CH 5

CHAPTER FIVE
5. ECONOMICS OF POLLUTION CONTROL AND

ENVIRONMENTAL POLICY
5.1.Pollutant Taxonomy
Pollutants are the residuals of production and
consumption. Based on the absorptive capacity
of the environment, pollutants can be classified
as Stock pollutant and Fund pollutant. If the
waste disposal (emission) load exceeds the
absorptive capacity of the environment, then
the pollutant accumulates in the environment.
04/21/2024 Lati M., Dadu, Department of Economics 1
a)Stock pollutants: Pollutants for which the
environment has little or no absorptive
capacity. Examples; on bio degradable bottles,
heavy metals such as lead, and synthetic
chemicals.
b)Fund pollutants: Pollutants for which the
environment has some absorptive capacity.
Example are organic substances, etc.
• Pollutants can also be classified by their
zone of influence (horizontal and vertical
aspects).
04/21/2024 Lati M., Dadu, Department of economics 2
a)Horizontal dimension refers to the local
and regional aspects of pollution. The
damage caused by local pollutants is
experienced near the source of emission,
while the damage from regional pollutants is
experienced at greater distances from the
source of emission. The local and regional
categories are not mutually exclusive; it is
possible for a pollutant to be both. Sulfur
oxides and nitrogen oxides are both local and
regional pollutants.
b)Vertical dimension zone of influence
describes whether the damage is caused
mainly by ground-level concentrations of an
air pollutant or by concentrations in the upper
atmosphere.There are surface pollutant and
global pollutant (the concentration is in the
upper atmosphere). Water pollutants are
obviously surface pollutants, but air
pollutants can be surface pollutants, global
pollutants, or both. Carbon dioxide (Co2) is a
global pollutant which raises the world
5.1.1.The Efficient Allocation of Pollution
The presence pollution in the environment may
depreciate the service flows received; an efficient
allocation of resources must take this cost into
account. What is meant by the efficient allocation of
pollution depends on the nature of the pollutant?
The Case of Stock Pollutants
Suppose that the production of commodity X
involves the generation of stock pollutant. The
amount of this pollution can be reduced, but that
takes resources away from the production of X.
04/21/2024 Lati M. Dadu, Department of economics 5
The damage caused by the presence of this pollutant in
the environment is assumed to be proportional to the size
of the accumulated stock. The efficient allocation is the
one which maximizes the present value (PV) of the net
benefit. In this case the net benefit at any point in time t
is equal to the benefit received from the consumption of
X minus the cost of the damage caused by the presence
of the stock pollutant in the environment. The
accumulation of the stock pollutant is proportional to the
production of X, i.e., it increases continuously as the
extraction cost of minerals. When extraction cost rises,
the efficient quantity of a depletable resource extracted
and consumed declines over time.
 Exactly the same pattern would emerge for a
commodity which is produced jointly with a stock
pollutant. The efficient quantity of X (and the
addition to the accumulation of this pollutant to the
environment) would decline over time as the marginal
cost (MC) of the damage rises. The price of X would
rise over time, reflecting the rising social cost of
production. To cope with the increasing marginal
damage the amount of resources committed to
controlling
04/21/2024 the pollutant would
Lati M., Dadu, Department increase over time. 7
of economics
The Case of Fund Pollutants
When the emission rate of fund pollutants is
less or equal to the assimilative capacity of the
environment, the link between present
emissions and future damage may be broken.
When this happens, current emissions cause
current damage and future emissions causes
future damage, but the level of future damage
is independent of current emissions. This
independency allows us to use static
efficiency analysis rather than dynamic
analysis.
Fig5.1: efficient allocation of a fund pollutant.
Marginal Control Marginal Damage
MC Cost (MCC) Cost (MDC)
Total Total
Damage cost control cost
Quantity of pollution
0 Q* emitted (units)
Form the above graph:
A movement from right to left refers to greater
control and less pollution emitted.
Marginal control costs (MCC) commonly
increase with the amount of controlled.
The efficient allocation is represented by Q*,
where MCC = MDC (the damage caused by the
marginal unit of pollution is exactly equal to the
marginal cost of avoiding it).
Since the benefit is damage reduction: marginal
benefit from control of pollution, MB = MC
(marginal cost of controlling pollution), implies
maximizing net benefits.
Greater degrees of control (points to the left of
Q*) are inefficient because the increment in
MCC is higher than the reduction in MDC.
Hence total costs would rise. Similarly, levels
of control lower than Q* would result in a
lower cost of control but the increase in MDC
is even larger, yielding an increase in total cost.
Hence Q* must be efficient. The diagram
suggests that, the optimal level of pollution is
not zero. For instance, take the damage caused
by automobile accidents.
Yet we do not reduce that damage to zero because the
cost of doing so would be too high. To have a zero
accident what we would have to do is eliminating
automobiles.
nm
5.2.Environmental Policy Instruments
Do you know any policy that Ethiopia has formulated
to protect the natural resources and the
environment?
As we discussed earlier efficiency is achieved when
the marginal cost of control (MCC)= Marginal
damage cost (MDC) caused by the pollution of each
However, while the efficient levels of policy
instruments (by setting Q*) can be easily defined in
principle, they are very difficult to implement in
practice. To implement, we must know the level of
pollution at which the two marginal cost curves cross
for every emitter. That is a tall order, one that imposes
an unrealistically high information burden on control
authorities.
Consider also there are two emission sources currently
emitting a total 30 units of emissions. Assume further
that the control authority determine 15 units of
pollution can be assimilated by the environment.
However, it is criticized due to different reasons:
The price of the product may be affected by
agreement among producers not only because
of scarcity;
There may be government intervention in the
factor market which affects price of a product
The price of natural resources does not include
social opportunity cost because producers are
not obliged to pay the environmental damage
they create during extraction and processing.

It is argued that oil price should be
low because producers are not obliged
to pay all the external costs of oil
devilling and refining.
So that; a reduction of 15 units is
necessary. How could these 15 units be
allocated between the two sources in
order to minimize the total cost of the
reduction?
MC MC2 Marginal cost of control MC1 Marginal cost of control
for source 2 for source 1
A
B Quantity of emission reduced
Source 1 0 10 15
15 5 0 Source 2
Fig 5.2:Cost-effective allocation of a uniformly mixed pollutant
In the cost-effective allocation, the first source cleans
up 10 units, while the second cleans up 5 units. The
TC (total cost) of control = A+B. Any other
allocation would result in a higher total control cost.
Hence according to the propositions of the economics
of pollution control, the cost for a given reduction of
pollution is minimized if and only if the MC1 = MC2
(point T in the figure).
The Policy Instruments to Reduce Pollution
1)Emission standards (Command-and-Control):An
emission standard is a legal limit on the amount of
the pollutant an individual source is allowed to emit.
In our example (above) the total allowable emission
is 15 units but due to lack of information it is very
difficult to divide these 15 units to each emitter. So,
in the absence of information the easiest method is to
allocate each source an equal reduction. But this
strategy would not be cost effective. While the first
source would have lower costs and the second would
have higher costs-and the TC would be higher than
the efficient level. Emission standards are supported
by enforcement or high punishment to those violates
the standard (the controlled quantity).

2)Emission Charges: An emission charge is a
fee, collected by the government, levied on
each unit of pollutant emitted into the air or
water. Thus, to save money, the source seeks
ways to reduce its pollution. A profit
maximizing firm would control, rather than
emit, pollution whenever it proved cheaper
to do so. Consider the following figure: Cost-
minimizing control of pollution with an
emission charge.

Cost MC1= Marginal cost of control
T1
T A B
O units of emission
D C controlled

If the firm decides to control nothing, it will have
to pay T times 15 (total emit), represented by area
OTBC in the form of tax. Since the firm can
control some pollution at a lower cost than paying
the emission charge, it would pay the firm to
reduce emissions until the MC of reduction is
equal to the emission charge. The firm would
minimize its cost by choosing to clean up 10 units
of pollution and emitting 5 units. At this allocation
the firm would pay control costs equal to area
OAD and total emission charge equal to area
ABCD for a total cost of OABC.
This is clearly less than OTBC, if the firm would
not clean up any pollution. Thus, if T increases to
T1, the polluter tries to control much.
3)Transferable (tradable) emission permits: Under
this system, all sources are required to have
permits to emit. Each permit specifies exactly how
much the firm is allowed to emit. The permits are
freely transferable through trade. The control
authority issues exactly the number of permits
needed to produce the desired emission level. This
system automatically leads to a cost-effective
allocation or emission control.

Fig 5.3:Transferable (tradable) emission permits
MC MC2
MC1
Sources
One 0 8 10 15 source two
15 7 5 0

Suppose that the first source or firm found itself
with 7 permits, this would mean it must control, 8
units (out of the total 15 uncontrolled emissions).
Similarly, suppose that the second source or firm
has the remaining 8 permits, it would have to
clean up 7 units. Notice that both firms have an
incentive to trade. The MC2 (i.e., C on the vertical
axis) is substantially higher than that for the first
MC1 (i.e., A). The second source could lower its
cost if it could buy a permit from the first source
at a price lower than C.

The first source would be better off if it could sell a
permit for a price higher than A. Since C is greater than
A, grounds for trade certainly exist. A transfer of
permits would take place until the first source had only
5 permits left (and is controlling 10 units). While the
second source had 10 permits (and was controlling 5
units). The permit price would be B; at this point the
permit market would be in equilibrium. This point is
the cost-effective allocation.

Simply by issuing the appropriate number of
permits (15) and letting the market do the rest;
the control authority can achieve a cost-effective
allocation without having even the slightest
knowledge about control costs.
4)Liability Rules: Liability rules are set in such a
way that there is an incentive for a producer to
follow some prescribed mandate, technological
restriction or acceptable behavior. Liability rules
can be set so that the producer pays a bond in
advance and is reimbursed if there is no harm
committed or pays a noncompliance fee after the
harm has occurred.
Liability rules attempt to reduce the level of
shirking on environmental pollution control by
raising the costs of misbehavior. Types of liability
rule are the following:
A)Non-compliance fee: A producer is fined if his
actions lead to a level of pollution that exceeds
some set standard. But given the moral hazard
problems associated with many types of pollution,
identifying the exact culprit (guilty party) may not
be that straightforward since ambient concentrations
cannot be perfectly assigned to the responsible
producer.
 This system has an incentive mechanism to induce
polluters to supply the target level of pollution control.
 B) Deposit refund systems: Under these systems
purchasers of potentially polluting products pay a
surcharge, which is refunded to them when they return
the product or its container to an approved center for
recycling or proper disposal. This instrument rewards
good environmental behavior. It has been in place
worldwide to control the disposal of beverage
containers, batteries (to prevent the release of toxic
substances into the environment) pesticide containers,
plastics, etc. The systems provide economic benefits for
good environmental behavior and impose costs for bad
behavior (those who would not return the materials).
C)Performance bonds; With a performance
bond, a producer posts a bond before
operations begin, or feting the bond if his
activities cause environmental harm or if he
pollutes in excess of acceptable levels. The
bond increases the costs of shirking, thereby
reducing the incentive for malfeasance. It is
common especially in surface mining. The
administrative efficiency of non-compliance
fees is low because of the high proportion of
cases that must be settled in court.
5.3.Trans-Boundary Environmental Problems
Many of the best-known examples of pollution
involve the actions of more than one country.
Obvious examples include acid rain, (greenhouse
effect), global warming, ozone layer depletion,
biodiversity, international waters, etc.
Transnational pollution can take any of several
forms. In the simplest case, the polluting emissions
of one nation can flow across its borders and
damage its neighbors.

This is the case of unidirectional transnational
pollution, such as the emission of various wastes
into a river that pollute the downstream waters
flowing into a neighboring country. Global
environmental problems possess the characteristic
of being reciprocal externalities. Each country’s
action has a spillover effect on the other’s country
utility. The existence of reciprocal externalities
implies that expenditures by one country on
pollution abatement will give benefits not only to
the country doing that abatement but to others as
well similarly; if a country chooses to spend
nothing on pollution control, it can obtain benefits
Trans-boundary pollution is best characterized as
a problem of international externalities, which
arises from a lack of property rights in the global
commons (environmental assets). These commons
include the atmosphere, oceans, global
biodiversity reserves and important terrestrial
ecosystems, such as tropical rainforests. A crucial
distinction between national and international
externality problems is that, for the former a
government exists which can internalize these
externalities by various policies (like pollution
taxes).
This is not the case with the global commons.
No super national government exists which has
complete authority to internalize externalities.
So, to internalize international externalities,
voluntary international agreements are
necessary to safeguard the global commons.
However, an obvious difficulty with any such
agreements and conventions is the free-rider
problem.

Forms of international co-operations
Countries are becoming much aware about the
damages due to environmental problems and to
mitigate these problems they have signed different
agreements. Some forms of the international co-
operations are the following.
1)The Global Environment Facility (GEF) was
established in 1991 by the World Bank, the UNEP to
provide help for developing countries to deal with
climate change, threats to biodiversity and water
pollution.

2)The So-called Earth summit in Rio de Janeiro,
Brazil in 1992. In this convention industrialized
countries agreed to stabilize carbon emissions from
power stations, industry and traffic at 1990 levels by
the year depletion.
3)The Montreal Protocol to cut CFC by 50% by the
year 2000, to protect the ozone depletion. Other
examples of international conventions (agreements)
with a focus on trade include the following:
4)CITES (convention an international trade in
endangered species). Date signed 1973. The objectives
are protection of species of plants and animals from
over exploitation & extinction. It is to control the
trade in species threatened with extinction.
5)African convention on the conservation of
natural and natural resource (1968).
6)ITTA (international tropical timber
agreement (1983)-for sustainable use of
tropical rainforests.

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CH 5

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CHAPTER FIVE

5. ECONOMICS OF POLLUTION CONTROL AND

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