Econ 100 Lecture 9.4

1. Econ 100Lecture 9.4 Taxes, Standards and Tradable Permits 3-5-09

2. 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

3. Two Big Questions • What is the optimal level of pollution? • How should it be allocated among its sources (firms)?

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

5. Comparing Standards • Essentially all 3 approaches can theoretically be set to achieve an optimal standard • MC[damages] = MC[abatement] • In practice • Hard to obtain accurate data on damages • Standards have been set arbitrarily in all 3 cases

6. Evaluating the Efficiency of Allocation? • Economic Efficiency • Does the policy result in meeting the standard in a least-cost manner? • Administrative Cost Efficiency • What are the monitoring, enforcement and other administrative costs? • Flexibility: responding to changes in market dynamics, e.g., inflation, changes in demand? • Self-adjusting or not?

7. Comparison of Approaches • Standards • Can produce optimal level of pollution • But setting same standard for all firms (and are not productively efficient, e.g. min cost) • To set individual quotas: requires knowledge of each firm’s costs • Provide no incentive for firms to reduce pollution below current “authorized” levels • Have higher administrative costs • Not only have to monitor emissions • Enforcement costs: legal proceedings (time delays and expense) • Not very flexible: regulatory process for changing standards • Can not respond easily to changes in market conditions • Require rewriting legislation, establishing new standards

8. Comparison of Approaches • Standards • Are most useful when: • Problem is short-lived (“burn” bans for high pollution days) • Optimal level is zero

9. Comparison of Approaches • Taxes • Can produce “optimal” amount of pollution at minimum costs and lower administrative costs • Kneese (1977): comparing taxes versus standards found that desired quality costs half as much using taxes • Automatically allocates pollution levels among firms based on their costs • Provides incentive for firms to reduce pollution levels through technological innovation • Easy to adjust/”tune” to “right” level • But does not respond without change to tax rate • Tax revenues can be used finance admin costs

10. Cost Savings from Charges versus Standards

11. Comparison of Approaches • Tradable Permits • Cost efficient • Firms will purchase permits from more efficient firms if permit cost < abatement (technology) costs • Technological incentive to reduce pollution • Marginal cost of abatement = permit cost • Similar to taxes • Administratively simpler • Require less information about the firms’ cost • Better able to handle “spatial” variation in pollution • Fewer permits auctioned in bad areas • Adjust “automatically” for changes in inflation and growth • E.g., Ca RECLAIM experience • If auctioned -> revenues for admin costs

12. A Webinar on Tradable Permits • http://www.sightline.org/research/energy/res_pubs/cap-in-trade-2009-sightline-webinar