Regulatory Options & Efficiency

1. Regulatory Options & Efficiency What guidance can economics provide about how to regulate polluting industries or firms?

2. Why regulate? • Does free market efficiently provide goods and services? • Market failure (externalities, public goods, etc.) • Market power (monopolies inefficiently restrict production to raise prices) • Information problems (damages uncertain, food safety, env quality)

3. Types of questions in regulation • What is the “optimal” amount of pollution? • To reduce by X%, who should reduce and by how much? • What regulatory instrument(s) should be used to achieve that level?

4. The efficient amount of pollution Marginal Control Cost $/unit Marginal Damage Cost Total Damage Cost Total Control Cost Q* Units of pollution

5. Recall example from 1st day • 60 firms, each pollute 100 tons • 30 low abatement cost ($100/ton) • 30 high abatement ($1000/ton) • Everyone reduces 1 ton: Cost=$33,000 • Total reduction = 60 tons. • For same cost could have reduced 330 tons.

6. If low cost firms abate: Either: • Reduce more pollution for the same amount of money…or • Reduce the same amount of pollution for less money. So we always want low-cost firm to abate.

7. If costs aren’t constant: greenhouse emissions of Nitrogen Cost ($) Who should abate the 1st unit of N? MCA MCB  N

8. How much abatement from each? $ (A) Loss from equal reduction MCA $ (B) MCB A: 0 40 25 80 80 B: 55 40 0

9. How did he do that? • Determine how much total abatement you want (e.g. 80) • Draw axis from 0 to 80 (A), 80 to 0 (B) • Sum of abatements always equals 80. • Draw MCA as usual, flip MCB • Lines cross at equilibrium • Price is MC for A and for B.

10. The “equimarginal principle” • Not an accident that the marginal abatement costs are equal at the most efficient point. • Equimarginal Principle: Efficiency for a homogeneous pollutant requires equating the marginal costs of control across all sources.

11. Control costs • Should include all other costs of control • monitoring & enforcement • administrative • Equipment • High cost firms have incentive to innovate and change production technology • Regulatory uncertainty increases costs.

12. Instruments for regulation • Taxes: charge $X per unit emitted. This increases the cost of production. Forces firms to internalize externality. • Quotas/standards: uniform standard (all firms can emit Y) or non-uniform. • Tradable permits: All firms get Y permits to pollute, can buy & sell on market. Other initial dist’n mechanisms.

13. Example 1: Taxes in China • China: extremely high air pollution – causes significant health damage. • Instituted wide-ranging system of environmental taxation • 2 tiers • World Bank report estimates that MC of abatement << MB of abatement.

14. A creative quota: bubble policy • Multiple emissions sources in different locations. • Contained in an imaginary “bubble”. • Regulation only governs amount that leaves the bubble. • May apply to emissions points within same plant or emissions points in plants owned by other firms.

15. Example 2: Bubble policy in RI • Narraganset Electric Company: • 2 generation facilities in Providence, RI. • Required to use < 2.2% sulfur in oil. • Under bubble policy: • Used 2.2% in one plant, burned natural gas at other plant • Savings: • $3 million/year

16. $/unit MSC MPC P* MEC Pp D Q* Qc Dirty Good

17. What tax or quota is required? • We know: • Optimal level of pollution is Q* • Marginal Social Cost at the optimum is P* • Marginal Private Cost at optimum is Pp. • Optimal tax exactly internalizes externality: • t* = P* - Pp • Effectively raises MC of production

18. MPC (with tax) $/unit MSC t* MPC (no tax) P* Pp D Q* Qc Q (pollution)

19. Taxing consumption instead • Taxing consumption: • Taxing consumers for every unit of a polluting good that is purchased. • E.g. Automobile gasoline • Can equivalently be used: • Instead of raising production costs, a consumption tax lowers demand.

20. $/unit MSC MPC (no tax) P* Pp t* D (no tax) D (with tax) Q* Qc Q (pollution)