ppa 723: managerial economics lecture 19: externalities and public policy the maxwell school,...

PPA 723: Managerial Economics

Lecture 19:

Externalities and Public Policy

The Maxwell School, Syracuse UniversityProfessor John Yinger

Managerial Economics, Lecture 19: Externalities & Policy

Outline

Alternative Policies to Address Externalities

Fees vs. Standards

Pollution Markets


Reducing Externalities

Competitive markets produce excessive negative externalities, as indicated by deadweight loss.

Hence government intervention may benefit society.


Alternative PoliciesCharge approach: effluent fee (a charge per

unit of pollution) or a tax on products of polluting firms.

Regulatory approach: emissions standard (quantity restrictions on outputs or inputs)

Because output and pollution move together, either approach works in principle.


$

Pollution Reduction

100%

MC

MB

OptimalStandard

0%

OptimalFee

Fees and Standards


Optimal Regulation

Unfortunately, the government often does not know enough to regulate optimally.

The government needs to know:The marginal benefits from pollution

reduction.The marginal costs of pollution reduction.


Enforcement Even if government knows enough to set optimal

regulation, it must enforce regulation to achieve social optimum

U.S. Environmental Protection Agency (EPA) smog standards violated in 33 metro areas including Baltimore, Boston, Chicago, Houston, LA,

Milwaukee, New York, and Philadelphiahttp://www.epa.gov/enviro/zipcode.html http://www.scorecard.orghttp://www.formyworld.com

http://www.epa.gov/enviro/zipcode.html

http://www.scorecard.org/

http://www.formyworld.com/


Emission Standards for Ozone

Ozone is a major air pollutant.

It is formed in the atmosphere through a

chemical reaction between organic gases and nitrogen oxides in sunlight


Standards for Ozone

The Clean Air Act of 1990 sets national air-quality standards for major pollutants: 0.12 parts per million (ppm).

California Air Resources Board (CARB) has an even tighter standard: 0.09 ppm.


Costs and Benefits Cost of reducing ozone are greater

expenses ofmanufacturing driving

The benefits arebetter health in urban areasincreased agricultural yields in rural areas

Consequently, optimal level differs in urban and rural areas.


Estimated Benefits and Costs

Kim, Helfand, and Howitt (1998) estimate that meeting the CA’s 0.09 ppm standardhealth benefits range from $2.58 million to $51.58

millionconsumer surplus ranges from $229 million to $270

millionproducer surplus ranges from $297 million to $348

million

Welfare is maximized at slightly below 0.14 ppm (conservative estimates)


Emissions Standards for Ozone

0.12 0.11 0.10 0.090.16 0.15 0.14 0.13Ozone concentration, ppm

Marginal benefit,Marginal cost, $ millions

400

300

200

100

MC

MB

0.12 0.11 0.10 0.090.16 0.15 0.14 0.13Ozone concentration, ppm

State standardFederal standardOptimalCost

Benefit

Benefit, Cost, $ millions(a) Cost and Benefit

1,000

800

600

400

200

(b) Marginal Cost and Marginal Benefit


Fees vs. Standards Although fees and standards can, in

principle, both achieve the optimal pollution level, they are very different in practice in the following ways:Costs imposed on firms.Ability to account for variation in pollution

reduction costs across firms. Cost of errors under conditions of uncertainty.


Costs for FirmsFees, but not standards, produce tax

revenues.

When a standard is used rather than a fee, firms are better off, and the government is worse off, by the amount of the fees.

In either case, firms must pay for clean-up.


Government Revenues

$

Pollution Reduction

100%

MC

MB

OptimalStandard

0%

OptimalFee

Government Revenue

Clean-upCosts


Variation in Firms’ Costs

Standards (not fees) require the same actions of all firms—limit pollution to a certain level, install certain equipment, etc.

But firms’ pollution-reduction costs may differ.

As a result, standards may not reduce pollution in the least costly way.


$

Pollution Reduction

100%

MC = MC1 + MC2

MB

Optimal = R1+R20%

MC2

MB*

R1 R2

MC1

Variation in Firms’ Costs


$

Pollution Reduction

100%

MC = MC1 + MC2

MB

R* = R1+R20%

MC2

MB*

R1 R2R* 2

Lossfrom Standard

Inefficient Pollution Reduction


Uncertainty

If the government has imperfect information about the cost of pollution reduction,

Then the optimal policy depends on the shapes of MB and MC curves for abating pollution.


Uncertainty about Costs


Interpretation of Figure

The preceding figure shows the deadweight loss from an improperly set fee or standard.

If the true MC curve is MC1, the optimal standard is S1 and the optimal fee is f1

Setting f too low causes DWL=Setting S too high causes DWL =So the fee look better.

1fDWL1SDWL


Figure (cont.)

Similarly, it’s better to use the fee if the true MC is MC2.

However, if the MB curve is very steep, which implies that there is a threshold of pollution reduction that yields huge benefits, we might conclude that the standard was better. If reducing pollution below a certain level would save

many lives, it makes no sense to use a fee that might not be high enough to reduce pollution this much.


Uncertainty about Benefits


The preceding figures shows the deadweight loss from an improperly set fee or standard.

If the true MB curve is MB1, the optimal standard is S1 and the optimal fee is f1, so setting f or S (too high) causes DWL= DWL1

If MB2 is the true MB, setting f or S (too low) causes DWL= DWL2.

Thus, DWL from a mistaken belief about MB does not depend on whether the government uses a fee or a standard.

Interpretation of Figure


Pollution Markets

Many economists argue in favor of using markets to reduce pollution.

With this approach, the government must first assign property rights (i.e. the rights to pollute) and let them be traded.

This approach combines aspects of standards (control total, no revenue to government) and fees (most efficient pollution reduction).


U.S. Clean Air Act of 1990 This act created a market for sulfur dioxide (SO2)

pollution generated by power plants.

The law set an emissions cap of 8.7 million tons for 1995, when it would take effect.

Actual production in 1995, however, fell nearly 50% to just 5.3 million tons, and at a cost between ½ and 1/3 of traditional standard approach as firms used smokestack scrubbers (which remove sulfur from exhaust gases) and low-sulfur coal to cut pollution.


Permits

EPA issues permits, each of which allows a firm to produce 1 ton of emissions of sulfur dioxide annually, equal to the aggregate emissions cap.

Electric utilities that operate the 445 largest and dirtiest coal-fired power plants in the United States received permits in proportion to the amount of fuel they used in a historical period.


Effects U.S. SO2 emissions from power plants in 2001 were 1/3

that in 1990.

Schmalensee et al. (1998) estimated that, in mid-1990s, the pollution reduction under the market program cost about a ¼ to 1/3 less than if permits had not been tradable, with a savings of $225 to $375 million per year.

Environmental groups encourage citizens to buy up and retire pollution permits: cleanairconservancy.org/Markets/le.sulfur.html

For $10, you can buy the rights to about 200 pounds of SO2.


Brokers

Brokers trade 30 types of air pollution, including from SO2, nitrogen oxides (NOx), and carbon dioxide (CO2).

Cantor Fitzgerald Environmental Brokerage Service, www.emissionstrading.com/index_mpi.htm, lists prices at which permit trade.

In 2002, the SO2 market was $4 billion a year and growing.


Other Pollution Markets A southern Californian smog market started in

1994.

The South Coast Air Quality Management District (AQMD) regulates emissions in four southern California counties It allocates credits for nitrogen oxides or sulfur oxides,

two key pollutants, to firms

AQMD believes that allowing trading cuts the cost of complying with clean air regulations by $58 million, 42% of the total.

ppa 723: managerial economics lecture 19: externalities and public policy the maxwell school,...

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