CHAPTER 4: SOLUTIONS TO ENVIRONMENTAL PROBLEMS

THE COMMAND-AND-CONTROL APPROACH & MARKET APPROACH

Conventional Solution: Command-and-Control (CAC)

Assessing Cost-Effectiveness

Standards in Environmental Policy

Types of Environmental Standards Ambient standard a standard that designates the quality of the environment to be achieved, typically expressed as a maximum allowable pollutant concentration Technology-based standard a standard that designates the equipment or method to be used to achieve some abatement level Performance-based standard a standard that specifies a pollution limit to be achieved but does not stipulate the technology
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Implications of Using Standards

Two key implications
Are standards set to achieve allocative efficiency? where MSB of abatement equals MSC of abatement Given some environmental objective, is that objective being achieved in a manner that is cost-effective?

Efficient Standards

MSBAbatement = MSCAbatement
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MSB of Abatement
Additional social gains as pollution abatement increases Measured as reduction in damages or costs caused by pollution (i.e., reduction in MEC) Represents societys D for environmental quality
Implies MSB is negatively sloped

MSC of Abatement
Sum of all polluters marginal abatement costs plus governments marginal cost of enforcement Two components: MSC = MACMKT + MCE MACMKT is the sum of all polluters individual marginal abatement cost (MAC) functions (MACi = MACMKT) MCE is marginal cost of enforcement Change in governments cost of monitoring and enforcing abatement MSC is positively sloped
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Firm-Level MAC
Measures the change in cost from reducing pollution, using least-cost method Equals forgone M if the least-cost abatement method is to reduce output Typically positively sloped and increasing at increasing rate For simplicity, it is usually assumed that MAC is linear

MAC $

Single Polluters Marginal Abatement Cost (MAC)

MAC

MAC 2

MAC 1 A1 A2

Abatement (A)
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MSC of Abatement
$ MSC = MACMKT + MCE

MACMKT
MCE

A1

Abatement (A)
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Allocatively Efficient Level of A (AE) $

AE occurs at the point where: MSB of abatement = MSC of abatement Graphically where the two curves intersect

MSC

MSB AE Abatement (A)

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Why Standards May Not Be Efficient

Legislative Constraints Many standards are benefit-based, i.e., set to improve societys well-being with no consideration for the associated cost Imperfect information Inability to identify MSB and/or MSC MSB: due to the problem of nonrevelation of preferences MSC: difficulty in identifying each firms MAC, including implicit costs
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Why Standards May Not Be Efficient

(continued)
Nonuniformity of pollutants Changes in emissions do not have uniform effects on environment e.g., if polluters are at different distances from populations or ecosystems, MSB would vary Regional differences Even if AE is identified at the national level, it is not likely to be efficient at regional level

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Modeling Regional Differences

Consider two regions, X and Y, with same MSC of abatement Suppose their MSB of abatement curves differ, such that MSBX < MSBY Result: Allocatively efficient level of abatement for region X (AX) would be lower than for region Y (AY)

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Regional Differences
$ MSCX = MSCY

MSBY = MSCY

MSBY
MSBX = MSCX

A single national abatement standard would not be optimal for both regions

MSBX AX AY A
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Next Step
If allocatively efficient standards are unlikely, we use costeffectiveness to evaluate how standards are implemented Cost-effectiveness depends on the approach Command-and-control: using standards or rules to control pollution Market: using incentives and market forces to motivate or encourage abatement and conservation

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Command-and-Control (CAC)
Assessing Cost-Effectiveness

Two Standards to Examine

Technology-based standard Uniform standard

Technology-Based Standards
Technology-based standards specify the type of abatement equipment or method to be used By definition, these standards potentially prevent firms from selecting and using the least-cost abatement method

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Analysis: Use MAC Curve

Technology-based standard If prevented from using the least-cost abatement method, firms would operate above their MAC curve Performance-based standard If allowed to select an abatement method to achieve some performance level, -maximizing firms will choose the least-cost method and operate on the MAC curve

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Modeling Cost-Ineffectiveness
$
Technology-based standard

MAC

Performance-based standard

MAC represents least-cost method of abatement Technology-based standards can force some firms to operate above MAC

AX

Abatement (A)

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 Uniform standards waste economic resources as long as abatement costs differ among polluting sources
Cost savings can be obtained if low-cost abaters do more cleaning up than high-cost abaters Lets prove this by building a model of 2 hypothetical firms

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Modeling Uniform Standard

Assumptions
2 polluting sources in some region Each generates 10 units of pollution Government sets emissions limit of 10 units for region or 5 units per firm Uniform standard: each firm must abate 5 units

Cost conditions
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 pollution abated by Polluter 2
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Modeling Uniform Standard

Find the total abatement costs using the uniform standard Solution: The TACs for each firm are TAC1 = 1.25(A1)2 = 1.25(5)2 = $31.25 TAC2 =0.3125(A2)2 = 0.3125(5)2 = $7.81 Sum of TACs = $39.06, which represents the value of resources given up by society to clean up the pollution
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Modeling Uniform Standard

Use MACs to prove that the uniform standard is not cost-effective Solution
With uniform standards, the MACs are not equal MAC1 = 2.5(5) = $12.50 MAC2 = 0.625(5) = $3.125

Shows that Polluter 2 has a cost advantage

The 5th unit of A (i.e., the marginal unit) costs Polluter 2 $9.37 less than it costs Polluter 1

It would be cheaper if Polluter 2 did more of the abating, but it lacks an incentive to do so

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Modeling Uniform Standard

Find the cost-effective abatement, A1 and A2

Solution: uses 3 simple steps

(i) Set MAC1 = MAC2 2.5A1 = 0.625A2

(ii) Set A1 + A2 = Abatement Standard

A1 + A2 = 10

An application of the equimarginal principle of optimality

(iii) Solve equations (i) and (ii) simultaneously 2.5 (10 - A2) = 0.625A2 25 - 2.5A2 = 0.625A2, so A1 =2 A2 =8

Prove that this is cost-effective

MAC1 = 2.5A1 = 2.5(2) = $5.00 MAC2 = 0.625A2 = 0.625(8) = $5.00

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Modeling Uniform Standard

Show that total abatement costs are lower at this abatement allocation than the costs when a uniform standard is used Solution
TAC1 = 1.25(2)2 = $5.00 TAC2 = 0.3125(8)2 = $20.00 TACs (cost-effective) = $25.00 TACs (uniform standard)= $39.06

Cost Savings= ($39.06 - $25.00) = $14.06

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Further Observations
Problem: Public officials will not know where to set firmspecific standards without knowing MAC for every polluter Implies that a cost-effective solution is virtually impossible under CAC framework Result is possible using market approach

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ECONOMIC SOLUTION: MARKET APPROACH

Overview
Market approach refers to incentive-based policy that encourages conservative practices or pollution reduction strategies Difference between market approach and commandand-control approach is how each approach attempts to achieve its objectives Types of Market Instruments Pollution charge Subsidies Deposit/refund systems Pollution permit trading systems

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Pollution Charge
Fee that varies with amount of pollutants released Based on Polluter-Pays Principle Types of pollution charges Effluent/emission fees Product charge User charge Administrative charge

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Product Charge
Fee added to price of pollution-generating product, which generates negative externality

Impose product charge as per unit tax on product, e.g., gas tax
How does the tax on gasoline in the US compare with that of other nations? If the tax equals the marginal external cost (MEC) at QE, it is called a Pigouvian tax

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Modeling a Pigouvian Tax

$

MSC = MPC + MEC MPCt a b MPC Amount of tax

MPB = MSB 0 QE QC Q of gasoline

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Assessing the Model Product Charge

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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Emission (Effluent) Charge

A fee imposed directly on the discharge of pollution
Assigns a price to pollution

Typically implemented through a tax

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Model: Single Polluter Case

Government sets an abatement standard at AST Policy options to polluter are:
Abate up to AST and incur those costs OR Pay a constant per unit tax, t, on any abatement less than AST Total Tax = t(AST - AO)
where AO is actual abatement level

Marginal Tax (MT) = t

Because t is constant, t = MT

Firm will choose the least-cost option: the marginal tax (MT) or the marginal abatement cost (MAC)
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Modeling Emission Charge

Single Polluter

Firm abates up to Ao since MAC < MT; firm pays tax between AO and AST, since MAC > MT in that range

MAC

c t a b

0aAO = cost to abate AO AOabAST = tax on pollution not abated up to AST

MT

AO

AST

Abatement (A)
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Assessing the Model (cons)

Tax authority will not know where MACs are equal Will have to adjust rate until objective achieved Monitoring costs potentially higher Firms might evade tax by illegally disposing pollutants Distributional implications Consumers may pay higher prices due to tax Job losses may result from polluter paying new taxes and/or changing technology to abate
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Pollution Charges in Practice

Internationally, the pollution charge is the most commonly used market-based instrument
Some countries use effluent charges to control the noise pollution generated by aircraft Others levy charges on products such as motor vehicles, pesticides, fertilizers, batteries and gasoline

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Environmental Subsidies
Two major types of subsidies:
Abatement equipment subsidies Pollution reduction subsidies

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Abatement Equipment Subsidy

Defined as 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 (s) equals the marginal external benefit (MEB) at QE, it achieves an efficient equilibrium and is called a Pigouvian subsidy

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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 Austria, 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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Pigouvian Subsidy
Market for Scrubbers
($ millions) MSC K PE = 175 PC = 170 PE s = 161 L MSB MPBS MPB 0 QC = 200 QE = 210 Q of scrubbers

Subsidy = $14 million

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Assessing the Model

It is difficult to measure the MEB May bias polluters decisions about how best to abate

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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(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 Austria, 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 lowemission vehicles

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Deposit/Refund Systems
A deposit/refund system is 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 Targets the potential vs. actual polluter The deposit is intended to capture the MEC of improper waste disposal (IW) in advance Preventive vs. ameliorative
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Modeling Deposit/Refund System

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

MSCIW MPCIW + Deposit MPCIW

Deposit=MEC at Qe

a b

MPBIW = MSBIW
QE 0 100 QIW 100 0
Improper Waste Disposal (%) Proper Waste Disposal (%)

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 US, 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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Pollution Permit Trading Systems

A pollution permit trading system establishes a market for rights to pollute by issuing tradeable pollution credits or allowances Credits are issued for emitting below a standard Allowances indicate how much can be released Two components of the system are 1. Fixed number of permits is issued based on an acceptable level of pollution set by government 2. The permits are marketable Bargaining gives rise to a market for pollution rights
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How Permit Trading Works

There is an incentive to trade as long as polluters face different MAC 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 sell at any P higher than their MAC

High-cost abaters will buy permits rather than abate

They will buy at any P lower 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 equal

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Assessing the Model

Trading establishes the price of a right to pollute without government trying to search for a price No tax revenues are generated Trading system is flexible Note that an emissions standard can be adjusted by changing the number of permits issued

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Pollution Trading Systems in Practice

International examples
Trading of greenhouse gas allowances are part of the Kyoto Protocol, an international accord aimed at global warming Canada has a trading program for ozone-depleters Denmark has one for carbon dioxide emissions

Most of the evolution of trading is occurring in the U.S.

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