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Enconomics of Environmental Policy - Assignment A

Enconomics of Environmental Policy - Assignment A

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Published by Carlos Ferreira

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Published by: Carlos Ferreira on Feb 18, 2009
Copyright:Attribution Non-commercial

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06/16/2009

 
Environmental Economics and Policy Question 1
Any model that deals with the interaction between the environment and theeconomy must take in account the fact that all economic activity happens within agiven environment, and therefore is dependent upon it. It's a form ointerdependence: the environment sets the conditions in which development andgrowth will occur, and the economic activity impacts on the environment.The environment provides four different inputs to the economy: The first is aslife-support system; no activity can occur in its absence. The second service, thataffects mostly the production side, is as a source of energy and materials. The third,affecting both the production and the consumption side, is as a waste sink. Andfinally, affecting mostly the consumption side, is as a source of amenity.A model that depicts the interactions of these two economics and environmentmust correctly assess the mutual feedback loops and the impact of one in the other.A good model of this interaction will not fail to show that the environment willconstrain the economic activity, and that economics can help with the efficientdistribution of the scarce environmental resources, in order to provide the greatestpossible utility for everyone within an optimum level of usage and damage to theenvironment.
1
 
Environmental Economics and Policy Question 2 
Consider a situation in which a company emits CO
2
into the atmosphere. Thiscompany is using a public good (clean air) without paying for its usage. It is imposinga cost on every other member of the society, who sees the utility derived out of theclean air decrease. This is a negative externality: unintended costs of production thatthe producer passes on to society. For every unit of pollution added to theatmosphere, this cost is increased. We can plot a chart (with emissions in X andmarginal cost in Y) with the cost per unit of CO
2
emitted as the Marginal Damage(MD) curve.If the polluter company reduced its emissions in order to abate this cost tosociety (by reducing its output), it would incur a cost for every unit of output reduced.We can also plot this information in the same chart, as the Marginal Abatement Cost(MAC) curve:e*
e*e
1
The area beneath the MD curve represents the total cost society facesbecause of the polluter company's emissions, and the area beneath the MACrepresents the total costs the company will face from reducing its emissions.A Pigouvian tax is an instrument whereby a polluter will pay a tax for each unitof pollution emitted. It's set at the level where MAC equals MD – the optimal level of pollution (e*). The company will have the incentive to reduce its output from e
1
to e*.A tax is a monetary instrument, so it is set at “marginal cost” axis.Let's make a cost analysis for the society and for the company, with andwithout the Pigouvian tax:
2MACEmissionsMarginalCostT
1
a bcdaeMDMD
T
 
Environmental Economics and Policy 
Cost to SocietyCost to PolluteNo tax
b+c+d+e0
T
1
, production at e
1
ea+b+c+d
T
1
, production at e*
Nonea+bComparing the “No tax” condition with the hypothetical “T
1
, production at e
1
situation, it's easy to see that the taxes manages to transfer most of the external costto the polluter, internalising it. However, the tax is giving the company an incentive tomove its emissions to e*, internalising all the cost.However, for all its merits the Pigouvian tax is not necessarily efficient, mostlybecause of information deficiencies: the model assumes the policy maker knows theexact location and format of the MD curve. However, it's not always possible to knowprecisely the damage of pollution on the environment, so it won't be possible todetermine the optimal level of pollution and, therefore, the tax may be set to high or too low. This situation is shown in our chart considering that the government set thetax at level T
1
, for an e* optimal level of pollution, but that the real damage curve isMD
. The tax should have been set at level T
. Setting it at T
1
keeps a part of thedamage externalized, imposing a cost on society (the area beneath MD
and aboveMD
1
).Despite not being necessarily efficient, a Pigouvian tax in cost-effectivebecause it respects the equi-marginal principle, which states that the marginalabatement costs across sources must be equal. Let's consider two companiesemitting CO
2
, one which faces a Low Abatement Cost (LMAC) and one that faces aHigh Abatement Cost (HMAC) :BAe
1
3HMACEmissionsMarginalcostT
1
MDLMAC

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