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Understanding Taxes, Standards, and Tradable Permits for Addressing Negative Externalities

This lecture delves into how negative externalities, such as pollution, impact economic decisions, and discusses the roles of taxes, standards, and tradable permits in managing these externalities. It explores the concepts of marginal private costs versus marginal social costs, the optimal levels of pollution, and methods for setting emission standards. The lecture highlights the effectiveness and efficiency of emission taxes in encouraging firms to innovate, reduce pollution, and internalize environmental costs. It underscores the importance of cost-efficient approaches to pollution control.

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Understanding Taxes, Standards, and Tradable Permits for Addressing Negative Externalities

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  1. Taxes, Standards and Tradable Permits 3-04-09 Econ 100Lecture 9.2

  2. Negative Externality • Marginal Private Costs < Marginal Social Costs Ideal Actual Pi Pa

  3. Negative Externalities • An Example: Pollution • Emitted by factories as a by product of the production process • Air, water, electricity • Emitted by vehicles • Typically treated as a “zero-cost” input into the production process • Source will be “over” consumed (beyond point marginal benefit = marginal cost as mc = 0)

  4. What Are the Consequences? • Without Intervention • Consumers/producers will not take such costs into economic decisions • Produce too much of the good & externality (e.g., pollution)

  5. Two Big Questions? • What is the optimal level of pollution? • How is that amount allocated among firms/sources?

  6. How Do We Set the Standard? Equate MC of damage To MC of abatement

  7. What Do We Know About the Costs of Reducing Pollution? • Costs of reducing • Additional costs of reducing pollution will be greater when level of pollution is higher • An Example: • First electrostatic precipitator reduces emissions by 80% • Second (added) EP by another 80% • Effectively 80% x 20% (remaining) = 16% • Third EP • 80% x 4% = 3%

  8. What Does the Cost Curve Look Like?

  9. How Do We Set the Standard? Equate MC of damage To MC of abatement

  10. Remedies for Negative Externalities • Standards • Permissible level of emissions for each factory in an industry (each industry gets same target), or • Targets how much emissions must be reduced by each factory (again, same target for all) Taxes • Direct tax on emissions • Indirect on input/output if there is a direct correlation between input/output and pollution • E.g., tax on gasoline, coal based on sulfur content • Tradable permits • Gives each firm the “right” to pollute to a certain level • Firms are allowed to trade/sell permits

  11. Standards • Emission standards • Could be set at same “optimal” amount of pollution as the tax Two approaches • Establishes the level of pollution that can be emitted by “polluter” • Require all firms to reduce pollution by “x” amount • Typically divided up among the firms equally • Disregards technological/cost differences between firms • Therefore will not be cost efficient

  12. Standards • Same amount of pollution for all firms • Newer firms with newer/efficient technology able to easily meet standard and may not even reach it • Same amount of reduction • Newer firms already emitting less • Maybe increasingly more costly for them to reduce pollution by x amount then firms with older technology • Either way • Approach is not cost efficient • Provides no incentive for firms to reduce emissions below standard

  13. Negative Externalities & Taxes • How to Set the Optimal tax • Set at point where MBen = MCost of Pollution • Tax: equals difference between MSC and MPC and • “internalizes” it into the consumption decision • Firm’s cost = price*quantity of inputs plus tax*emissions/output Tax

  14. EmissionTaxes • Emission taxes • Will be cost-efficient • Firms will adopt new technology if marginal abatement costs are less than marginal cost of tax • Otherwise will pay the tax • Consequently firms will adopt least cost approach to meeting optimal pollution goal • Taxes have lower administrative costs • Can be easily raised/lowered to fine tune meeting of the standard • Do not require litigation

  15. Cost-Minimizing Control of Pollution with an Emission Charge

  16. Cost Savings from Technological Change: Charges versus Standards

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