Question 7: What microeconomic concepts can address some of the issue?

Explain using
concepts of cost benefit analysis, taxation, and permits.

Answer: In devising policies to internalize environmental externalities, a Pigovian tax is just

one type of environmental policy. Decision-makers generally have other policy options, and
which one is appropriate depends on the particular context. The four basic environmental
policy options are:

1. Pollution standards
2. Technology-based regulation
3. Pigovian (or pollution) taxes
4. Tradable pollution permits

Pollution taxes, along with tradable pollution permits, are considered market-based
approaches to pollution regulation because they send information to polluters about the
costs of pollution without mandating that firms take specific actions. Market-based
approaches: economic regulations that create market incentives for behavioral change
among participants (buyers and sellers), including taxes and tradable permits.

Cost Benefit Analysis

In a basic economic analysis of markets, supply and demand curves represent costs and
benefits. A supply curve tells us the private marginal costs of production—in other words,
the costs of producing one more unit of a good or service. Meanwhile, a demand curve can
be considered a private marginal benefits curve because it tells us the perceived benefits
consumers obtain from consuming one additional unit. The intersection of demand and
supply curves gives the market equilibrium.

Taxation

A pollution tax reflects the principle of internalizing externalities. If producers must bear the
costs associated with pollution by paying a tax, they will find it in their interests to reduce
pollution so long as the marginal costs of reducing pollution are less than the tax.

All firms in the industry will determine how much to reduce their pollution based on their
own MCR curve. Assuming that each firm is acting in a cost-effective manner, the total cost
of pollution reduction is minimized. Those firms that can reduce pollution at low costs will
reduce pollution more than firms that face higher costs. This is the main advantage of
market-based approaches to pollution regulation—they achieve a given level of pollution
reduction at the lowest overall cost. In other words, they are economically efficient
compared to pollution standards or technology-based approaches.

One disadvantage of pollution taxes, however, is that it is very difficult to predict the total
amount of pollution reduction a given tax will produce. It depends on the shape of each
firm’s MCR curve, which is usually not known to policymakers.
Tradable Pollution Permits

Tradable pollution permits: tradable permits that allow a firm to emit a certain quantity of a
pollutant.

An alternative is to set up a system of tradable pollution permits. The total number of

permits issued equals the desired target level of pollution. These permits can then be
allocated freely to existing firms or sold at auction. Once allocated, they are fully tradable,
or transferable, among firms or other interested parties. Firms can choose for themselves
whether to reduce pollution or to purchase permits for the pollution they emit—but the
total volume of pollution emitted by all firms cannot exceed a maximum amount equal to
the total number of permits.

Those firms with higher MCR curves will generally seek to purchase permits so they don’t
have to pay high pollution reduction costs. Firms that can reduce pollution at lower cost
may be willing to sell permits, as long as they can receive more money for the permits than
it would cost them to reduce pollution. With this system private groups interested in
reducing pollution could purchase permits and permanently retire them, thus reducing total
emissions below the original target level. Pollution permits are normally valid only for a
specific time period. After this period expires the government can choose to issue fewer
permits, resulting in lower overall pollution levels in the future.

Virtually all economists agree that carbon emissions, as a negative externality, should be
internalized through market mechanisms such as a Pigovian tax or a tradable permit system.