b


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Pursuing Environmental Quality by

Equating Marginal Abatement Costs

When both polluters are required to reduceemissions by 50%, regardless of marginalabatement costs, polluter 2 incurs a highercost ($3) than polluter 1 ($2).

Societys total abatement costs can belowered by keeping total emissions constant,but reallocating level of emissions by

marginal abatement costs. The optimal level of emissions will be where

marginal abatement costs are equal, for agiven level of emission.

P i E i l Q li b


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P i E i l Q li b


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Since polluter 2 has higher marginal abatementcosts, polluter 2 should be allowed to emit more,and polluter 1 will be required to pollute less.

Polluter 1 reduces pollution by one half unit (to 4 )and polluter 2 increases pollution by one half unit (to3 ).

Polluter 1s marginal abatement costs increase and

polluter 2s marginal abatement costs decrease.

Total abatement costs are minimized.

Th R l f C d d C l


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The Role of Command and Control

Policies

Despite their typical inability to equate marginalabatement costs across polluters, command andcontrol policies may still be the most desirable policy

instrument under the following circumstances: When monitoring costs are high.

When the optimal level of emissions is at or nearzero.

During random events or emergencies that canchange the relationship between emissions anddamages.

Th R l f C d d C l


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Policies

While it might be possible to achieve anoptimal amount of litter through the use of atax or per person allocation, this wouldrequire the litter police.

It is easier to make ALL littering illegal andestablish a punitive fine for those caughtlittering.

The fine multiplied by the probability of beingcaught would be factored into the choice tolitter.

Th R l f C d d C l


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Policies

When the optimal level of pollution is zero or at zero,direct controls make sense.

This is the case for extremely dangerous pollutants,such as heavy metals and radioactive waste.

Damages associated with these pollutants are quitesevere.

Direct controls also make sense in other cases

where initial damages are quite high compared toinitial marginal abatement costs.

An example is CFCs, where accumulated amounts

are dangerous but there are low cost alternatives.

Th R l f C d d C l


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Policies

Emergency situations may make directcontrols the preferable policy instrument.

These events occur in random and

unpredictable fashion. Examples include smog alerts and droughts.

P i E i l Q li i h


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Economic Incentives

Economists advocate policies based oneconomic incentives for two primary reasons:

Economic incentives minimize total abatement

costs by equating marginal abatement costsacross polluters and encouraging a broader arrayof abatement options.

Economic incentives encourage more research

and development into abatement technologiesand alternatives to the activities that generate thepollution.

E i I i d Mi i i d T l


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Economic Incentives and Minimized Total

Abatement Costs

Consider the following graph. A polluter is polluting at an unregulated level of 10

units.

The government imposes a tax equal to tdollars per

unit of pollution. The polluter compares the tax oftdollars to the

marginal abatement cost (MAC) of reducingpollution.

As long as the MAC is less than the tax, polluter willreduce level of emissions.

Each polluter will chose an emission level whichequates MAC and the tax.

E i I ti d Mi i i d T t l


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Economic Incentives and Minimized Total

Abatement Costs

E i I ti d th C t i t f


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Economic Incentives and the Certainty of

Attaining a Target Level of Pollution

If the aggregate marginal abatement costfunction is know, then achieving a targetedlevel of pollution is easily accomplished.

If the aggregate marginal abatement costfunction is not known, the appropriate taxlevel is much harder to determine.

Consider Figure 3.16, where evidence

suggests that the true MAC function liesbetween an upper and lower bound set ofMACs.

E i I ti d th C t i t f


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E mi I ti d th C rt i t f


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Suppose policymakers believe MAC1b is the trueMAC. In an effort to achieve an emissions level ofE1, they impose a tax of t1.

However, if MACt

describes how polluters willrespond, the emissions level will be E2.

E2 is higher than the desired level of pollution.

Because the choice of pollution abatement andproduction technologies is sensitive to specific taxstructures, it may not be easy to change the tax toachieve the desired level of pollution emissions.

E onomi in enti es nd in enti es for


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Economic incentives and incentives for

research

If a firm is faced with a tax on its pollution, ithas the incentive to find ways to reduce itspollution cheaply

The motivation that taxes provide fortechnology development is an advantage oftaxes over command and control



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research for a firm

MAC after R&D

MAC initially

Abatement

damages,costs, $

t

ab

cd

Firm cost initially =

a + b + c (tax bill) +d + e (abatement cost)

Firm cost after R&D =

a (tax bill) +

b + e (abatement cost)

e

I r


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In summary:

Pollution taxes are preferable to commandand control techniques since pollution taxesminimize abatement costs and provide

incentives for R&D But, taxes do not put the level of pollution

under direct control so when there isuncertainty in abatement costs one might notget the desired level of pollution.

Marketable permits might achieve both?

M rk t bl P ll ti n P rmits


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Marketable Pollution Permits

Marketable pollution permits are permitswhich give a firm the right to emit a specificnumber of units of pollution.

Polluters are free to buy and sell these rights

to pollute. A marketable pollution permit system can

both minimize total abatement costs, provideflexibility in the choice of mechanisms used tomeet pollution goals, and achieve the desiredlevel of pollution emissions.

Marketable Poll tion Permits


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A system of marketable pollution permitsbegins with the determination of the targetlevel of pollution.

The next step is to allocate pollution acrosspolluters.

This allocation can be based on historicpollution levels, auctions, a lottery, or some

other allocation scheme. The buying and selling of pollution permits

will reallocate the emission rights.



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Marketable pollution permits equate marginalabatement costs across polluters.

Each polluter compares his/her marginal abatementcosts with the price of a permit.

If the marginal abatement costs are higher than theprice, they have an incentive to buy.

If the marginal abatement costs are lower, they havean incentive to sell.

Buying and selling will continue until the equilibriumprice is reached which equates marginal abatementcosts across all firms.

Marketable Pollution Permits and


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Geographic Considerations

Geographic location of emissions can have aprofound impact on the damages thepollution generates for some categories ofpollution.

Central to the importance of location ofemissions is the manner in which thepollution disperses when it enters the

environment. Pollution controls must take into

consideration the geographic variation in theeffect of pollution on society.



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Geographic Considerations

A pollution control system based on taxescould take variation into account by charginghigher taxes in areas where emissions aremore damaging.

A marketable pollution permit system mustdivide the overall region into subregions.

These subregions can account for

geographic variability in one of two ways:development of a receptor-based system ordevelopment of separate markets forsubregions.

Marketable Permits and Geography:


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Ambient-based Permit System

A receptor-based or ambient-based system allocatespollution receptors across the subregion.

Locations relatively close to, and downwind from, thepolluter may require more permits.

Dispersion coefficients are used to help define theterms of trade in this type of marketable pollutionpermit market.

In the following figure, the location of a particularpolluter is denoted by a star and receptors aredesigned by letters. This polluter may have to buy

some combination of 15 different types of permits.



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Geographic Considerations:

Ambient-based Permit System



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Emissions-based Permit System

An alternative to the ambient-based system is todivide the subregions into separate markets.

Polluters need only purchase permits for thesubregion in which they are located.

The inability to trade across subregions may meanthat firms with lower abatement costs will not beable to trade permits with higher abatement costfirms in another subregion.

A compromise would be to have one type of permitand allow trade across all regions, as long as thetrade does not result in ambient quality standardsbeing violated at any receptor point.



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Geographic Considerations:

Emissions-based Permit System

Other Types of Economic Incentives


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Deposit-refund systems are a good way ofemploying economic incentives when monitoringcosts are high.

This system is based on requiring a payment upfront for undesirable acts and then building in arefund when a desirable action occurs.

The most common example of this is the deposit-refund system in place for beverage containers.

This system has also been used for cars andbatteries in other countries.



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Bonding systems are closely related to deposit-refund systems.

A bonding system requires a potential degrader ofthe environment to place a large sum of money inan escrow account.

This money is returned if the environment isundamaged (or returned to its original condition) andwill be forfeit otherwise.

Bonds need to be large enough to provide anincentive to use appropriate safeguards and/orcover the cost of clean up if damage occurs.



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Liability systems are based on defining legal liabilityfor the damages caused by certain types of pollutiondischarges and facilitating collection of thesedamages.

The Comprehensive Environmental Response,Compensation and Liability Act of 1980 (CERCLA)defines legal rights to natural resources for local,state and federal governments and defines howdamages can be recovered.

A related system defines legal liability and thenrequires potential polluters to obtain full insuranceagainst any damages. There is a potential moralhazard problem with this option.



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A system of pollution subsidies would pay eachpolluter a fixed amount of money for each unit ofpollution reduced.

The polluter would reduce pollution to the point

where the subsidy is equal to the marginal cost ofabatement.

While the outcome is the same as a tax on polluters,there are distributional effects, problems with

political acceptability and the possibility thatstrategic behavior would lead to higher initial levelsof pollution in order to obtain the subsidy. Inaddition, the subsidy could potentially attract morepolluters into the industry.

Conclusion


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Conclusion

Market failures associated with environmentalexternalities generate losses in welfare.

Command and control policies are the basis ofcurrent policy but do not equate marginal abatementcosts across polluters.

Economic incentives, such as taxes or marketablepollution permits do equate marginal abatementcosts.

While there are some problems with economicincentives, they do create additional motivation fortechnological innovation to reduce pollution

govt intervention on market failure

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