Chapter Five

Pollution Control: Targets and Instruments

Instructor: Derese G. (Assistant professor)

Email: dereget21@[Link]

Derese G. (Assistant professor) 1

5.1. Concept and classification of pollution

The past, present and potential global threat of environmental

pollution and degradation is one of the main factors that has
an effect on the formation of society’s environment.

Since it is hardly possible to have zero level of pollution, we

should have to determine the optimum level of it to protect the
environment. The economic theory provides the efficient
allocation of pollution which requires the fulfillment of a
competitive market assumption. However, in reality, markets
fail to allocate resources efficiently.
Derese G. (Assistant professor) 2
 Cont’d…
Pollution is the addition to the ecosystem of something what has
a detrimental effect on it. It is contamination of the
environment rendered to be unhealthy for intended or desired
use. One of the most important causes of pollution is the high
rate of energy usage by modern, growing populations.

Pollution exists whenever human activity generates a sufficient

concentration of a substance in the environment to cause harm
to people or to resources valued by people.

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 Types and source of pollution

Pollutant is any substance released into the environment as a result of

human activity or natural processes that has an adverse impact on living
organisms.
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Cont’d…

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Cont’d…

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 Classification of pollution
 Pollution can be classified in terms of its damage mechanism.
 The distinction concerns whether damage arises from the flow of
the pollutant (that is, the rate of emissions) or from the stock (or
concentration rate) of pollution.
1. Flow-damage pollution occurs when damage results only from
the flow of residuals: that is, the rate at which they are being
discharged into the environmental system.
 E.g. noise or light so that when the emission is terminated no
residuals remain in existence.

Derese G. (Assistant professor) 7

 Cont’d…
2. Stock-damage pollution describes the case in which
damages depend only on the stock of the pollutant
in the environmental system at any point in time.
For a stock of the pollutant to accumulate,
emissions are being produced at a rate
which exceeds the assimilative capacity of
the environment.

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3. Mixed cases, where pollution damage arises from both flow and
stock effects, also exist.

 Waste emissions into water systems are sometimes modelled as

mixed stock-flow pollutants.

 Using “M” to denote the pollution flow, “A” to denote the

pollution stock and D to denote pollution damage, we therefore
have two variants of damage function:

Flow-damage pollution: D = D(M) (1a)

Stock-damage pollution: D = D(A) (1b)
• For simplicity of notation, we shall from this point on call these
‘flow pollution’ and ‘stock pollution’.
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Figure 1 Economic activity, residual flows and environmental damage

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 [Link] Control: Targets
About pollution policy, economists are interested in
two issues:

1. How much pollution should there? (the efficient

level of pollution?) given that some target
level has been chosen

2. What is the best method of achieving that level

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 Cont’d…
Pollution Control: Two Aspects
Damages

Abatement Costs

•In general the greater the level of pollution the greater the level of damages and the
greater the abatement costs

•A damage function describes the relationship between pollution and damage

•A marginal damage function shows the changes in damages stemming from a one unit
change in emissions or ambient concentrations

•The height and shape of a damage function depends on the pollutant and circumstances
involved

•The main way of solving the problem of pollution is to make businesses that generate the
pollution take account of it in their costs.
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5.2.1. The efficient level of pollution
emissions
The efficient level of pollution is the quantity at which its
total benefits exceed its total costs by the greatest
possible amount. This occurs where the marginal benefit
of an additional unit of pollution equals its marginal cost.
Or
Marginal abatement cost is equal to the marginal damage
cost due to pollution i.e. MAC = MDC
“Determining the Efficient Level of Pollution” shows how
we can determine an efficient quantity of pollution.
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 Cont’d…
The marginal abatement cost (MAC): is the cost of abatement or
controlling an extra unit of pollution. It is also known as the
marginal control cost.

There is a negative relationship between MAC and the quantity of pollution.

The higher the MAC, the lower will be the quantity of pollution and vice
versa.
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 Cont’d…
Marginal damage cost (MDC): is the health or environmental damage caused
by an extra unit of pollution. It is also known as the marginal pollution cost.

There is a positive relationship between MDC and the quantity of pollution. The
higher the MDC, the higher will be the quantity of pollution and vice versa.

Graphically, the MDC does not start at zero, but at positive amount of pollution
because of the ability the environment to assimilate certain pollution without any
danger. Thus point p indicates ecologists’ optimum point.
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 Cont’d…
• We now investigate how pollution targets can be set using an
efficiency criterion.
• Given that pollution is harmful, some would argue that only a
zero level of pollution is desirable.
• But, pollution can also be beneficial.
• Therefore, zero pollution is not economically efficient except in
particular special circumstances.
• In what sense is pollution beneficial?
 One answer comes from the fact that producing some goods
and services that we do find useful may not be possible
without generating some pollution.
 More generally, goods might only be producible in
nonpolluting ways atDerese
large additional expense.
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  Thus, relaxing a pollution abatement constraint allows the
production of goods that could not otherwise have been made,
or to produce those goods at less direct cost.

 This is the sense in which pollution could be described as

beneficial.

• With both benefits and costs, economic decisions about the

appropriate level of pollution involve the evaluation of a trade-off.

• Stricter pollution targets will generate benefits but will also

generate costs.

• The trade off is optimized at the point where the marginal

benefits arising from reduced pollution damage fall to a level
equal to the marginal benefit from avoided control costs.

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 I. A static model of efficient flow pollution
 A simple static model – one in which time plays no role – can be
used to identify the efficient level of a flow pollutant.
 In this model, emissions have both benefits and costs.
 the costs of emissions are called damages (negative/adverse
externality).
 these damages can be thought of as a Production entails joint
products: the intended good or service, and the associated
pollutant emissions.
 In an unregulated economic environment, the costs associated
with production of the intended good or service are paid by
the producer, and so are internalised.
 But the costs of pollution damage are not met by the firm, are
not taken into accountDerese
[Link] decisions, and so are externalities.
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 For simplicity, we suppose that damage is independent of the
time and the source of the emissions, and that emissions have no
effect outside the economy being studied. We relax these
assumptions later.
 An efficient level of emissions is one that maximizes the net
benefits from pollution, where net benefits = pollution benefits
minus pollution costs (or damages).
 In the case of flow pollution, damage (D) is dependent only on the
magnitude of the emissions flow (M), so the damage function:
D=D(M)
 Matters are a little less obvious with regard to the benefits of
pollution.
 Suppose for the sake of argument that firms were required to
produce their intended final output without generating any
pollution. Derese G. (Assistant professor) 19
  This would, in general, be extremely costly (and perhaps even
impossible in that limiting case).
 Now consider what will happen if that requirement is gradually
relaxed.
 As the amount of allowable emissions rises, firms can
increasingly avoid the pollution abatement costs that would
otherwise be incurred.
 , firms make cost savings (& so profit increases) if they are
allowed to generate emissions in producing their goods.
 The larger is the amount of emissions generated, the greater
will be those cost savings ( or Benefits).
 Symbolically, we can represent this relationship by the function
B=B(M), (2)
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B denotes the benefits from emissions.
 The social net benefits (NB) from a given level of emissions are
defined by:
NB =B(M) − D(M)
 It will be convenient to work with marginal, rather than total,
functions.
 Thus dB/dM(or B′(M) is the marginal benefit of pollution and
 dD/dM(or D′(M)) is the marginal damage of pollution.
 We assume for simplicity that:
 total damage rises at an increasing rate with the size of the
emission flow, and so the marginal damage will be increasing in M
 total benefits will rise at a ing rate as emissions  (because per-
unit emissions abatement costs will be more expensive at greater
levels of emissions reduction).
o , the marginal benefit of emissions would fall as their flow .
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• To maximise the net benefits (NBs) of economic activity, we
require that the pollution flow, M, be chosen so that
(3a)

or, equivalently, that

• (3b)

 which states that the net benefits of pollution can be maximised

only where the MBs of pollution = the MD of pollution.
 The efficient level of pollution is M* (see Figure1).
 If pollution is less than M* the MBs of pollution are > the MD
from pollution, so higher pollution will yield additional NBs.
 Conversely, if pollution is >M*, the MBs of pollution are < the
MD from pollution, so Derese
[Link] will yield more net benefits.
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Figure 1. Total and marginal damage and benefit functions, and the efficient level of flow pollution emissions

D(M) D(M)
B(M)

B(M)

Maximised net
benefits

Emissions, M

dD
dM

* B
dB
dM
A

M* Mˆ Emissions, M
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• The value of MD and MB functions at their intersection is labelled
µ* in Figure 1.
 We can think of this as the equilibrium ‘price’ of pollution.
• This price has a particular significance in terms of an efficient
rate of emissions tax or subsidy.
• However, as there is no market for pollution, µ* is a
hypothetical or shadow price rather than one which is actually
revealed in market transactions.
 We could also describe µ* as the shadow price of the pollution
externality.
• If a market were to exist for the pollutant itself (thereby
internalising the externality) so that firms had to purchase rights
to emit units of the pollutant, µ* would be the efficient market
price.
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• Thus, taking the lower part of Figure 1, in the absence of
internalisation of the externality, the emissions level would be
• However, if a Pigovian tax at rate μ* per unit emission were
levied on the externality generator, then emissions would fall to
their first-best level, M*.
• The efficiency gain that results from the introduction of the
Pigovian tax is given by area B. Moving from to M*:
 reduces the value of output by the amount A, the integral of the
area under the marginal benefit curve between and M*.
 it also reduces the value of environmental damage by the
amount A + B, the integral of the area under the marginal
damage curve between and M*.
 So the net efficiency gain is (A + B) – A = B.

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 Another interpretation of the emissions efficiency condition:
• The efficient level of pollution is the one that minimizes the sum
of total abatement costs plus total damage costs.
• notice that in the diagram we have relabelled the curve previously
called marginal benefit as marginal abatement cost.
• To confirm this cost-minimising result, note that at the efficient
pollution level, M*, the sum of total damage costs (area C2) and total
abatement costs (area C1) is C2 + C1 =total cost. (see fig. 2)
• Any other level of emissions yields higher total costs.
 If too little pollution is produced (or too much abatement is
undertaken) with a pollution flow restricted to MA, it can be
deduced that total costs rise to C1+ C2 +C3,
o so C3 is the efficiency loss arising from the excessive abatement.
 too much pollution (too little abatement) results in higher costs
than C1+ C2. Derese G. (Assistant professor) 26
Figure 2: The economically efficient level of pollution minimizes the
sum of abatement and damage costs

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 Cont’d…
To achieve maximum economic efficiency, the government should
allow pollution up to the point where marginal benefits equal
marginal costs, as shown by the intersection of the two curves
above. Of course, these are only theoretical curves, and are difficult
to derive in real life. Drawing a line straight down from this
intersection point leads to the level of allowable pollution that
maximizes economic efficiency, M*. This is the optimal level of
pollution.

If the allowable level was left of that point, polluters would lose less
than society would gain, but this net gain could be taken further.

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 Cont’d…
If we move to the right of the optimal level, the costs to polluters
would outweigh the gains to society. As the level of pollution
prevented goes up, meaning that you move to the right in the graph,
the marginal cost increases. This is because eliminating small to
medium amounts of pollution may be relatively easy, but total
elimination of pollution may cost considerably more. Also, those
companies that have great difficulty in reducing pollution, and incur
great costs in removing it, will be forced to reduce pollution so that the
economy can achieve extremely high levels of pollution prevented.

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 II. Efficient Levels of Emission of Stock Pollutants
• The analysis of pollution dealt with the case of flow pollution, in
which pollution damage depends directly on the level of emissions.
• How should the analysis change for stock pollutants, where
damage depends on the stock of the pollutant?
• The flow pollution model also provides correct answers in the
special (but highly unlikely) case where the pollutant stock
degrades into a harmless form more-or-less instantaneously.
 Here the stock dimension is distinguishable from the flow
only by some constant of proportionality, and so we can work
just as before entirely in flow units.
• But in all other cases of stock pollutants, the flow pollution
model is invalid.

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 Spatial and Inter-Temporal Considerations
The majority of important pollution problems are associated with
stock pollutants.
• Pollution stocks derive from the accumulation of emissions that
have a finite life (or residence time).
• Because stock pollutant:
 are persistent over time and
 so may be transported over space,
 the analysis of stock pollution often necessitates taking
account of:
o space as well as time

• It will be convenient to deal with these two dimensions separately.

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 A. Pollution Control Where Damages Depend on
Location of the Emissions
• In this section we deal with stock pollutants which have
relatively short residence times in the environmental media into
which they are dumped.
• consider Fig. 3 which represents two polluting ‘sources’, S1 and
S2, that are located near four urban areas, R1, R2, R3 and R4.
 These areas contain populations whose health is adversely
affected by local ambient concentrations of the pollutant.
 Our interest lies in the amount of pollution these areas – called
‘receptors’ – receive from the emission sources.
• We assume that emissions from the two sources persist for at
most a few days; atmospheric processes break up and degrade
concentrations rather quickly, so that on any one day pollutant
concentrations are determined purely by emissions of the last few
days. There is no long-term
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Figure 3. A spatially differentiated airshed

R1
R2

S1

S2

R4
R3

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 Pollutant Dispersion and Mixing
 Now consider the extent of pollutant dispersion and mixing.
• Mixing of a pollutant refers to the extent to which physical
processes cause the pollutant to be dispersed or spread out.
• A pollutant is ‘uniformly mixing’ (UM) if physical processes
operate so that the pollutant quickly becomes dispersed to the point
where its spatial distribution is uniform.
– That is, the measured concentration rate of the pollutant does
not vary from place to place.
– This property is satisfied, for e.g., by most greenhouse gases.
• By definition, the location of the emission source of a UM
pollutant is irrelevant as far as the spatial distribution of pollutant
concentrations is concerned.
– Irrespective of the source location, pollutant stocks become
evenly distributed across
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(Assistant professor) spatial area of interest. 34
 What can be said about the efficient level of emissions with the
twin properties of short residence time (whose accumulation is
therefore negligible) and uniform mixing?
 Intuition suggests that the simple flow pollution model developed
in the above can be used with only minor modification.
 note that there will be a one-to-one relationship between the
level of emissions of the pollutant (M) and the pollutant stock
size (A).
 Specifically, M and k are related by a fixed coefficient
relationship of the form A=kM, with k fixed for any particular
kind of pollution.
 Therefore, while damage is a function of the stock, the damage
function can be translated into an equivalent flow function
using the A=kM relationship, permitting use of the flow
pollution model. Derese G. (Assistant professor) 35
 Where pollutants are not uniformly mixing, location matters.
 flow pollution model cannot be used where the pollutant is not
uniformly mixing nor where it has a relatively long lifespan.
 Most air, water and ground pollutants are not uniformly mixing.
 Suppose that the principal determinants of the spatial distribution
of the pollutant are wind direction and velocity.
 Clearly, emissions from S1are going to matter much more for the
four receptor areas than emissions from S2.
 Furthermore, looking at emissions from S1 alone, these are likely
to raise pollutant concentration levels to a greater amount in R1
than in the other three receptors.
 There will not be a single relationship between emissions and
concentration over all space.
 Non-uniform mixing is of importance as many types of pollution
fall into this category. Derese G. (Assistant professor) 36
 B. Inter-Temporal Analysis of Stock Pollution
• We now consider the case of stock pollutants that have a relatively
long active (i.e. damaging) lifespan but which are uniformly mixing.
• Doing so has two implications:
– 1st , the uniformly mixing assumption implies that pollutant
concentrations will not differ from place to place, and so the
spatial dimension of emissions control is no longer of direct
relevance.
– 2nd , persistence of pollution stocks over time means that the
temporal dimension is of central importance.
• As we shall see, an efficient pollution control programme will
need to take account of the trajectory (Path) of emissions over
time, rather than just at a single point in time.
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 Modelling
 The model we use to examine pollution targets is the simplest
possible one that can deal with the intertemporal choices involved.

• Damage at time t is determined by the stock size or

concentration of the pollutant in a relevant environmental
medium (At) .

• Gross benefits depend on the level of emissions of the pollutant

(Mt).

 Hence our damage and (gross) benefit functions have the

general forms:

Dt = D(At) (4)

Bt = B(Mt) (5)
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 Emissions Stock-Flow Relationship
 The variables A and M are not independent of one another.
 With relatively long-lived pollutants, current emissions add to
existing stocks and those stocks accumulate over time.
 However, part of the existing stock will decay or degrade into a
harmless form over time:
At  M t  αAt _________________(6)
 The parameter  is a decay coefficient, and must lie b/n 0 & 1.
  = 0 exhibits no decay, and so the second term on the right-hand side
of equation 6 is zero.
o This is known as a perfectly persistent pollutant.
o In this case, integration of equation 6 shows that the stock at any
time is the sum of all previous emissions (e.g. heavy metal
residuals, and toxins such as DDT and dioxin).
o Damages arising fromDerese
current emissions
G. (Assistant professor) will last indefinitely. 39
 Emissions Stock-flow Relationship
 0 <  < 1, imperfectly persistent pollutant.
o Here, the pollutant stock decays gradually over time, being
converted into relatively harmless elements or compounds.
• Greenhouse gases provide one example, but with slow or
very slow rates of decay.
  = 1, implies instantaneous decay, and so the pollutant can be
regarded as a flow rather than a stock pollutant.
• The specification given in equation 6 imposes the restriction that
the parameter  is constant; a constant proportion of the pollution
stock decays over any given interval of time.
 This may be invalid in practice.

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 Emissions Stock-flow Relationship
• By integrating equation 6 over time we obtain

A
t

t

 M  αA dτ
t t

t0

 where t0 denotes the first point in time at which the pollutant in

question was emitted.
 the pollution stock at time t will be the sum of all previous
pollution emissions less the sum of all previous pollution decay,

• Thus the pollution stock level at any time t, At, depends on the
entire history of emissions up to that point in time.
• Even if emissions had been at a constant level in the past and were to
remain so in the future,
• A would not be constant throughout time, except in the very long run.
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 Targets
• As time periods are linked together through a stock–flow
relationship, efficient pollution targets and policies must be
derived from an intertemporal analysis.
• Assume that the policy maker aims to maximise discounted net
benefits over some suitable time horizon.
• For simplicity, we take the horizon/time to be of infinite span.
• Using t = 0 to denote the current period of time, and defining the
net benefits of pollution = gross benefits minus damages the
policy maker’s objective is to select Mt for t = 0 to t = ∞ to
maximise t
BM t   D A t  e -rt dt
(7)
t0

where r is the social (consumption) discount rate.

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A complete description of efficient stock pollution will, therefore,
consist not of a single number for, but a trajectory (or time
path) of, emission levels through time.
• In general, this optimal trajectory will be one in which emission
levels vary throughout time.
• However, in many circumstances, the trajectory will consist of
two phases.
 One of these phases is a so-called steady state in which
emissions (and concentration levels) remain constant
indefinitely at some level.
 The other is an adjustment phase; the trajectory describes a
path by which emissions (and concentrations) move from
current levels to their efficient, steady-state levels.
o This adjustment process may be quick, or it may take place
over a long period of time.
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 Optimal Steady-state Trajectory
• Even with complete information, obtaining an optimal emissions
trajectory is technically difficult.
• In this section, we consider only the efficient steady-state
pollution level, in which the pollution flow and the pollution stock
are each at a constant level.
• With an unchanging stock( ) , equation 6 simplifies to M = A
– Intuition: for a pollutant that accumulates over time, the pollution
stock can only be constant if emission inflows to the stock (M) are
equal to the amount of stock which decays each period (A).
• It then follows that in a steady state, the stock–flow relationship
between A and M can be written as:
A = M/  (8)
• In a steady state, the smaller is the value of , the larger will be
the pollution stock for anyDerese
given level
G. (Assistant of emissions (M).
professor) 44
• Here, an efficient steady-state level of pollution emissions
requires that the following condition be satisfied:
dB dD  1 
   (9)
dM dA  r  α 

 This is familiar with marginal condition for efficiency.

o The marginal benefit and the marginal cost of the chosen
emissions level should be equal.
 It can be read as an equality between the instantaneous value
of the gross benefit of a marginal unit of pollution (the LHS of
9) and the present value of the damage that arises from the
marginal unit of pollution (the RHS of 9).
 If we knew the values of α and r, and the functions dB/dM and
dD/dA, equation 9 could be solved for the numerical steady-
state solution value of M, M*. Then from the relationship A
=(1/α)M, the steady-state solution for A is obtained, A*.
Derese G. (Assistant professor) 45
• Note that a marginal emission today has benefits only today,
and so the present value of that marginal emission is identical to
its current marginal benefit.
• In contrast, the damage arising from the marginal emission
takes place today and in future periods.
• The discount factor 1/(r + ) has the effect of transforming the
single period damage into its present-value equivalent.
• the value taken by the expression on each side of the equation is
known as the shadow price of a unit of emission.
 It is labelled as  in several of the diagrams in this chapter and
will figure prominently in our discussions in the next chapter.
• So we could also interpret equation 9 in terms of an equality
between two present values.
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5.4. Pollution Control: Instruments

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 Introduction
• Here we consider how an Environmental Protection Agency
(EPA) could attain a predetermined pollution target by
investigating the instruments that could be used.
• In some circumstances no intervention would be required.
 Perhaps by chance, the prevailing level of pollution is not
different from the target.
 Or intervention may be unnecessary because of the
existence of voluntary bargaining.
• we will be thinking about instruments in the context of
‘pollution problems’ in general, rather than separately for air
pollution, water pollution, soil contamination, and so on.

Derese G. (Assistant professor) 48

 Criteria for choice of pollution and control instruments
• There are many instruments available to an EPA charged
with attaining some pollution target.
• How should it choose among these?
 The best instrument would be the one which meets the target
with greatest reliability.

• Each available instrument can be characterized by a set of

attributes, relating to such things as impacts on income and
wealth distribution, the structure of incentives generated, and
the costs imposed in abating pollution.
• A score can be given to each instrument, dependent on how
well its attributes match with the set of objectives sought by
the EPA.
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Table 1. Criteria for selection of pollution control instruments

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Instruments for achieving pollution abatement targets

Table 2. Classification of pollution control instruments

Instrument category
Institutional approaches to facilitate internalisation
of externalities

Command and control instruments

Economic incentive (market-based) instruments

Derese G. (Assistant professor) 51

Instrument category Description
Institutional approaches

Facilitation of bargaining Cost of, or impediments to,

bargaining are reduced
well defined and enforceable
allocation of property rights

Specification of liability Codification of liability

(legal accountability) for
env’tal damage

Development of social responsibility Education and socialisation

programmes promoting
‘citizenship’
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Instrument category Description
Command and control

Input controls over quantity Requirements to use particular inputs, or

and/or mix of inputs prohibitions/restrictions on use of others
Technology controls Requirements to use particular methods
or standards
Output quotas or prohibitions Non-transferable ceilings on outputs

Emissions licences Non-transferable ceilings on emission

quantities
Location controls (zoning, Regulations relating to admissible
planning controls, relocation) location of activities
Derese G. (Assistant professor) 53
Instrument category Description
Economic incentive
Emissions charges/taxes Direct charges based on quantity of a pollutant
User charges/fees/natural Payment for cost of collective services (charges), or for
resource taxes use of a natural resource (fees or resource taxes)
Product charges/taxes Applied to polluting products
Emissions abatement and Financial payments designed to reduce damaging
resource management subsidies emissions or conserve scarce resources
Marketable(transferable) Two systems: those based on emissions reduction credits
emissions permits (ERCs) or cap-and-trade
Deposit-refund systems A fully or partially reimbursable payment incurred at
purchase of a product
Non-compliance fees Payments made by polluters or resource users for non-
compliance, usually proportional to damage or to  gains
Performance bonds A deposit paid, repayable on achieving compliance
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Liability payments Payments in compensation for damage
 1. Approaches which facilitate voluntary, decentralised internalisation of
externalities

• One approach to achieving emissions, or other environmental policy,

targets is to improve existing social or institutional arrangements that
facilitate env’tal damage-reducing voluntary decentralised behaviour.
• Two variants of this approach:
– Improve the effectiveness of property rights regimes in
bringing about socially efficient allocations of resources;
– Encourage greater social responsibility in making choices and
taking decisions.
 Both shares the characteristic of potentially preventing the
emergence of externalities, or internalising externalities which
have arisen.
• In doing so, it is possible that decentralised behaviour by
Derese G. (Assistant professor) 55
consumers and producers may generate efficient outcomes.
 Bargaining solutions and its limitations to env’tal problems
• Ronald Coase (1960) explored the connection between property
rights and the likelihood of efficient bargaining solutions to
inefficient allocations of resources.
• He proposed that a necessary condition for bargaining between
agents to bring about efficient resource allocation is the existence of
a well defined and enforceable allocation of property rights.
• limitations:
1. The possibility of bargaining taking place is at best low unless
well-defined and enforceable property rights exist.
– For many environmental resources, well-defined and
enforceable property rights do not exist.
– An important example is an open access resource in which
exclusion is impossible except at very high, and possibly
prohibitive, cost. Derese G. (Assistant professor) 56
2. Difficulty (or impossibility) of inter-temporal bargaining,
including bargaining between current and future generations.
– Often, environmental externalities cut across generations –
our behaviour today imposes externalities on future persons.
– While bargaining b/t affected individuals at one point in time
seems feasible, it is difficult to imagine that this could happen
b/t representatives of the present generation and those not yet
living.

Derese G. (Assistant professor) 57

 Role of government
• If bargaining does offer the prospect of substantial efficiency
gains, then government should facilitate it wherever that is cost-
effective.
• It could do so by clearly defining and explicitly allocating
property rights where that is practicable (and ethically acceptable).
• Where env’tal problems spill over national boundaries, as in the case
of biodiversity decline or greenhouse gas emissions, further
complications arise.
• Government might seek to develop and sustain an institutional
structure that maximises the scope for bargaining behaviour.
• Access to the judicial system should be easy and cheap, and also
equitable between different classes of parties.
 This will facilitate use of the liability principle.
Derese G. (Assistant professor) 58
 Specification of liability
• The role that may be played by the judicial system to bring about
efficient outcomes has been implicit in our discussion of bargaining.
• Liability can be used as a means of dealing with environmental
hazards.
• Suppose that a general legal principle is established which
makes any person or organization liable for the adverse external
effects of their actions.
 In effect, property rights are then vested in the party
adversely affected by the action which generates the harm.
• In the context of risky activities, an appropriate public policy
response to activities that are beneficial but also generate
positive risks of harmful outcomes would be one that induces
precautionary, risk-reducing, behaviour by those who undertake
risky activity.
Derese G. (Assistant professor) 59
 Development of social responsibility
• Pollution problems happen, in the final analysis, because of self-
interested but uncoordinated behavior.
• Encouraging people – either as individuals or in their roles within
organizations - to behave as socially responsible citizens can help
to attain environmental goals.
• Gov’t has limited influence over the cultural context of human
behavior.
• But it would be wrong to ignore the opportunities that exist for
using educational institutions and the mass communications
media to help achieve specific targets and to promote ethical
behavior.
• Given this, ‘cultural’ instruments that promote ‘social
responsibility’ may be powerful ways of achieving general
environmental goals. Derese G. (Assistant professor) 60
 2. Command and control instruments
• The dominant method of reducing pollution in most countries has
been the use of direct controls over polluters.
 Emissions are by-products in the production of intended final
output.
 The amount (and type) of emissions will depend on which
goods are being produced, and in what quantities.
 It will also depend on the production techniques being
employed, and on the amount (and mix) of inputs being used.
 For uniformly mixing pollutants (UMPs), pollution levels will
depend only on total emissions levels.
 For non-UMPs (indicated in the diagram by the dotted lines)
the spatial distribution of pollution levels will also depend on
the location of emission sources.
Derese G. (Assistant professor) 61
 pollution levels

Location of
Emissions output emissions

Quantity of goods produced

Production technique

Inputs used

Figure 3a The pollution process

Derese G. (Assistant professor) 62
• Command and control instruments can be designed to
intervene at any of these stages.
 So, in Figure 3b , regulations may apply to :
o outputs of emissions themselves,
o the quantity of final production,
o production techniques used, or
o the level and/or mix of productive inputs.
o For non-UMPs, controls may also apply to location of
emission sources.
• In general, there should be advantages in directing the controls at
points closest (in this sequence of linkages) to what is
ultimately being targeted: that is, ambient pollution levels.
Derese G. (Assistant professor) 63
 Ambient pollution
requirements

Zoning
Emissions
licenses

Output quotas

Technology controls

Input restrictions

Figure 3b Command and control instruments

Derese G. (Assistant professor) 64
 Non-transferable emissions licences
• Suppose that the EPA is committed to attaining some overall
emissions target for a particular pollutant. It creates licences (also
known as permits or quotas) for that total allowable quantity.
– After adopting some criterion for apportioning licenses among
the individual sources, the EPA distributes licenses to emissions
sources.
– These licenses are non-transferable; that is, the licences cannot
be transferred (exchanged) between firms.
– Therefore, each firm’s initial allocation of pollution licences
sets the maximum amount of emissions that it is allowed.
• License schemes will have to be supported by monitoring systems
and by sufficiently harsh penalties for non-compliance.
• Under special conditions, the use of such emissions licenses will
achieve an overall target atDerese G. (Assistant professor)
least cost (that is, be cost-efficient). 65
 Instruments which impose minimum technology requirements

• regulations which specify required characteristics of production

processes or capital equipment used.
• Examples of this approach have been variously known as:
 best practicable means (BPM),
 best available technology (BAT) and
 best available technology not entailing excessive cost
(BATNEEC).
• In some variants of this approach, specific techniques are
mandated, such as requirements to use flue-gas desulphurization
equipment in power generation or minimum stack heights.
• Sometimes the specific technique adopted is negotiated between
the EPA and the regulated parties
Derese G. (Assistanton an individual basis.
professor) 66
 Location
• Pollution control objectives could be met by separating the
locations of people and pollution sources.
• This is only relevant where the pollutant is not uniformly
mixing, so that its effects are spatially differentiated.
• Separation can be done ex ante or ex post.
• Separation ex ante, by zoning or planning control, is common:
– Planning controls and other forms of direct regulation directed at
location have a large role to play in the control of pollution with
localised impacts and for mobile source pollution. They are also
used to prevent harmful spatial clustering of emission sources.
• Ex post relocation decisions are rarer because of their draconian
nature; examples include people being removed from heavily
contaminated areas, such as Chernobyl.
Derese G. (Assistant professor) 67
 Economic incentive (quasi-market) instruments
• Command and control instruments operate by imposing mandatory
obligations or restrictions on the behavior of firms and individuals.
• Incentive-based instruments work by creating incentives for
individuals or firms to voluntarily change their behaviour.
• Employing incentives to make behavior less polluting can be
thought about in terms of prices and markets.
• Taxes, subsidies and transferable permits create markets (or
quasi-markets, something equivalent to markets) for the pollution
externality.
• This can be done in many ways. We focus on two of them:
1. By the imposition of taxes on polluting emissions (or on outputs
or activities deemed to be environmentally harmful), or by the
payment of subsidies for emissions abatement (or reduction of
Derese G. (Assistant professor)
outputs or activities deemed to be environmentally harmful). 68
 2. By the use of tradable emission permit (or allowance)
systems in which permits command a market price. Those
prices are, in effect, the cost of emitting pollutants.
• Other forms include:
 deposit-refund systems,
 liability payments,
 non-compliance fees,
 charges on landfill or other disposal of waste, and
 performance bonds.

Derese G. (Assistant professor) 69

 Emissions taxes and pollution abatement subsidies
• For simplicity, we begin with the special case of uniformly
mixed pollutants, for which the magnitude of damage created by
an emission is independent of the location of its source.
• It is shown later that the results also apply, with minor amendment,
to non-uniformly mixing pollutants.
• Given that taxes on emissions are equivalent to subsidies
(negative taxes) on emissions abatement, it will be convenient to
deal explicitly with tax instruments.
 There are several points at which a tax could be applied.
o We focus here on emissions taxes.

• Taxes on output will not have the same effect as emissions taxes,
and will generally be less efficient in attaining pollution targets.
Derese G. (Assistant professor) 70
 Figure 4 illustrates the working of an emissions tax.
• the diagram uses aggregate, economy wide marginal benefit and
marginal damage functions (not individuals or single firms).
 If firms behave without regard to the pollution they generate, and in
the absence of an emissions tax, emissions will be produced to the
point where the private marginal benefit of emissions is zero.
o This is shown as Mˆ , the pre-tax level of emissions.

 Now suppose an emissions tax was introduced at µ* per unit

emission, the value of MD at the efficient pollution level.
 Given this, the post-tax marginal benefit schedule differs from its
pre-tax counterpart by that value of marginal damage.
 Once the tax is operative, profit maximizing behavior by firms leads
to a pollution choice of M* (where the post-tax MBs are zero) rather
than Mˆas was the case before the tax.
Derese G. (Assistant professor) 71
• Note that levying an emissions tax at the rate µ* creates just the
right amount of incentive to bring about the targeted efficient
emission level, M*.
 It is sometimes more convenient to view the problem in terms of
abatement, Z, rather than the level of pollution itself, Figure 5.
 This can be done by reinterpreting the emission tax causes
abatement to increase from zero (at to )its efficient level Z*:
Z* = −M* at the point M*.
• In the absence of an emissions tax (or an abatement subsidy),
firms have no economic incentive to abate pollution.
 However, when an emissions tax is levied (or, equivalently,
when an abatement subsidy is available) an incentive to abate
exists in the form of tax avoided (or subsidy gained).
• If the tax/subsidy is levied at the level µ*, the efficient pollution
Derese G. (Assistant professor) 72
level is attained.
 Marginal benefit Marginal damage
(before tax)

Marginal
benefit (after
tax)
*

0 M* Mˆ Emissions, M
Figure 4 An economically efficient emissions tax and level

Marginal cost of
abatement

* Marginal benefit of
abatement

0 Z* = Mˆ  M * Z Emissions abatement,
Z
Figure 5 The economically efficient level ofDerese
emissions abatement
G. (Assistant professor) 73
 Marketable Emissions Permits
 also known as tradable or transferable permits on the
quantity of emissions.

are based on the principle that any increase in emissions

must be offset by an equivalent decrease elsewhere.
 There is a limit set on the total quantity of emissions allowed.

 There are two broad types of marketable emission permit

systems:

the ‘cap-and-trade’ system and

the emission reduction credit (ERC) system.

Derese G. (Assistant professor) 74

 Cap and trade permit systems (for UMP)
 involves:
• A total quantity of emissions of some particular type (the ‘cap’)
that is to be allowed by a specified class of actual and potential
emitters over some period of time.
• The creation of a quantity of emissions permits that in sum
equal, in units of permitted emissions, the emissions cap (the target
level of emissions).
• A mechanism by which the total quantity of emission permits is
initially allocated between potential polluters.
• A rule which states that no firm is allowed to emit pollution (of
the designated type) beyond the quantity of emission permits it
possesses.
• A system whereby actual emissions are monitored and penalties
are applied to sources which emit in excess of the quantity of
permits they hold. Derese G. (Assistant professor) 75
• A guarantee that emission permits can be freely traded between
firms at whichever price is agreed for that trade.
 Marketable permit schemes differ from tax or subsidy schemes
by working in terms of quantities rather than prices.
 But this feature is also true for command and control instruments
such as quotas, licences and standards.
 The distinguishing feature is the transferability of permits
between individual sources in the marketable permits case.
 Permit trading is not allowed in command and control licence
systems.

Derese G. (Assistant professor) 76

 The Emission Reduction Credit (ERC) Form of Marketable Permit
System
• ERC system is an alternative to a cap-and-trade permit system.
• In an ERC approach, a baseline profile of allowable emissions is
established (for both aggregate emissions and emissions by
individual sources that must sum to that aggregate).
 Emissions by any particular source above its baseline volume
are subject to some prohibitive non-compliance penalty.
 if a source emits less than its calculated baseline level, it
earns a corresponding amount of emission reduction credits.
 Such credits can be sold to other sources that anticipate
exceeding their baseline emission level.
– If banking is allowed, they may also be used by the source at
a later date.
Derese G. (Assistant professor) 77
• The purchased ERCs constitute an entitlement to exceed
baseline emissions without penalty.

 Put another way, each firm is legally entitled to emit a quantity of

pollutants up to the sum of its standard entitlement plus any ERC
it has acquired.

• Each ERC is in principle equivalent to a marketable emissions

permit.

 Other things being equal, the equilibrium market price of

ERCs would be identical to that in a cap and trade regime.

Derese G. (Assistant professor) 78