Chapter 7 Pigouvian Fees

1. Chapter 7 Pigouvian Fees Making Prices Work for the Environment

2. The Welfare Economic Point of Prices • Market prices should reflect marginal cost of production and marginal willingness to pay. • If market prices do not reflect this, can we change the prices? • Yes we can (at least in principle)

3. The Porrige Model with many damage to several individuals • x is pollution from a firm • Damage = D(x) = ∑iDi(x) • Cost of pollution reduction C(x) • Optimal x* minimize (D(x) + C(x)) • First order condition D’(x) = ∑iD’i(x) = C’(x) • Market outcome if there are no property rights C’(xM) = 0.

4. Pigouvian Fee – The Tax Case • Regulator choses an emission tax T • Firms maximise – C(x) – Tx • Foc: C’(x)=–T • If –T = D’(x*) = ∑iD’i(x*) . Then optimal x is achieved in a market economy. • Firm pays Tx* in total taxes

5. Pigouvian Fee – The Subsidy Case • Regulator selects a subsidy S • Firms maximise S(xM–x) – C(x) • Foc: C’(x)=–S • If –S = D’(x*) = ∑iD’i(x*) . Then optimal x is achieved in a market economy. • Firm Receive S(xM–x*) in total subsidies

6. Insights: • Efficiency can be achieved both through pollution taxes and pollution reduction subsidies. • Again there are distributional issues involved. • The choice of whether to choose taxes or subsidies depend on: • How we feel about distribution • What does the most damage to the rest of the economy • A tax reduces the need for taxation in the rest of the economy (Good) • A subsidy requires a tax somewhere else (bad)

7. But wait – There is more to this • Briefly – The choice between taxes ond subsidies also affect entry/exit decisions in the market. • A subsidy may lead to firms staying in the market that really should be allowed to go bust.

8. Imperfect competition and Pigouvian fees • With imperfect competition a badly set fee may make things worse. • If a tax is set at marginal damage, then the monopolist makes the consumers carry some of the taxation burden and reduce output ”too much.”

9. Chapter 8 Regulation Assessing regulatory regimes

10. Different approaches to Pollution Control • Command and Control. The government directly fixes: • Outputs • Pollution quotas • Technology choice • Market oriented approach. The government sets incentives by affecting prices

11. Pros and Cons of different Approaches • Command and Control introduces weak incentives for altering behaviour. • Market incentives are decentralised. Firms can choose innovative ways of achieving their aims • The economics of information makes the choice of regime hard. Weitzman. Prices vs Quantities)

12. Chapter 9 Fees and Permits Complications

13. Spatial Issues • How to model efficiency when the damage is emission location specific? • A physical model of emission transportation is required. • For instance if there are n polluters and m areas affected, and the fraction of pollution from i that ends up in j is aij, then we must specify this e.g. by y = Ax where A is a m×n matrix with elements aij.

14. Example – Acid Rain • Min ∑iCi(xi) subject to Ax = y y* • Gives rise to FOC: Ci’(xi) = ∑ji aij. • The optimal marginal cost is therefore location specific.

15. Emission trading – a market based approach • n polluters pollute x=∑xi • Decouples efficiency and welfare maximisation. • How to choose x • Given x, how to choose xi • Two different questions. The first is hard, but emission trading makes the second easy

16. Emission trading • Efficient allocation of xi requires that C’i = Constant acorss different polluters. • If firms can trade emission quotas at a price q, then marginal costs are equalised. C’i = q for all i. • But this requires that there are no spatial problems. See brilliant article Førsund and Nævdal(1998) to see how emission trading can be done in a spatial context.