POLLUTION TAX

1. POLLUTION TAX Using the paper market as an example: • Paper mills generate chemical wastes as part of their production process and dump some of these wastes into rivers. • If a city downstream was required to treat the river water to make it safe for drinking, it might impose a pollution tax to cover the cost of additional water treatment.

2. POLLUTION TAX • The paper market is a market that generates spillover costs. • Another word for spillover cost is external cost. • A pollution tax internalizes the externality. • If the firm pays $4 per gallon of waste, the cost of polluting the river is internal to the firm, not external.

3. FIRM’S RESPONSE TO POLLUTION TAX • Most polluting firms can control the amount of polluting waste they dump into the environment; • As a firm continues to decrease waste, it becomes progressively more expensive to do so.

4. COST PER TON OF PAPER WITH VARYING AMOUNTS OF POLLUTION Waste Production Cost Tax Cost Total Cost per ton per ton per ton per ton 5 $60 $20 $80 4 $61 $16 $77 3 $64 $12 $76 2 $71 $8 $79 1 $86 $4 $90 0 $116 $0 $116

5. COST PER TON OF PAPER WITH VARYING AMOUNTS OF POLLUTION Waste Production Cost Tax Cost Total Cost per ton per ton per ton per ton 5 $60 $20 $80 4 $61 $16 $77 3 $64 $12 $76 2 $71 $8 $79 1 $86 $4 $90 0 $116 $0 $116

6. MARGINAL PRINCIPLE Increase the level of activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible pick the level at which the marginal benefit equals the marginal cost.

7. MARKET EFFECTS OF A POLLUTION TAX • The original price of $60 just covered the cost of producing paper without the pollution tax; • The tax increases the cost of producing paper because the typical firm pays some pollution tax and incurs some costs when it cuts back its pollution; • Since old price is not high enough to cover higher production costs, some firms leave the market; • The supply curve shifts left: at each price a smaller quantity of paper will be supplied; • The leftward shift of the supply curve increases the equilibrium price of paper (point i to point f).

8. MARKET EFFECTS OF A POLLUTION TAX Price per ton of paper $$ Supply Curve with $4 pollution tax f 68 Initial Supply i 60 Demand 80 100 Tons of paper per day

9. MARKET EFFECTS OF A POLLUTION TAX • Like other taxes, a pollution tax is partially shifted to consumers in the form of a higher price; • When consumers face the full cost of producing paper, they decide to consume less of it.

10. THE MARKET EFFECTS OF A POLLUTION TAX How does the pollution tax affect the volume of waste dumped into the river ? 1. Abatement There is less waste per ton of paper (3 gallons instead of 5 ). 2. Lower Output The industry produces less paper (only 80 tons per day instead of 100).

11. COMMAND AND CONTROL REGULATION POLICY The government commands each firm to produce no more than a certain volume of pollution and controls the firm’s production process by forcing the firm to use a particular pollution-control technology.

12. COMMAND AND CONTROL REGULATION POLICY The mandated abatement technology is unlikely to be the most efficient technology for two reasons: • The regulatory policy specifies a single abatement technology for all firms; while efficient for one firm, this may not be efficient for others. • The regulatory policy decreases the incentives to develop more efficient abatement technologies.

13. MARKET EFFECTS OF REGULATION BY COMMAND AND CONTROL Price per ton of paper $$ Supply Curve with regulation f 74 Initial Supply i 60 Demand 70 100 Tons of paper per day

14. COMMAND AND CONTROL REGULATION • The mandated technology will be less efficient and more costly than the technology developed under a pollution tax; • The supply shift resulting from the regulatory policy will be larger than the supply shift from the pollution tax.

15. COMMAND AND CONTROL REGULATION Everyone will be unhappy with command and control policy: • Consumers will be unhappy because the price is higher ($74 instead of $68); • Firms will be unhappy because there is less paper (70 tons per day instead of 80 with the tax). • Environmentalists will be unhappy because there is more pollution (280 gallons per day instead of 240).

16. ADVANTAGES OF POLLUTION TAX AND COMMAND AND CONTROL POLICY POLLUTION TAX COMMAND & CONTROL • The money raised from • The policy specifies pollution tax could be how much waste each used to cut other taxes firm can produce, so or increase spending on we can predict the public programs total volume of waste

17. MARKETABLE POLLUTION PERMITS The government picks a target pollution level for a particular area, issues just enough pollution permits to meet the pollution target, and allows firms to buy and sell the permits. The key innovation is that these permits are marketable.

18. MARKETABLE POLLUTION PERMITS PAPER INDUSTRY EXAMPLE: 1.There are 100 paper mills in the market, each producing 1 ton of paper per day and initially generate 5 gallons of waste per day; 2. Half the paper mills can abate the pollution at a relatively low cost; 3. Half the paper mills have relatively high abatement costs.

19. ABATEMENT COSTS: LOW-COST VERSUS HIGH-COST FIRM Waste Production cost Production cost per Ton per Ton: per Ton: (gallons) Low Cost High Cost 5 $60 $60 4 $61 $67 3 $64 $82 2 $71 $112 1 $86 $172 0 $116 $300

20. ABATEMENT COST: LOW-COST VERSUS HIGH-COST FIRM Suppose government decides to decrease the volume of waste to 400 gallons per day: • The government issues 4 marketable permits to each of the 100 paper firms; • If a particular firm wants to generate 5 gallons of waste per day, it can buy a fifth permit; • The firm that sells one of its permits can only generate 3 gallons of waste per day.

21. ABATEMENT COST: LOW-COST VERSUS HIGH-COST FIRM Each low-cost firm will sell a permit to a high-cost firm: 1. Each high-cost firm is willing to pay up to $7 for a permit. If a high-cost firm gets a fifth permit, it can generate 5 gallons of waste and produce a ton of paper for $60 instead of $67 with four permits; 2. Each low-cost firm is willing to accept any amount above $3, since if low-cost firm gives up one permit, it can generate only 3 gallons of waste. Its production cost would increase by $3 (from $61 to $64).

22. DIFFERENCES IN TOTAL ABATEMENT COSTS Gallons Abatement Costs Abated High-Cost Firms Low-Cost Firms Total With 100 0 $200 $200 Trading Without 100 $350 $50 $400 Trading

23. DIFFERENCES IN TOTAL ABATEMENT COSTS With Trading • Each high-cost firm will generate 5 gallons of waste and spend nothing on pollution abatement; • Each low-cost firm will generate 3 gallons of waste and incur an abatement cost of $4 ($64 - $60); • Total cost of cutting from 500 to 400 gallons waste is $200. Without Trading • Each high-cost firm incurs $7 to abate 1 gallon of waste: production cost increases from $60 to $67. With 50 high-cost firms, total abatement cost is $350 for these firms; • Each low-cost firm incurs $1 to abate 1 gallon of waste: production cost increases from $60 to $61. With 50 low-cost firms, total abatement cost for these firms is $50. • The total cost under traditional permit policy is $400.

24. EXAMPLES OF MARKETABLE PERMIT EXCHANGES WHO PAID TO WHOM TO DUMP Duquesne $3,750,000 Wisconsin Power 15,000 tons of Light Co. ($250 / ton) and Light sulfur dioxide Mobil Oil $3,000,000 Torrence, CA 900 pounds of Corp. (earlier rights reactive vapors from GM) per day • Another example is a firm in Los Angeles which installed a new incinerator that decreased hydrocarbon emissions by 100 tons per year and offered to sell the rights to emit 100 tons of hydrocarbons for $400,000.

25. GLOBAL WARMING • Solar energy comes through the atmosphere and heats the air near the earth’s surface. • Certain types of gases in the atmosphere (called greenhouse gases) trap the heat close to the earth’s surface. • Unfortunately, we are pumping more of these greenhouse gases into the atmosphere, so the earth’s temperature is increasing.

26. HOW DOES DESTRUCTION OF TROPICAL RAIN FORESTS AFFECT GLOBAL WARMING ? 1. If trees and plants are burned to clear the land, the carbon stored in these plants is converted into carbon dioxide. 2. Once the forest is cleared, there is less plant material to convert carbon dioxide into stored carbon.

27. EFFECTS OF GLOBAL WARMING • Total rainfall will increase, with some areas getting more and others getting less; • Increased carbon dioxide will make all plants (including weeds) grow faster; • Net effect on agriculture is likely to be negative: expect less rainfall in areas with fertile soil and more in areas with less fertile soil; • Increasing global temperatures will melt glaciers and polar ice caps, increasing sea levels.

28. CARBON TAX • Economist’s response to global warming is a tax on fossil fuels; • Tax would force people who use fossil fuels to pay the full cost (spillover cost) of using them; • spillover cost of a particular fuel depends on how much carbon dioxide is released into the atmosphere; • Carbon tax for a particular fuel would be determined by the fuel’s carbon content.

29. MARKET EFFECTS OF CARBON TAX ON COAL Supply Curve with carbon tax Price per ton of paper $$ t 42 Initial Supply i 35 Demand 78 100 Tons of Coal per day

30. EFFECTS OF DIFFERENT CARBON TAXES low tax high tax Taxper ton of carbon $5.00 $100.00 Effect on price of coal Tax per ton $3.50 $70.0 Percentage increase 10 % 205 % Effect on price of oil Tax per barrel $0.58 $11.65 Percentage increase 2.8 % 55 % Effect on price of gasoline Tax per gallon $0.014 $0.28 Percentage increase 1.2 % 23 % Percentage reduction in 10 % 43 % greenhouse emissions Total tax revenue per year $10 billion $125 billion

31. OZONE DEPLETION • A layer of ozone in the upper atmosphere prevents most of the sun’s harmful ultraviolet light from reaching the surface of the earth; • Ultraviolet light causes living cells to mutate, causing • skin cancer, • eye disease, • death of marine organisms; • Chlorofluorocarbons (CFCs), used in refrigeration, air conditioning, spray products, etc..., were the culprit; • The nations of the world have agreed to stop producing CFCs altogether; • The ban on CFCs will increase the equilibrium prices of the goods that were produced with these chemicals.

32. ACID RAIN • sulfur-dioxide emissions of coal-burning power plants combined with nitrogen oxides and other chemicals in the atmosphere to form acid rain; • Rainfall downwind from the power plants changed soil and water acidity, causing problems for trees, fish, and other aquatic life; • The Clean Air Act of 1990 established a system of marketable pollution permits for sulfur dioxide: • Each utility will receive enough permits to generate 30% to 50% of the sulfur dioxide it had produced 10 years earlier; • The permit system will decrease sulfur dioxide emissions by 10 million tons per year.

33. URBAN SMOG • The result of mixing several pollutants, including nitrogen oxides, sulfur dioxide, and volatile organic compounds -- ground-level ozone; • Smog causes health problems in human beings and other animals, retards plant growth and decreases agricultural productivity; • The automobile is the most important source of the pollutants that lead to smog; • The Environmental Protection Agency currently uses a command-and-control approach to regulate automobile pollution; • An alternative to the EPA policy is to levy an annual pollution tax on each car.