Energy, Environmental Economics

1. Energy Systems Division, Ajou University Energy, Environmental Economics Energy Modelling Lab. Department of Energy Studies, Energy Systems Division, Ajou University Prof. Suduk Kim suduk@ajou.ac.kr

2. The Production Opportunities of the Farmer and Rancher Test of Hypothesis by its Realism of Assumption?

3. The Circular Flow Diagram Test of Hypothesis by its Realism of Assumption?

4. Positive Economics • The essence of science is the scientific method • the dispassionate development and testing of theories about how the world works. • This method of inquiry is as applicable to studying a nation's economy as it is to studying the earth's gravity or a species' evolution. • As Albert Einstein once put it, "the whole of science is nothing more than the refinement of everyday thinking • The scientific method • observation, theory, and more observation • How does the interplay between the theory and observation work? • Does the challenge that experiments are often difficult in economics make economics not scientific? • The role of Assumption • Should an assumption be real? Or what does it have to do with the art of scientific thinking? • What is the role of different assumptions to answer different questions? • Positive vs. Normative Analysis

5. Natural resource economics • Natural resource economics deals with the supply, demand, and allocation of the Earth's natural resources. One main objective of natural resource economics is to better understand the role of natural resources in the economy in order to develop more sustainable methods of managing those resources to ensure their availability to future generations. • One main objective of natural resource economics is to better understand the role of natural resources in the economy in order to develop more sustainable methods of managing those resources to ensure their availability to future generations. • The economics and policy area focuses on the human aspects of environmental problems. Traditional areas of environmental and natural resource economics include welfare theory, pollution control, resource extraction, and non-market valuation, and also resource exhaustibility,]sustainability, environmental management, and environmental policy. • Research topics could include • the environmental impacts of agriculture, • transportation and urbanization, • land use in poor and industrialized countries, • international trade and the environment, • climate change, and methodological advances in non-market valuation, to name just a few. welfare theory, pollution control, resource extraction, and non-market valuation, • and also resource exhaustibility, sustainability, environmental management, and environmental policy. • Natural resource economics also relates to energy, and is a broad scientific subject area which includes topics related to supply and use of energy in societies. Source: http://en.wikipedia.org/wiki/Natural_resource_economics

6. Environmental economics • Environmental economics is a subfield of economics concerned with environmental issues. Quoting from the National Bureau of Economic Research Environmental Economics program: • “ [...] Environmental Economics [...] undertakes theoretical or empirical studies of the economic effects of national or local environmental policies around the world [...]. Particular issues include the costs and benefits of alternative environmental policies to deal with air pollution, water quality, toxic substances, solid waste, and global warming.” • Environmental economics is distinguished from Ecological economics that emphasizes the economy as a subsystem of the ecosystem with its focus upon preserving natural capital. One survey of German economists found that ecological and environmental economics are different schools of economic thought, with ecological economists emphasizing "strong" sustainability and rejecting the proposition that natural capital can be substituted by human-made capital. For an overview of international policy relating to environmental economics, see Runnals (2011). • Central to environmental economics is the concept of market failure. Market failure means that markets fail to allocate resources efficiently. As stated by Hanley, Shogren, and White (2007) in their textbook Environmental Economics. Source: http://en.wikipedia.org/wiki/Environmental_Economics

7. Externality & Market Failure

8. The Market for Aluminum (Efficiency)

9. What is an externality? • Why do externalities make market outcomes inefficient? • How can people sometimes solve the problem of externalities on their own? Why do such private solutions not always work? • What public policies aim to solve the problem of externalities?

10. Introduction • One type of market failure: externalities. • Externality: the uncompensated impact of one person’s actions on the well-being of a bystander • Negative externality: the effect on bystanders is adverse • Positive externality: the effect on bystanders is beneficial • Self-interested buyers and sellers neglect the external effects of their actions, so the market outcome is not efficient.

11. Pollution: A Negative Externality • Example of negative externality: Air pollution from a factory. • The firm does not bear the full cost of its production, and so will produce more than the socially efficient quantity. • How govt may improve the market outcome: • Impose a tax on the firm equal to the external cost of the pollution it generates

12. Other Examples of Negative Externalities • the neighbor’s barking dog • late-night stereo blasting from the dorm room next to yours • noise pollution from construction projects • talking on cell phone while driving makes the roads less safe for others • health risk to others from second-hand smoke

13. Positive Externalities from Education • A more educated population benefits society: • lower crime rates: educated people have more opportunities, so less likely to rob and steal • better government: educated people make better-informed voters • People do not consider these external benefits when deciding how much education to “purchase” • Result: market eq’m quantity of education too low • How govt may improve the market outcome: • subsidize cost of education

14. Other Examples of Positive Externalities • Being vaccinated against contagious diseases protects not only you, but people who visit the salad bar or produce sectionafter you. • R&D creates knowledge others can use • Renovating your house increases neighboring property values Thank you for not contaminating the fruit supply!

15. The market for gasoline P $ 5 4 3 $2.50 2 1 0 Q(gallons) 25 0 10 20 30 Recap of Welfare Economics The market eq’m maximizes consumer + producer surplus. Supply curve shows private cost, the costs directly incurred by sellers Demand curve shows private value, the value to buyers (the prices they are willing to pay)

16. The market for gasoline P $ 5 external cost 4 3 2 1 0 Q(gallons) 0 10 20 30 Analysis of a Negative Externality Social cost= private + external cost Supply (private cost) External cost = value of the negative impact on bystanders = $1 per gallon(value of harm from smog, greenhouse gases)

17. The market for gasoline P $ 5 4 3 2 1 0 Q(gallons) 0 10 20 30 Analysis of a Negative Externality The socially optimal quantity is 20 gallons. Social cost S At any Q < 20, value of additional gas exceeds social cost At any Q > 20, social cost of the last gallon isgreater than its value D 25

18. The market for gasoline P $ 5 4 3 2 1 0 Q(gallons) 0 10 20 30 Analysis of a Negative Externality Market eq’m (Q = 25) is greater than social optimum (Q = 20) Social cost S One solution: tax sellers $1/gallon, would shift supply curve up $1. D 25

19. “Internalizing the Externality” • Internalizing the externality: altering incentives so that people take account of the external effects of their actions • In the previous example, the $1/gallon tax on sellers makes sellers’ costs equal to social costs. • When market participants must pay social costs, the market eq’m matches the social optimum. (Imposing the tax on buyers would achieve the same outcome; market Q would equal optimal Q.)

20. Positive Externalities • In the presence of a positive externality, the social value of a good includes • private value – the direct value to buyers • external benefit – the value of the positive impact on bystanders • The socially optimal Q maximizes welfare: • At any lower Q, the social value of additional units exceeds their cost. • At any higher Q, the cost of the last unit exceeds its social value.

21. P 50 $ 40 30 20 10 Q 0 0 10 20 30 ACTIVE LEARNING 1: Analysis of a positive externality The market for flu shots External benefit = $10/shot • Draw the social value curve. • Find the socially optimal Q. • What policy would internalize this externality? S D 21

22. P 50 $ external benefit 40 30 20 10 Q 0 0 10 20 30 25 ACTIVE LEARNING 1: Answers The market for flu shots Socially optimal Q = 25 shots To internalize the externality, use subsidy = $10/shot. S Social value = private value + external benefit D 22

23. Effects of Externalities: Summary If negative externality • market produces a larger quantity than is socially desirable If positive externality • market produces a smaller quantity than is socially desirable To remedy the problem, “internalize the externality” • tax goods with negative externalities • subsidize goods with positive externalities

24. Market Failure • Externality: the basic idea is that an externality exists when a person makes a choice that affects other people that are not accounted for in the market price. For instance, a firm emitting pollution will typically not take into account the costs that its pollution imposes on others. As a result, pollution in excess of the 'socially efficient' level may occur. A classic definition influenced by Kenneth Arrow and James Meade is provided by Heller and Starrett (1976), who define an externality as “a situation in which the private economy lacks sufficient incentives to create a potential market in some good and the nonexistence of this market results in losses of Pareto efficiency.” In economic terminology, externalities are examples of market failures, in which the unfettered market does not lead to an efficient outcome. • Common property and non-exclusion: When it is too costly to exclude people from access to an environmental resource for which there is rivalry, market allocation is likely to be inefficient. The challenges related with common property and non-exclusion have long been recognized. Hardin's (1968) concept of the tragedy of the commons popularized the challenges involved in non-exclusion and common property. "commons" refers to the environmental asset itself, "common property resource" or "common pool resource" refers to a property right regime that allows for some collective body to devise schemes to exclude others, thereby allowing the capture of future benefit streams; and "open-access" implies no ownership in the sense that property everyone owns nobody owns. The basic problem is that if people ignore the scarcity value of the commons, they can end up expending too much effort, over harvesting a resource (e.g., a fishery). Hardin theorizes that in the absence of restrictions, users of an open-access resource will use it more than if they had to pay for it and had exclusive rights, leading to environmental degradation. See, however, Ostrom's (1990) work on how people using real common property resources have worked to establish self-governing rules to reduce the risk of the tragedy of the commons. • Public goods and non-rivalry: Public goods are another type of market failure, in which the market price does not capture the social benefits of its provision. For example, protection from the risks of climate change is a public good since its provision is both non-rival and non-excludable. Non-rival means climate protection provided to one country does not reduce the level of protection to another country; non-excludable means it is too costly to exclude any one from receiving climate protection. A country's incentive to invest in carbon abatement is reduced because it can "free ride" off the efforts of other countries. Over a century ago, Swedish economist Knut Wicksell (1896) first discussed how public goods can be under-provided by the market because people might conceal their preferences for the good, but still enjoy the benefits without paying for them.

25. Four Types of Goods/Bads Garbage Indoor air pollution Air, Noise pollution Garbage without enforcement & Law • Garbage:  Excludable bad, so long as there are laws and enforcement that help control its management and disposal

26. Market Efficiency and Market Failure MEC (Marginal External Cost) Maximizing the Surplus MEC +MC Maximization of Social Welfare - Check the difference between private optimum and social optimum

27. Public Good and Market Failure • Environmental Good and Its Characteristics • Three Lakeside Households • Current pollution ofLake, 5ppm could be improved by the installation of a purification unit. • Each household has following WTP. Household 1 Household 2 Household 3 • Incentive to Under-report • => Market Failure

28. Public Policies Toward Externalities • Property Rights and Coase Theorem Two approaches • Command-and-control policiesregulate behavior directly. Examples: • limits on quantity of pollution emitted • requirements that firms adopt a particular technology to reduce emissions • Market-based policiesprovide incentives so that private decision-makers will choose to solve the problem on their own.

29. Solutions (Market Failure and Gov’t Intervention) • Environmental Regulations • Pay-As-You-Throw • Taxes and tariffs on pollution/Removal of "dirty subsidies • TREC (tradeable emissions reduction permits)

30. RFID (radio frequency identification) for Waste Management Source: B.T.Kim, 2011. 11. 25

31. Solutions (Taxes and tariffs on pollution) • Corrective tax: a tax designed to induce private decision-makers to take account of the social costs that arise from a negative externality • Also called Pigouvian taxes after Arthur Pigou (1877-1959). • The ideal corrective tax = external cost • For activities with positive externalities, ideal corrective subsidy = external benefit • Taxes and tariffs on pollution/Removal of "dirty subsidies." • Increasing the costs of polluting will discourage polluting, and will provide a "dynamic incentive," that is, the disincentive continues to operate even as pollution levels fall. • A pollution tax that reduces pollution to the socially "optimal" level would be set at such a level that pollution occurs only if the benefits to society (for example, in form of greater production) exceeds the costs. • Some advocate a major shift from taxation from income and sales taxes to tax on pollution - the so-called "green tax shift."

32. Corrective Taxes & Subsidies • Example: Acme, US Electric run coal-burning power plants. Each emits 40 tons of sulfur dioxide per month. SO2 causes acid rain & other health issues. • Policy goal: reducing SO2 emissions 25% • Policy options • regulation: require each plant to cut emissions by 25% • corrective tax: Make each plant pay a tax on each ton of SO2 emissions. Set tax at level that achieves goal.

33. Corrective Taxes & Subsidies • Suppose cost of reducing emissions is lower for Acme than for US Electric. Socially efficient outcome: Acme reduces emissions more than US Electric. • The corrective tax is a price on the right to pollute. • Like other prices, the tax allocates this “good” to the firms who value it most highly (US Electric). • Under regulation, firms have no incentive to reduce emissions beyond the 25% target. • A tax on emissions gives firms incentive to continue reducing emissions as long as the cost of doing so is less than the tax. • If a cleaner technology becomes available, the tax gives firms an incentive to adopt it. • Other taxes distort incentives and move economy away from the social optimum. • But corrective taxes enhance efficiency by aligning private with social incentives.

34. Example of a Corrective Tax: The Gas Tax The gas tax targets three negative externalities: • congestionthe more you drive, the more you contribute to congestion • accidentslarger vehicles cause more damage in an accident • pollutionburning fossil fuels produces greenhouse gases

35. Solutions (Environmental Regulations) • Congestion charges or road usage charges Source: Jonathan Leape, The London Congestion Charge, Journal of Economic Perspectives—Volume 20, Number 4—Fall 2006—Pages 157–176

36. Solutions (Environmental Regulations) • Pay-As-You-Throw • EPA supports this new approach to solid waste management because it encompasses three interrelated components that are key to successful community programs: • Environmental Sustainability - Communities with programs in place have reported significant increases in recycling and reductions in waste, due primarily to the waste reduction incentive created by PAYT. Less waste and more recycling mean that fewer natural resources need to be extracted. In addition, greenhouse gas emissions associated with the manufacture, distribution, use, and subsequent disposal of products are reduced as a result of the increased recycling and waste reduction PAYT encourages. In this way, PAYT helps slow the buildup of greenhouse gases in the Earth's atmosphere which leads to global climate change. For more information on the link between solid waste and global climate change, go to EPA's Climate Change Web site. • Economic Sustainability - PAYT is an effective tool for communities struggling to cope with soaring municipal solid waste management expenses. Well-designed programs generate the revenues communities need to cover their solid waste costs, including the costs of such complementary programs as recycling and composting. Residents benefit, too, because they have the opportunity to take control of their trash bills. • Equity - One of the most important advantages of a variable-rate program may be its inherent fairness. When the cost of managing trash is hidden in taxes or charged at a flat rate, residents who recycle and prevent waste subsidize their neighbors' wastefulness. Under PAYT, residents pay only for what they throw away.

37. Tradable Pollution Permits in the Real World • SO2 permits traded in the U.S. since 1995. • Nitrogen oxide permits traded in the northeastern U.S. since 1999. • Carbon emissions permits traded in Europe since January 1, 2005. • Examples: • CCX(Chicago Climate Exchange), • CFE(Chicago Climate Future Exchange) • ECX(European Climate Exchange) • Types of Emission Credit • AAUs (Assigned Amount Units) • EUAs (EU Allowance Units) • CERs (Certified Emission Reductions) • ERUs (Emission Reduction Units) • RMUs (Removal Units) • Let’s Check! – Introduction of Market Mechanism under Kyoto Protocole • CDM (Clean Development Mechanism) • JI (Joint Implementation) • ET (Emission Trading)

38. Solutions (Quotas on pollution) • tradeable emissions permits, which if freely traded may ensure that reductions in pollution are achieved at least cost. • In theory, if such tradeable quotas are allowed, then a firm would reduce its own pollution load only if doing so would cost less than paying someone else to make the same reduction. • In practice, tradeable permits approaches have had some success, such as the U.S.'s sulphur dioxide trading program or the EU Emissions Trading Scheme, and interest in its application is spreading to other environmental problems. Point Carbon Secondary CER OTC 자료: http://www.pointcarbon.com

39. Tradable Pollution Permits • Recall: Acme, US Electric each emit 40 tons SO2, total of 80 tons. • Goal: reduce emissions 25% (to 60 tons/month) • Suppose cost of reducing emissions is $100/ton for Acme, $200/ton for US Electric. • If regulation requires each firm to reduce 10 tons, cost to Acme: (10 tons) x ($100/ton) = $1,000 cost to USE: (10 tons) x ($200/ton) = $2,000 total cost of achieving goal = $3,000

40. Tradable Pollution Permits • Alternative: • issue 60 permits, each allows its bearer one ton of SO2 emissions (so total emissions = 60 tons) • give 30 permits to each firm • establish market for trading permits • Each firm can choose among these options: • emit 30 tons of SO2, using all its permits • Trade the permit • emit < 30 tons, sell unused permits • buy additional permits so it can emit > 30 tons

41. Tradable Pollution Permits Suppose market price of permit = $150 One possible equilibrium: Acme • spends $2,000 to cut emissions by 20 tons • has 10 unused permits, sells them for $1,500 • net cost to Acme: $500 US Electric • emissions remain at 40 tons • buys 10 permits from Acme for $1,500 • net cost to USE: $1,500 Total cost of achieving goal: $2,000

42. Tradable Pollution Permits • A system of tradable pollution permits achieves goal at lower cost than regulation. • Firms with low cost of reducing pollution - sell whatever permits they can. • Firms with high cost of reducing pollution - buy permits. • Result: Pollution reduction is concentrated among those firms with lowest costs. • When policymakers do not know the position of this demand curve, the permits system achieves pollution reduction targets more precisely. • Some politicians, many environmentalists argue that no one should be able to “buy” the right to pollute, cannot put a price on the environment. • However, people face tradeoffs. • The value of clean air & water must be compared to their cost. • The market-based approach reduces the cost of environmental protection, so it should increase the public’s demand for a clean environment.

43. The Equivalence of Pigovian Taxes and Pollution Permits Price EC (External Cost) Pollution Pollution Permit

44. Private Solutions to Externalities Types of private solutions: • moral codes and social sanctions, e.g., the “Golden Rule” • charities, e.g., the Sierra Club • contracts between market participants and the affected bystanders • The Coase theorem: If private parties can bargain without cost over the allocation of resources, they can solve the externalities problem on their own.

45. See Spot bark. The Coase Theorem: An Example Dick owns a dog named Spot. Negative externality: Spot’s barking disturbs Jane, Dick’s neighbor. The socially efficient outcome maximizes Dick’s + Jane’s well-being. • If Dick values having Spot more than Jane values peace & quiet, the dog should stay. Coase theorem: The private market will reach the efficient outcome on its own…

46. The Coase Theorem: An Example • CASE 1: Dick has the right to keep Spot. Benefit to Dick of having Spot = $500Cost to Jane of Spot’s barking = $800 • Socially efficient outcome: Spot goes bye-bye. • Private outcome: Jane pays Dick $600 to get rid of Spot, both Jane and Dick are better off. • Private outcome = efficient outcome.

47. The Coase Theorem: An Example • CASE 2: Dick has the right to keep Spot. Benefit to Dick of having Spot = $1000Cost to Jane of Spot’s barking = $800 • Socially efficient outcome: See Spot stay. • Private outcome: Jane not willing to pay more than $800, Dick not willing to accept less than $1000, so Spot stays. • Private outcome = efficient outcome.

48. The Coase Theorem: An Example • CASE 3: Benefit to Dick of having Spot = $500Cost to Jane of Spot’s barking = $800But Jane has the legal right to peace & quiet. • Socially efficient outcome: Dick keeps Spot. • Private outcome: Dick pays Jane $600 to put up with Spot’s barking. • Private outcome = efficient outcome. The private market achieves the efficient outcome regardless of the initial distribution of rights.

49. Why Private Solutions Do Not Always Work • Transaction costs: the costs that parties incur in the process of agreeing to and following through on a bargain • Sometimes when a beneficial agreement is possible, each party may hold out for a better deal. • Coordination problems & costs when the number of parties is very large.