Lect 4a

ECONOMIC SOLUTIONS TO
ENVIRONMENTAL PROBLEMS
THE MARKET APPROACH
 Chapter 5
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Overview
 Market approach refers to incentive-based policy that
encourages conservative practices or pollution reduction
strategies
 Difference between market approach and command-and-control
approach is how each approach attempts to achieve its
objectives
 Types of Market Instruments
 Pollution charge
 Subsidies
 Deposit/refund systems
 Pollution permit trading systems
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2
Pollution Charges
Pollution Charge
 Fee that varies with amount of pollutants
released
 Based on “Polluter-Pays Principle”
 Types of pollution charges
 Effluent/emission fees
 Product charge
 User charge
 Administrative charge
Product Charge
 Fee added to price of pollution-generating product,
which generates negative externality
 Impose product charge as per unit tax on
product, e.g., gas tax
 How does the tax on gasoline in the US compare with
that of other nations?
 If the tax equals the marginal external cost (MEC) at Q E,
it is called a Pigouvian tax
Selected International Gasoline Tax Rates
Nation Tax Rate % of Price
(2011)
United States 13.2

U.K. 61.6
France 58.1
Germany 60.5
Japan 45.8
Spain 50.1
Source: International Energy Agency, January 2011

Modeling a Pigouvian Tax
$
MSC = MPC + MEC
MPCt
MPC
a
Amount of tax
b
MPB = MSB
0 QE QC Q of gasoline7
Assessing the Model
 In theory, achieves an efficient outcome

 In practice, difficult to identify the value of
MEC at QE
 Allows only for an output reduction to reduce
pollution
Emission (Effluent) Charge
 A fee imposed directly on the discharge of

pollution
 Assigns a price to pollution
 Typically implemented through a tax
Model: Single Polluter Case
 Government sets an abatement standard at AST
 Policy options to polluter are:
 Abate up to AST and incur those costs OR
 Pay a constant per unit tax, t, on any abatement less than
AST
 Total Tax = t(AST - AO)
 where AO is actual abatement level
 Marginal Tax (MT) = t
 Because t is constant, t = MT
 Firm will choose the least-cost option: the marginal
tax (MT) or the marginal abatement cost (MAC)
Modeling Emission Charge
Single Polluter
$ Firm abates up to Ao since

MAC < MT; firm pays tax
MAC
between AO and AST, since
MAC > MT in that range
0aAO = cost to abate AO
c AOabAST = tax on pollution
not abated up to AST
a b MT
t
0 AO AST Abatement (A)

Model: Multiple Polluter Case
 To facilitate comparison, we use the same model

as in the uniform standard case
 Assumptions
 2 polluting sources in some region
 Each generates 10 units of pollution
 Government sets emissions limit for region as 10
units, which implies AST = 10
 Policy: To achieve AST, government imposes an
emission charge as a unit tax (t) of $5
Model: Multiple Polluter Case
 Each firm responds as in the single polluter case
 Abates as long as MAC < MT
 Pays emission charge when MAC > MT
 Polluter 1: TAC1 = 1.25(A1)2

MAC1 = 2.5(A1)
 where A1 is pollution abated by Polluter 1
 Polluter 2: TAC2 = 0.3125(A2)2
MAC2 = 0.625(A2)
 where A2 is pollution abated by Polluter 2
 Find each firm’s abatement level. Then, find each firm’s
total abatement costs (TAC) and tax payment at that
level. Support with a graph.
Solution
 Polluter 1:
 Abates up to the point where MAC1 = MT,
 Set 2.5(A1) = $5, or A1 = 2
 Incurs TAC1 = 1.25(2)2 = $5
 Incurs Total Tax = 5(10 - 2) = $40
 Polluter 2:
 Abates up to point where MAC2 = MT
 Set 0.625(A2) = $5, or A2 = 8
 Incurs TAC2 = 0.3125(8)2 = $20
 Incurs Total Tax = 5(10 - 8) = $10
Modeling An Emission Charge
Multiple Polluter
MAC1 MAC2
Total Abatement Level = 10 = AST
25.00
TAC1 + TAC2 = $25 (right triangles)
Total Tax Payments = $50 (rectangles)
C1
MA
6.25
MT = 5.00 MT = 5.00
MAC
2
0 2 10
Polluter 1’s Abatement
10 8 Polluter 2’s Abatement 0

Assessing the Model (pros)
 Abatement standard is met
 Generates $40 in tax revenues from high-cost
abater and $10 from low-cost abater
 Low-cost abaters do most of cleaning up
 Cost-effective solution is obtained
 MACs are equal at $5 tax rate
 Combined TAC of $25 is lower than $39.06 under
command-and-control with a uniform standard
Assessing the Model (cons)
 Tax authority will not know where MACs are equal
 Will have to adjust rate until objective achieved
 Monitoring costs potentially higher

 Firms might evade tax by illegally disposing
pollutants
 Distributional implications
 Consumers may pay higher prices due to tax
 Job losses may result from polluter paying new taxes
and/or changing technology to abate
Pollution Charges in Practice
 Internationally, the pollution charge is the most
commonly used market-based instrument
 Australia, France, Germany, and Japan use fees or
taxes to control noise pollution generated by aircraft
 Canada, France, Mexico, and Poland are among the
nations using effluent charges to protect water
resources.
 Others levy charges on products such as batteries, tires,
lubricant oil, packaging, paint, paint containers, and
gasoline
Environmental Subsidies
Environmental Subsidies
 Two major types of subsidies:

 Abatement equipment subsidies
 Pollution reduction subsidies
Abatement Equipment Subsidy
 Defined as a payment aimed at lowering the cost
of abatement technology
 Goal is to internalize the positive externality associated
with the consumption of abatement activities
 If the subsidy (s) equals the marginal external
benefit (MEB) at QE, it achieves an efficient
equilibrium and is called a Pigouvian subsidy
Pigouvian Subsidy
Market for Scrubbers
($ millions)
MSC
K
PE = 175 Subsidy = $14 million
PC = 170
PE – s = 161 L MPBS
MSB
MPB
0 QC = 200 QE = 210 Q of scrubbers
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Assessing the Model
 It is difficult to measure the MEB

 May bias polluters’ decisions about how best to
abate
Pollution Reduction Subsidy
 To implement, government pays the polluter a

subsidy (s) for every unit of pollution abated
below some pre-established level ZST
 Per unit subsidy = s(ZST - ZO), where ZO is the
actual level of pollution
 Analogous to an emission charge
Assessing the Model
 Might be less disruptive than an equipment

subsidy
 Can have the perverse effect of elevating
pollution levels in the aggregate since the
subsidy lowers unit costs and raises profit,
encouraging entry
Subsidies in Practice
 Environmental subsidies typically are implemented as
grants, low-interest loans, tax credits or exemptions,
and rebates
 Many countries around the world use these
instruments, including Belgium, Denmark, Finland,
Japan, and Turkey
 In the U.S., common uses include federal funding to
build publicly-owned treatment works and subsidies to
encourage the development of cleaner fuels and low-
emission vehicles
Deposit-Refund Systems
Deposit/Refund Systems
 A deposit/refund system is a market

instrument that imposes an up-front charge
to pay for potential damages and refunds it
for returning a product for proper disposal
or recycling
 Targets the potential vs. actual polluter
 The deposit is intended to capture the MEC of
improper waste disposal (IW) in advance
 Preventive vs. ameliorative
Modeling Deposit/Refund System
IW disposal market
 MECIW: health damages + aesthetic impairment

from litter, trash accumulation, etc.
 MPCIW: costs to disposer (e.g., trash receptacles,
collection fees, plus forgone revenue from not recycling)
 MSCIW = MPCIW + MECIW
 MPBIW: demand for improper disposal
 Assume MEBIW = 0, so MPBIW = MSBIW
Deposit-Refund Model
$ Deposit converts % of overall waste
disposal, measured by (QIW - QE), MSCIW
from improper methods to proper
MPCIW + Deposit
MPCIW
a
Deposit=MEC at Qe
b
MPBIW = MSBIW
QE QIW
0 Improper Waste Disposal (%) 100
Proper Waste Disposal (%) 0
100
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Assessing the Model
 Promotes responsible behavior

 Requires minimal supervision by government
 Can help slow the use of virgin raw materials
by improving availability of recycled materials
Deposit/Refund Systems in Practice
 Deposit/refund systems are used worldwide

 Many nations use these systems to encourage
proper disposal of beverage containers
 In the US, 10 states have bottle bills
 Deposits range from 2 cents to 15 cents per
container
 Other applications include systems used to
promote responsible disposal of used tires,
car hulks, and lead-acid batteries
Pollution Permit Trading Systems
Pollution Permit Trading Systems
 A pollution permit trading system establishes a

market for rights to pollute by issuing tradeable
pollution credits or allowances
 Credits are issued for emitting below a standard
 Allowances indicate how much can be released
 Two components of the system are
1. Fixed number of permits is issued based on an
“acceptable” level of pollution set by government
2. The permits are marketable
 Bargaining gives rise to a market for pollution rights
How Permit Trading Works
 There is an incentive to trade as long as
polluters face different MAC levels
 Suppose a firm has 50 permits but normally
emits 75 units of SO2. What must it do?
 Answer
 Abate 25 units of emissions OR
 Buy 25 permits from another producer
 Which option will the firm choose?
 Answer
 Whichever option is cheaper
Result
 Low-cost abaters will clean up pollution and sell
excess permits to other firms
 They will sell at any P higher than their MAC
 High-cost abaters will buy permits rather than abate
 They will buy at any P lower than their MAC
 Trading will continue until the incentive to do so no

longer exists, at which point, the cost-effective solution
is obtained, i.e., the MACs across firms are equal
Assessing the Model
 Trading establishes the price of a right to

pollute without government trying to “search”
for a price
 No tax revenues are generated
 Trading system is flexible
 Note that an emissions standard can be adjusted
by changing the number of permits issued
Pollution Trading Systems in Practice
 Most of the evolution of trading is occurring in U.S.
 An important example is the
allowance-based trading program to control sulfur
dioxide emissions under the Clean Air Act Amendments
of 1990
 More innovation has occurred at state and local levels
 Ozone Transport Commission in the Northeast
 California Regional Clean Air Incentives Market (RECLAIM)
 Key international example
 Trading of greenhouse gas allowances are part of the
Kyoto Protocol, an international accord aimed at global
warming
 Includes the European
Union Greenhouse Gas Emission Trading System (EU ETS
) Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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ECONOMIC SOLUTIONS TO

United States 13.2

Source: International Energy Agency, January 2011

 In theory, achieves an efficient outcome

 A fee imposed directly on the discharge of

$ Firm abates up to Ao since

0 AO AST Abatement (A)

 To facilitate comparison, we use the same model

 Polluter 1: TAC1 = 1.25(A1)2

10 8 Polluter 2’s Abatement 0

 Monitoring costs potentially higher

 Two major types of subsidies:

0 QC = 200 QE = 210 Q of scrubbers

 It is difficult to measure the MEB

 To implement, government pays the polluter a

 Might be less disruptive than an equipment

 A deposit/refund system is a market

 MECIW: health damages + aesthetic impairment

 Promotes responsible behavior

 Deposit/refund systems are used worldwide

 A pollution permit trading system establishes a

 Trading will continue until the incentive to do so no

 Trading establishes the price of a right to

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