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and the economy must take in account the fact that all economic activity happens within a given environment, and therefore is dependent upon it. It's a form of interdependence: the environment sets the conditions in which development and growth will occur, and the economic activity impacts on the environment. The environment provides four different inputs to the economy: The first is as life-support system; no activity can occur in its absence. The second service, that affects 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. And finally, affecting mostly the consumption side, is as a source of amenity. A model that depicts the interactions of these two economics and environment must 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 will constrain the economic activity, and that economics can help with the efficient distribution of the scarce environmental resources, in order to provide the greatest possible utility for everyone within an optimum level of usage and damage to the environment.
Environmental Economics and Policy Question 2 Consider a situation in which a company emits CO2 into the atmosphere. This company is using a public good (clean air) without paying for its usage. It is imposing a cost on every other member of the society, who sees the utility derived out of the clean air decrease. This is a negative externality: unintended costs of production that the producer passes on to society. For every unit of pollution added to the atmosphere, this cost is increased. We can plot a chart (with emissions in X and marginal 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 to society (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:
Marginal Cost MAC MDr MD e Tr T1 a b e*r e* c e1 Emissions d
The area beneath the MD curve represents the total cost society faces because of the polluter company's emissions, and the area beneath the MAC represents 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 unit of 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 and without the Pigouvian tax:
Environmental Economics and Policy Cost to Society No tax T1, production at e1 T1, production at e* b+c+d+e e None Cost to Polluter 0 a+b+c+d a+b
Comparing the “No tax” condition with the hypothetical “T1, production at e1” situation, it's easy to see that the taxes manages to transfer most of the external cost to the polluter, internalising it. However, the tax is giving the company an incentive to move its emissions to e*, internalising all the cost. However, for all its merits the Pigouvian tax is not necessarily efficient, mostly because of information deficiencies: the model assumes the policy maker knows the exact location and format of the MD curve. However, it's not always possible to know precisely the damage of pollution on the environment, so it won't be possible to determine 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 the tax at level T1, for an e* optimal level of pollution, but that the real damage curve is MDr. The tax should have been set at level Tr. Setting it at T1 keeps a part of the damage externalized, imposing a cost on society (the area beneath MD r and above MD1). Despite not being necessarily efficient, a Pigouvian tax in cost-effective because it respects the equi-marginal principle, which states that the marginal abatement costs across sources must be equal. Let's consider two companies emitting CO2, one which faces a Low Abatement Cost (LMAC) and one that faces a High Abatement Cost (HMAC) : Marginal cost HMAC MD LMAC T1
Environmental Economics and Policy After the introduction of the tax, both companies moved along their respective MAC curves to meet the tax target and reduce the amount of tax paid. This means that both companies brought their marginal abatement costs to the same level (HMAC=LMAC=T1) Having a lower MAC, LMAC reduced its emissions by more than HMAC, achieving the objective of bringing the emissions to a certain level (T1) with the least possible cost – if HMAC were to reduce its emissions to level B, it would face a much higher total cost than LMAC did.
Question 3 Coase's basic idea assumes that when a party is affected by another's activity, it can bargain with that second party for it to reduce its activity and, therefore, its impact. This idea rests on four assumptions: 1. All the private property rights are defined, recognised and enforceable 2. Both parties aim to maximize their personal utility and profit 3. Both parties have perfect information regarding the situation 4. Transaction costs are zero Consider a pig farmer, discharging the resulting waste in a nearby river, which he owns. This river is the focus of the activity of a company organising wildlife observation tours. Due to the increasing amount of waste on the river, many amphibians and birds, previously the focus of these tours, have moved away, endangering the activity of the company. So, the company will attempt bargaining with the pig producer for a reduction in the number of pigs raised and, therefore, of the pollution discharged in the river. The following chart provides information on the costs to the company and the benefit to the pig producer, relative to the number of pigs:
Number of Pigs Benefit (producer) Cost (Wildlife Tours) 1 30 3 2 51 9 3 68 15 4 81 23 5 90 33 6 95 45 7 96 59 8 93 75 9 86 95 10 75 119
From this information, we can calculate the marginal benefit (benefit of producing one more pig) and the marginal cost (cost of one more pig). We can also calculate the Net Social Benefit, a measure of how well-off this society is with one more pig, given by the difference between the benefit and the cost: 4
Environmental Economics and Policy
Number of Pigs 1 2 3 4 5 6 7 8 9 10 Marginal Benefit 22 18 14 10 6 2 -2 -6 -10 Marginal Cost Net Social Benefit 27 6 43 7 55 8 61 10 61 12 55 14 43 17 25 20 -1 24 -35
If the assumptions of the Coase theorem hold true, the company will be willing to bargain with the pig producer for a reduction in the number of pigs up to the level where the marginal cost equals the marginal benefit, paying for the producer to reduce his number of pigs, and the producer will be willing to accept the payment up to the point where his marginal benefit equals his marginal cost – reducing production to 5 pigs. Note that this is the outcome that produces the most net social benefit, as we would expect.
Question 4 A cost-effective mechanism leads to an equalization of the Marginal Abatement Cost along all the companies in the market. Consider two companies, one with High Marginal Abatement Costs (HMAC) and one with Low Marginal Abatement Costs, with the same initial amount of emissions. The government wants to limit the emissions to 800 tons of the pollutant, and for that effect sets up a tradable permits market. Each of the companies gets the same number of permits (400). LMAC, sees the relation between its emissions and its MAC described by the formula LMAC=-2E1+2200. HMAC, sees the relation between its emissions and its MAC described by the formula HMAC=-3E2+3300. The following table provides illustration of possible levels of MAC for both companies, depending on their emissions levels: Emissions (tons) 1100 1000 900 LMAC (€) 0 200 400 HMAC (€) 0 300 600 5
Environmental Economics and Policy 800 700 600 500 400 300 200 100 0 600 800 1000 1200 1400 1600 1800 2000 2200 900 1200 1500 1800 2100 2400 2700 3000 3300
After the introduction of the permits market, both will reduce their level of emissions, according to their different MAC, either selling permits when their MAC is lower than the price of permits in the market or buying permits when the cost is lower than their MAC. So, an equilibrium price for the permits in the market will eventually be reached, equal to both companies' MAC, with differing emissions for each. To calculate this price we use two conditions: E1+E2=800 and LMAC=HMAC Through algebraic substitution, we reach values of E1=260 tons and E2=540 tons. Substituting these values in the respective MAC equations, we reach an equilibrium price of 1680€ per permit. The fact that, at this price, both companies' MAC is equal confirms the equi-marginal principle, showing that this instrument is cost-effective.
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