Government Intervention to Correct Market Failure

1. Government Intervention to Correct Market Failure Chapter 7

2. Introduction • In many countries, governments attempt to correct market failures • This suggests that politicians believe that government intervention in free markets can improve social welfare • Significant economic arguments for and against government intervention includes the work of Pigou (1938) and Coase (1960), respectively • In this lecture we examine these theories and discuss the types of policies government can use to intervene in markets to correct failures.

3. The Pigouvian Approach to Market Failure • Pigou argued for taxes to address market failure • The principle is to use taxes to remove the divergence between MSC and MPC, and MSB and MPB

4. Pigou • Pigouvian tax on timber production in an important water catchment • A tax will internalize the externality

5. Pigou • What do you think the Pigouvian approach to market failure has to say about encouraging activities that generate positive externalities? • There is a problem with levying taxes on production of timber • Doesn’t encourage development of technology that minimises impacts on water quality • In this case, the externality should be taxed –sediment levels in water – not volume of timber harvested.

6. The Coasian Approach to Market Failure • Externality taxes are unnecessary and often undesirable because a market for the externality will develop without government intervention • The optimal level of the externality will be achieved automatically in a free market regardless of whether the generator of the externality has the (legal) property right to generate the externality or the victim has the (legal) property right to be free from exposure to the externality • That is, the final allocation will be independent of the initial property rights, and whatever the initial property rights, the efficient solution does not change

7. Coase • Marginal abatement cost (MAC) • Marginal damage function (MDF) • Efficient level of pollution abatement?

8. Coase • 1. Polluter has right to pollute • 2. Affected parties have a right to clean environment

9. Coase • Regardless of which party has the initial property rights – the polluter or those affected – an unimpeded process of bargaining should lead to the socially optimum level of emissions of c • Efficient solution is independent of the initial property rights • But distribution of costs and benefits will differ - the agent with the initial property rights will receive payments; the other party will have to make the payments. • On close examination, the Coase Theorem is found to rely on a number of assumptions which may not hold in practice • Efficient solution may not in fact be achieved by the ‘invisible hand’ of the market.

10. Assumption 1: Absence of transaction costs

11. Assumption 2: Well-defined property rights • Often, property rights regarding pollution (or rights to a clean environment) are not clearly specified by legislation, regulation or custom • This makes bargaining between the parties more difficult, and can favour ‘testing’ the rights through litigation.

12. Assumption 3: Perfect competition in the abatement market • If polluters have market power (e.g. monopoly situation) they could charge a higher price for abatement than their marginal abatement cost • Supposing the logging company has the initial property rights, downstream water users can only purchase abatement and better quality water by paying money to the monopolist logging company supplying the better quality water • Downstream water users may have to pay high monopoly prices.

13. Assumption 4: No income effects • Studies have shown WTA >> WTP • Much debate about why • Starting point bias (property rights) • Kinky preferences

14. Willingness to pay for improved environmental quality and willingness to accept compensation for reduction in environmental quality

15. Assumption 4: No income effects • May be important differences between the victim’s WTP for reducing the level of a detrimental externality below its present level and the victim’s WTA to allow increases in the level of the externality • This may be partly due to income effects: If being free from a detrimental externality raises an individual’s standard of living, the marginal valuation of the damages depends on the definition of property rights. • If the polluter has the initial property rights, this will tend to reduce the equilibrium quantity of abatement • If the rights rest with the affected parties, this will tend to increase the equilibrium level of abatement. • If the value of the externality damages (level of pollution) depends on the definition of property rights, then the way that the property rights are defined must have an effect on the negotiated level of the externality

16. Assumption 5: No effects on entry and exit of firms • If polluters are not responsible for damages, how do you think this will affect the number of polluters in the economy? • People and firms may relocate to collect payments • The relative numbers of pollution generators and victims will affect MAC and MDF, and therefore the socially efficient equilibrium level of pollution.

17. Assumption 6: No free riders • Is this likely with all environmental goods? • e.g. Greenpeace and whales in the Southern Ocean • In summary, the automatic (free market) solution of the Coase Theorem is unlikely to be achieved in most situations

18. Is Government intervention in markets desirable? • Economists that follow Pigou suggest that government intervention can improve social welfare • Economists that follow Coase say government intervention is unnecessary and may encourage compensation seeking • However, many assumptions of the Coase Theorem are likely to be broken • Consideration must be given for the option of government intervention • But costs of intervention must be compared with benefits

19. Types of Government Intervention • Moral suasion. Convince public that benefits >> costs. But free-rider problems, e.g Woodsy Owl’s, “Give a hoot, don’t pollute.

20. Types of Government Intervention • Direct production of environmental quality • e.g. reforestation of degraded farmland • Prevention is better! • Moral suasion and direct production likely to be of limited use in addressing major environmental problems like global warming • Pollution prevention – strategies to address market failure related to imperfect information • e.g. research collaboration between government, universities and private sector to develop new technologies • Extension programs with farmers in developing countries to learn more efficient production technologies

21. Types of Government Intervention • Command and control – government imposed restrictions on inputs and outputs • e.g. logging codes. Input restrictions, like equipment. Output restrictions, like habitat trees • Economic incentives – pricing externalities to let the market align private and social interests

22. Socially efficient level of environmental quality • Nice to eliminate pollution, but is zero pollution level efficient?

23. Social Costs When Pollution Level is Greater than Optimal

24. Social costs when pollution level is lower than optimal

25. Optimal level of pollution with technological innovation

26. Pursuing Environmental Quality with Command and Control Policies • Environmental regulations in OECD countries, including the USA, are primarily of the command and control type • e.g. 1, If the optimal level of pollution is known to be E1, permits to generate E1 units of pollution could be allocated among all polluters • e.g. 2, if the socially efficient level of pollution is 50% of the unregulated market level, then each polluting firm could be required to cut their emissions by 50%. • But such policies often generate excessive pollution abatement costs

27. Unregulated free market pollution level? • Suppose must reduce pollution by 50% • Why is this an inefficient allocation of abatement? • Command and control policies allocate pollution abatement efficiently between firms if: a) firms have identical MAC; or b) government knows MAC of each polluter.

28. Pursuing Environmental Quality with Economic Incentives • Most economists advocate pollution policies based on economic principles, because: • Economic incentives minimize total abatement costs by equating MACs across polluters • Economic incentives encourage research and development in abatement technology • If particular emissions targets are imposed by command and control measures, then there is no incentive for firms to go beyond meeting those targets • If particular emission abatement technologies are mandated, there is no incentive for firms to look at developing lower cost abatement technologies

29. The efficiency of taxing pollution • Cost-saving incentives to adjust emissions level to the point where MAC = t • Thus, a tax on each unit of pollution will equate the MAC of all polluters and minimize the total cost of achieving a particular level of pollution abatement. • Applies to uniformly mixed pollutants, like GHGs, where marginal damage costs are the same regardless of emitter location • Non-uniformly mixed pollutants, where geography is important, is considered shortly

30. Challenge of setting the appropriate tax level • Aggregate MAC for society is typically not known, so how does the government know the tax level that will bring about the target (socio-economically efficient) level of pollution (MAC = MDF)? • If taxes are set too high or too low, socially inefficient outcomes will result – the level of abatement will be too high or too low respectively. • Command and control techniques can achieve target pollution levels with more certainty than a tax • If the costs of governments setting the wrong tax level are high, then command and control techniques may be preferable.

31. The Irish Bag Levy • Rapid economic growth in Ireland during the 1990s was marked by a substantial increase in per capita waste • Lack of landfill sites increased costs of waste disposal and increased illegal dumping and littering • Fear that tourism and Ireland’s clean, healthy food products image would be tarnished • In 2002, government introduced a fee of 15c per plastic bag to retailers, which they were obliged by the government to pass onto shoppers • Designed to provide incentives for shoppers to shift to ‘bags for life’ • Expectations that the levy would reduce number of plastic bags by 50% • Estimated actual reduction in use of plastic bags was 95% (1.26 billion plastic bags per year to 120,000) See 2007 paper in environmental and resource economics 38(1) to update • Major success!

32. Marketable pollution permits • Pollution taxes are preferable to command and control techniques because they minimize abatement costs and provide other desirable incentives • Under particular conditions, pollution taxes may be less efficient than command and control techniques in achieving a target level of pollution • This presents a difficult choice between taxing and command and control techniques • Marketable pollution permits are an attractive alternative

33. Marketable pollution permits • Marketable pollution permits (MPPs) provide economic incentives to minimize abatement costs while achieving the target level of pollution with a high degree of certainty • MPP approach begins with the determination of the target level of pollution • The next step is to allocate the allowable pollution units among the polluters • there are many permit allocation methods, which have important equity considerations, but they do not affect the final socially efficient equilibrium

34. Marketable pollution permits • After the initial allocation is made, polluters are free to buy and sell rights to pollute. • MPPs will equate MAC across polluters • Polluters with high MAC will have incentives to buy pollution permits • Polluters with low MAC will have incentives to sell pollution permits

36. Marketable pollution permits • Does initial allocation of permits among polluters affect revenues and costs of firms? • Does initial allocation affect economic efficiency?

37. Article in The Economist trashing marketable pollution permits • There may be cases where taxes are more efficient than marketable pollution permits, but this article makes some misleading claims in favor of taxes. • Claim 1: Easy to fiddle with the carbon tax if we get it wrong, in particular if we set it too low and don’t get enough abatement • Apparently because climate change is a long-term problem, doesn’t matter if we have some short-term excesses of emissions • However, if we misjudge the number of permits, permit prices will be very high or very low – potentially high adjustment costs for firms • The case of too many permits and low permit price is analogous to setting the tax too low – article says this is not a problem for a tax and nor is it a problem for permits – just don’t distribute so many permits next year

38. Article in The Economist trashing marketable pollution permits • The case of distributing too few permits (high permit price) would have the same effect as setting the tax too high. • Avoiding setting the tax too high requires some knowledge about firms’ abatement costs – this info could be scarce • On the other hand, we have good information about CO2 emission levels • So, if avoiding high permit prices (at least initially) is of concern, how many permits should be allocated? • So, perhaps a better chance of avoiding high abatement costs with a permit system than with a tax! • Also, taxes may become ‘sticky’. Politically challenging to raise CO2 taxes, so the taxation approach may not be as flexible as suggested in the article.

39. Article in The Economist trashing marketable pollution permits • Claim 2: Article reports price volatility in the US SO2 market • In 1980, 17.1 M tonnes of SO2 emitted • Cap and trade began in mid-1990s • 2006 emissions capped at 10.6 M tonnes • The cap is 8.95 M tonnes in 2010 • Bush plan is to reduce cap to 3 M tonnes by 2018 • Each year, firms are allocated permits from the EPA on the basis of past fuel consumption and are required to purchase permits from EPA or from each other if they exceed that yearly allocation • Number of permits available is reduced each year by the EPA

40. Article in The Economist trashing marketable pollution permits • Claim 3: Invention of cleaner technology could push down the price of permits, thus reducing the innovator’s returns • Strategy of pollution control authority should be to reduce number of permits to keep permit prices relatively high • Claim 4: Carbon taxes will raise revenue while permits have traditionally been given away • No reason why permits could not be sold to industry to raise revenue • Claim 5: marketable pollution permits amenable to ‘paying-off’ politically powerful polluters by giving them more pollution permits • Yes, but could also do this with a tax – first XXX tonnes of emissions are tax free, but then pay $t/tonne emitted beyond XXX tonnes

41. Economic incentives and Geographic Considerations • Geographic location of emissions can have a profound impact on the damages the pollution generates for some categories of pollution. • Central to the importance of location of emissions is the manner in which the pollution disperses when it enters the environment. • Pollution controls must take into consideration the geographic variation in the effect of pollution on society.

42. Taxes and Geographic Considerations • A pollution control system based on taxes could take geographic variation into account by charging higher taxes in areas where emissions are more damaging. OR • Tax on basis of effect of each firm on concentration of pollutants at receptor site(s), not emissions from the firm

43. Effect of Location on Local Pollutant Concentration

44. Cost-Effectiveness for Non-uniformly Mixed Pollutants: A Hypothetical Example • Assume MACs of firms equal to show how location matters when MAC differences are not a factor. • Transfer coefficient (a) is higher for source 1 than source 2. • Objective is to meet pollution target at lowest cost • Suppose pollution has to be reduced by 7.5 units at the receptor to comply with an ambient pollution standard • How should pollution reduction be allocated between the firms?

45. Cost-effectiveness for non-uniformly mixes pollutants • The allocation six units of emissions reduction from source 1 and three units of emissions reduction from source 2 (1.5 units at the receptor) is most efficient. • Marginal costs of pollution concentration reduction are equalized at $6 at these levels of emissions control. • Policy approaches to meet the desired pollution level • Ambient charge: ti = aiMAC • where t is the per unit of emissions tax paid by the ith polluter • ai is the ith source’s transfer coefficient • MACis the marginal cost of a unit of pollution concentration reduction or marginal abatement cost ($6 for both sources). • So in our example, source 1 would pay a tax of $6 per unit of emission and source 2 would pay $3 per unit of emission. • This contrasts with a uniformly mixed pollutant where pollution emitters are required to pay the same charge!

46. Efficient Ambient Charges for non-uniformly mixed pollutants • How can the cost-effective ti be found? • Transfer coefficients can be found with hydrological and meteorological research. • But what about MAC (the marginal cost of pollution concentration reduction at the receptor)? • Iteratively change MAC until resulting pollution concentration equals the desired level.

47. Marketable Pollution Permits and Geographic Considerations • A marketable pollution permit system must divide the overall region into subregions. • These subregions can account for geographic variability in one of two ways: • development of a receptor-based system; or • development of separate markets for subregions.

48. Marketable Pollution Permits and Geographic Considerations: Ambient-based Permit System • A receptor-based or ambient-based system allocates pollution receptors across the region. • For receptor locations relatively close to the polluter, the polluter may require more permits. • Dispersion coefficients are used to help define the terms of trade in this type of marketable pollution permit market. • In the following figure, the location of a particular polluter is denoted by a star and receptors are denoted by letters. • This polluter may have to buy some combination of 15 different types of permits. • Price of permits for each receptor will differ according to how difficult it is to meet desired environmental quality at that location

49. Marketable Pollution Permits and Geographic Considerations: Ambient-based Permit System

50. Marketable Pollution Permits and Geographic Considerations:Emissions-based Permit System • An alternative to the ambient-based system is to divide the subregions into separate markets. • Polluters need only purchase permits for the subregion in which they are located. • The inability to trade across subregions may mean that firms with lower abatement costs will not be able to trade permits with higher abatement cost firms in another subregion. • A compromise would be to have one type of permit and allow trade across all regions, as long as the trade does not result in ambient quality standards being violated at any receptor point. • Or trading between zones after adjusting “trading ratios” to account for the locations of the trading polluters.