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  Economics Assignments | Expertsmind.com   1
Learning Outcomes
  Understand the concept of externalities and why in
   traditional economics they are considered to be a
   source of economic inefficiency
  Understand the policies to reduce emissions




                                                        2
Externalities & Inefficiency
                   An Externality is
An action by a producer or consumer which affects
 others in the community, but is not accounted for
                 in the market price.

 In traditional economics (informed by the ideas of
      Pigou) externalities are a source of economic
   inefficiency / market failure and a justification for
 government action in the form of taxes/fees/controls.

                                                           3
Externalities-taxonomy

  Externalities can arise in
  Consumption decisions
  Production decisions
 and can be either
  Positive (beneficial), or
  Negative (harmful).



                               4
Externalities & Inefficiency:
             The cows example
 There are 2 neighbouring farms: 1 produces cattle and
 the other crops. Cattle sometime stray into the
 neighbouring farm creating a negative external effect
 (namely crop loss).
Externalities & Inefficiency:
The traditional Pigovian analysis:
   Focuses on the costs and benefits of
   cattle production and argues for
   charges to be levied on the cattle
   producer that reflect the costs imposed
   on the crop producer. This would
   create a disincentive for cattle
   production.
Externalities & Inefficiency: Some basic
    concepts

 Marginal private cost (MC): Cattle producer’s direct
  costs of production when it increases output by one
  unit
 Marginal external cost (MEC): Cost imposed on the
  neighbouring farm when the cattle producer increases
  output by one unit
 Marginal social cost (MSC): Total marginal cost of the
  firm’s production activity; MSC = MC + MEC


                                                         7
Externalities & Inefficiency: more basic
    concepts

 Marginal private benefit = Reflected in the traditional
  demand curve, D
 Marginal external benefit (MEB): Benefit to
  individuals who are not part of the transaction
 Marginal social benefit (MSB): Total benefit to society
  => MSB = D + MEB




                                                       8
Negative Externalities & Inefficiency

 Firm’s profit-maximising/competitive output level:
    MR = MC
 Socially efficient/optimal level:
    MR = MSC; or
    MR = MC + MEC
 Because the cattle producer does not take into account
 MEC:
   OUTPUT is HIGHER than the efficient/optimal level




                                                           9
Negative Externalities & Inefficiency
   $
                                 MSC
                                       MC


                                       P=MR




                                       MEC



                   Optimal   Market     q
                   outcome   outcome


                                              10
Negative Externalities & Inefficiency
    $         MSB
        D



                                 MC


        MSB




               Optimal Market     q
               outcome outcome


                                        11
Pigou
 Suggested that the way to proceed is

1) Negative Externality – impose tax on firm equal to
   value of MEC – firms will then respond to
   MSC=MC+MEC and produce the optimal level

2) Positive Externality – provide subsidy equal to value
   of MEB – consumers will then make decisions based
   on MSB=D+MEB and consumer optimal level




                                                        12
Externalities & Inefficiency:
         The Coasian perspective

 The benefits of the activity associated with the
  externality should be weighed against the costs of
  the externality. Allocative efficiency will be
  fostered by allowing the cattle to stray if the value
  of the additional meat supplied to the market
  outweighs the value of the lost crops.
 There may not be a role for government via taxes
  or fees or direct regulation
The Coasian perspective
    $


                                    Damage
                                    caused
                                    (MEC)
        d
                        g


            e       f           Benefit to
                                firm
  a=0           b           c           pollutant
The Coasian perspective
 Pollution has benefits for firm
 Pollution cases damage
  Optimal level of pollution is where marginal
   value of damage = marginal value of benefit =
   level b
  Firm would like level c
  Consumers would like level a
The Coasian perspective
 IF there are no transaction costs, the operation of
  the price mechanism will achieve an efficient
  solution to the problem of externalities.
 If firm has property rights it will pollute to level
  c > b. Compared with b – damage of areas g+f,
  benefit of area f.
  So those adversely affected can pay the firm to
  reduce pollution to point b.
The Coasian perspective
 IF consumers have the property rights they will
 require pollution of level a=0. Compared with
 the optimal level of b – benefit from more
 pollution exceeds cost, or d+e > e.
 So firm could compensate consumers and
 pollute up to point b.
The Coasian perspective
 When transaction costs aren’t zero (and this is usually
  the case) then market processes won’t lead to efficient
  outcomes
 This creates an important role for the legal system and
  government in achieving economic efficiency
   The creation and enforcement of property rights is an
    alternative to taxes on production
   However, before any policy is introduced, its
    administrative and other costs should be weighed
    against the likely benefits
Application: policy on emissions

MSC of emissions:                      $ per unit of
 Social cost of each additional unit emission
  of emissions                                                MSC
 Upward-sloping function – the
  higher the level of emissions the
  higher the social cost
MCA (Marginal cost of abating
  emissions):
 Cost to firm of abating each
  additional unit of emissions
 Downward-sloping function –                                  MCA
  relatively easy to reduce emissions
  when they are high, but difficult to                 Emission level
  reduce to zero when they are                         (units)
  already low
                                                                 19
Application: Efficient Level of Emissions
       $ per unit of
       emission
                 MCA
                                  At E=10, MSC=MCA. This            MSC
                                  is the socially efficient
                                  level of emissions E*




           0    2     4       6      8    10     12    14     16    18   Emission level E
                                                                         (units)
At E=4, MSC<MCA so the               At E=14, MSC>MCA so the         If the firm is not required
firm can increase emissions          firm should be required to      to restrict emissions,
some more                            restrict emissions some more    E=18 units where MCA=0
                                                                                              20
Marginal Costs of Abatement
Dollars per unit of
emission                                 Are Likely to Vary Between Firms
                 Steep MCA                      Suppose emission level is
                                                abated by 1 unit (6 to 5 units)

                                                Steep MCA – Small changes in
                         B                      abatement add greatly to cost (A to B)

      Flat MCA                                Flat MCA – Small changes in abatement
                     C                        add very little to cost (A to C)

                                 A




  0       2      4           6       8   10    12      14      16      Emission level
                                                                       (units)
                                                                                         21
Marginal Benefits of Emissions
Dollars per unit of               Are likely to vary between different
emission                          industries.
                          Steep MSC             Suppose emission level is
                                                abated by 1 unit (6 to 5 units)


                                          Steep MSC – Small changes in abatement
                                          add greatly to benefits (A to B = great
                                          reduction in costs = great increase in
                                          benefits)

               C          A
                              Flat MSC        Flat MSC – Small changes in abatement
                                              add very little to benefits (A to C)

                  B




  0     2     4       6       8   10     12       14      16      Emission level
                                                                  (units)
                                                                                   22
Policies for Reducing Emissions
 Emissions standards
    Legal limit on emission level
                                                       Pigovian
 Emissions fees
    Charge levied on each unit of emission
 Transferable emission permits
    Government determines the socially
     efficient/optimal level of emissions – standard
     is set
    Government issues a number of permits that           Coasian
     will achieve this standard – fees have to be
     paid to purchase permits
    Permits are transferable among firms



                                                                  23
Policies for Reducing Emissions:
 How do we Evaluate each Option?
The best policy option will depend on:
 How the cost of abatement changes as emissions levels
  are reduced
 How the benefits of abatement change as emissions
  levels are reduced
 Whether the MCA of firms are similar or different
 What information is available or can be accurately
  determined



                                                     24
Policies for Reducing Emissions

Fees
Emission fee = charge levied on each unit of a
 firm’s emissions.
The emissions fee can be at a flat rate, or
 progressive



                                                 25
Policies for Reducing Emissions:
                    Suppose the government wants to reduce total
Fees                emissions by 16 units and impose a fee on each
                                  unit of emissions=$3
Dollars per unit of                              Scenario
emission                                         1. Flat MSC - Small changes in abatement
                      MCA1                       add very little to benefits (to simplify, assume
                                                 a horizontal MSC)
                                                 2. 2 firms, each with a different MCA (Firm 1 -
        MCA2                                     MCA1; Firm 2 - MCA2).

                                        Fee at F=$3
                                        Firm 1 (higher MCA) reduces emissions by 6 units
                                        Firm 2 (lower MCA) reduces emissions by 10 units
                                        Total = 16 units
  3




  0     2      4       6     8     10       12        14      16      Emission level
                                          Fees - Firm 1
                                                                      (units)
                                 Fees - Firm 2                                                26
Policies for Reducing Emissions

Standards
A standard is a legal limit on the emissions of
  a firm.
Significant monetary penalties are imposed if
  the legal limit is exceeded.



                                                  27
Policies for Reducing Emissions:
Standards
Dollars per unit of
emission
                      MCA1
                                         Scenario
                                         1. Flat MSC - Small changes in abatement
        MCA2                             add very little to benefits (to simplify, assume
                                         a horizontal MSC)
                                         2. 2 firms, each with a different MCA (Firm 1 -
                                         MCA1; Firm 2 - MCA2).




                                                          Standard at E=8 units
                                                          Both firms reduce emissions
                                 Standard - Firm 1&2      by 8 units each (total = 16)



  0     2      4       6     8   10     12      14     16     Emission level
                                                              (units)
                                                                                      28
Policies for Reducing Emissions

Comparing Standards & Fees
Objective: To reduce total emissions by 16
  units from the current level of 32 units.
Policy Alternatives:
1) Standards: A legal limit of 8 units per firm
2) Fees: A flat fee of $3 per unit of emissions.


                                                   29
Policies for Reducing Emissions:
                                                          Scenario
The Case for Standards over Fees                          1. Flat MCA – Small changes in
                                                          abatement add little to costs
                                          MSC             2. Steep MSC – Small changes in
                                                          abatement add greatly to benefits
                                      C                   3. All firms have identical MCA
                                                     Optimal fee is $8
Fee per unit of
emission                                              What if the fee is wrongly set at F=$7
                              E                       (12.5% error)?
        MCA
  10                                                 ABC is the net social cost caused by the
                                                     error
                          A
  8                                                       Optimal standard is E*=8.
                                           B
                                  D                       What if the standard is wrongly set
  6                                                       at E=9 units (12.5% error)?

                                                          ADE is the net social cost caused
  4                                                       by the error


  2                                                                         ADE<ABC

  0      2        4   6   8           10        12       14      16      Emission level (units)
                                                                                              30
Policies for Reducing Emissions:
The Case for Standards over Fees
      Standards are preferable over fees when …
      1. When the MCA curve is flat (Small changes
      in abatement add very little to costs)
      2. When the MSC curve is steep (Small changes
      in abatement add greatly to benefits)
      3. Firms have the same/similar MCA
      4. When you are more concerned about the
      reduction in emissions (set standard at 8 units
      in this case) than with the cost of abatement
      when there is general uncertainty
Policies for Reducing Emissions:
The Case for Fees over Standards
Dollars per unit of                   Fee at $3
emission                              Cost-minimising: emissions are reduced to the
                                      required level at a cost of $3 per unit
                      MCA1
                                      – Firm 1 (higher MCA) reduces less emissions
                                      – Firm 2 (lower MCA) reduces more emissions
        MCA2

                                                           Standard at E=8 units
4.5                                                        Achieves the same
                                                           reduction in emissions but
                                                           at a higher cost:
                                                           – Firm 1 incurs costs=$4.5
  3
                                                           per unit to move from 10 to
                                                           8
  2                                                        – Firm 2 would incur a cost
                                                           of only $1 per unit to move
                                                           from 8 to 6


  0     2      4       6     8   10     12     14     16     Emission level
                                                             (units)
                                                                                      32
Policies for Reducing Emissions:
The Case for Fees over Standards
      Fees are preferable over Standards when …
      1. Firm have different MCAs => Achieve same
         reduction in emissions as standards at
         lower cost
      2. When the MCA curve is steep (Small
         changes in abatement add greatly to
         costs)
      3. When the MSC curve is flat (Small changes
         in abatement add very little to benefits)
Policies for Reducing Emissions:
The Case for Fees over Standards
      Fees are preferable over Standards when …
      4. When you want to give firms an incentive
         to install new equipment to reduce
         emissions
      5. When the cost of abatement is a more
         important consideration than the reduction
         in emissions that is achieved when there is
         general uncertainty
Policies for Reducing Emissions:
Transferable Permits
 Transferable permits grant property rights over emissions.
  The policy maker must decide on the total level of
  emissions and ensure that sufficient numbers of permits
  are issued to achieve the efficient emission level
 They are preferable when…
   The values of the MCA or MSC are uncertain
   The MCA of firms are different
        Firms with high MCA will purchase permits from firms with low
         MCA – results in cost minimisation (similar to fees)
   Transaction costs are low (e.g. Permits can be traded)



                                                                         35
Policies for Reducing Emissions: The Case
for Transferable Permits
In the case of both fees and standards, we need to know:
 The benefits of abatement (MSC)
 The costs of abatement (MCA)
 The cow example:
   MSC or benefit of abatement is equivalent to the value
    to the crop producer of using the land
   MCA is the cost borne by the cattle producer if it
    reduces its use of the land
   To achieve an efficient outcome using fees or standards
    the policy maker would need to know the MCA and
    MSC

                                                          36
Policies for Reducing Emissions: The Case
for Transferable Permits
 In an transferrable permits system the producers may
  be allocated permits relating to the use of the land.

 They can trade these according to the value they place
  on the land

 If there are no transaction costs this should result in
  an efficient use of the resource/ level of “emissions”
 The policy maker doesn’t need detailed knowledge of
  MCA and MSC
                                                            37
Application: Transferable Permits

Imagine there are only 2 firms in the local
area.

The government has decided on the total
level of pollution for the area=11,000 units of
emissions and plans release this number of
permits




                                                  38
Application: Transferable Permits
Firm A has a strong demand for the permits
(Qd=10,000-10P)

Firm B’s demand is weaker (Qd=10,000-20P)

Total ‘market’ demand for permits is the sum of
individual demand (Qd=20,000-30P)

The price of permits will be determined where
supply=demand ($300)


                                                  39
Application: Transferable Permits
•At the market price:
     •Firm A’s demand for permits will be 7000:


    •Firm B’s demand for permits will be 4000

•If the government initially allocated the firms an
equal number of permits each (5,500), trading in
permits is likely to occur between the firms

•Similar to fees, differences in emissions will occur
between firms according to their costs of abatement




                                                        40
Learning Outcomes
  Understand the concept of externalities and why
   they are a source of economic inefficiency
    Positive externalities
    Negative externalities
  Policies to reduce emissions
    Emission standards
    Emission fees
    Transferable emission permits




                                                     41
A Past Exam Question on Externalities
   a) Compare and contrast the following three
    mechanisms for treating pollution externalities
    when the costs and benefits of abatement are
    uncertain: (i) an emissions fee, (ii) an emissions
    standard, and (iii) a system of transferable
    emissions permits. (15 marks)




                                                         42
A Past Exam Question                          Given the question is 15 marks you
                                               should attempt to draw diagrams
on Externalities                                     to get the full marks

             Fees                 Standards           Transferable permits

                Charge levied      Legal limit         Level of emissions
                on each unit of    on emission         specified; marketable
Define          emission           level               permits allocated among
                                                       firms; firms with high
                                                       MCA purchase permits
                                                       from firms with low MCA
         When small changes       When small changes When both cost and
The case in abatement add         in abatement add    benefits are uncertain
for…     greatly to costs and     little to costs and
         little to benefits       greatly to benefits
              When firms have      When firms have        When firms have
              varying MCA          identical MCA          varying MCA
Need to      Value of MCA &        Value of MCA &        Total level of
know ...     MSC                   MSC                   emissions

Conclusion     Among the 3 options, transferable permits are the best
               solution when costs and benefits are uncertain
                                                                                 43

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Externalities and inefficiency | Microeconomics | Expertsmind.com

  • 1. www.Expertsmind.com Economics Assignments | Expertsmind.com 1
  • 2. Learning Outcomes  Understand the concept of externalities and why in traditional economics they are considered to be a source of economic inefficiency  Understand the policies to reduce emissions 2
  • 3. Externalities & Inefficiency An Externality is An action by a producer or consumer which affects others in the community, but is not accounted for in the market price. In traditional economics (informed by the ideas of Pigou) externalities are a source of economic inefficiency / market failure and a justification for government action in the form of taxes/fees/controls. 3
  • 4. Externalities-taxonomy Externalities can arise in  Consumption decisions  Production decisions and can be either  Positive (beneficial), or  Negative (harmful). 4
  • 5. Externalities & Inefficiency: The cows example  There are 2 neighbouring farms: 1 produces cattle and the other crops. Cattle sometime stray into the neighbouring farm creating a negative external effect (namely crop loss).
  • 6. Externalities & Inefficiency: The traditional Pigovian analysis:  Focuses on the costs and benefits of cattle production and argues for charges to be levied on the cattle producer that reflect the costs imposed on the crop producer. This would create a disincentive for cattle production.
  • 7. Externalities & Inefficiency: Some basic concepts  Marginal private cost (MC): Cattle producer’s direct costs of production when it increases output by one unit  Marginal external cost (MEC): Cost imposed on the neighbouring farm when the cattle producer increases output by one unit  Marginal social cost (MSC): Total marginal cost of the firm’s production activity; MSC = MC + MEC 7
  • 8. Externalities & Inefficiency: more basic concepts  Marginal private benefit = Reflected in the traditional demand curve, D  Marginal external benefit (MEB): Benefit to individuals who are not part of the transaction  Marginal social benefit (MSB): Total benefit to society => MSB = D + MEB 8
  • 9. Negative Externalities & Inefficiency  Firm’s profit-maximising/competitive output level:  MR = MC  Socially efficient/optimal level:  MR = MSC; or  MR = MC + MEC  Because the cattle producer does not take into account MEC:  OUTPUT is HIGHER than the efficient/optimal level 9
  • 10. Negative Externalities & Inefficiency $ MSC MC P=MR MEC Optimal Market q outcome outcome 10
  • 11. Negative Externalities & Inefficiency $ MSB D MC MSB Optimal Market q outcome outcome 11
  • 12. Pigou Suggested that the way to proceed is 1) Negative Externality – impose tax on firm equal to value of MEC – firms will then respond to MSC=MC+MEC and produce the optimal level 2) Positive Externality – provide subsidy equal to value of MEB – consumers will then make decisions based on MSB=D+MEB and consumer optimal level 12
  • 13. Externalities & Inefficiency: The Coasian perspective  The benefits of the activity associated with the externality should be weighed against the costs of the externality. Allocative efficiency will be fostered by allowing the cattle to stray if the value of the additional meat supplied to the market outweighs the value of the lost crops.  There may not be a role for government via taxes or fees or direct regulation
  • 14. The Coasian perspective $ Damage caused (MEC) d g e f Benefit to firm a=0 b c pollutant
  • 15. The Coasian perspective  Pollution has benefits for firm  Pollution cases damage Optimal level of pollution is where marginal value of damage = marginal value of benefit = level b Firm would like level c Consumers would like level a
  • 16. The Coasian perspective  IF there are no transaction costs, the operation of the price mechanism will achieve an efficient solution to the problem of externalities.  If firm has property rights it will pollute to level c > b. Compared with b – damage of areas g+f, benefit of area f. So those adversely affected can pay the firm to reduce pollution to point b.
  • 17. The Coasian perspective  IF consumers have the property rights they will require pollution of level a=0. Compared with the optimal level of b – benefit from more pollution exceeds cost, or d+e > e. So firm could compensate consumers and pollute up to point b.
  • 18. The Coasian perspective  When transaction costs aren’t zero (and this is usually the case) then market processes won’t lead to efficient outcomes  This creates an important role for the legal system and government in achieving economic efficiency  The creation and enforcement of property rights is an alternative to taxes on production  However, before any policy is introduced, its administrative and other costs should be weighed against the likely benefits
  • 19. Application: policy on emissions MSC of emissions: $ per unit of  Social cost of each additional unit emission of emissions MSC  Upward-sloping function – the higher the level of emissions the higher the social cost MCA (Marginal cost of abating emissions):  Cost to firm of abating each additional unit of emissions  Downward-sloping function – MCA relatively easy to reduce emissions when they are high, but difficult to Emission level reduce to zero when they are (units) already low 19
  • 20. Application: Efficient Level of Emissions $ per unit of emission MCA At E=10, MSC=MCA. This MSC is the socially efficient level of emissions E* 0 2 4 6 8 10 12 14 16 18 Emission level E (units) At E=4, MSC<MCA so the At E=14, MSC>MCA so the If the firm is not required firm can increase emissions firm should be required to to restrict emissions, some more restrict emissions some more E=18 units where MCA=0 20
  • 21. Marginal Costs of Abatement Dollars per unit of emission Are Likely to Vary Between Firms Steep MCA Suppose emission level is abated by 1 unit (6 to 5 units) Steep MCA – Small changes in B abatement add greatly to cost (A to B) Flat MCA Flat MCA – Small changes in abatement C add very little to cost (A to C) A 0 2 4 6 8 10 12 14 16 Emission level (units) 21
  • 22. Marginal Benefits of Emissions Dollars per unit of Are likely to vary between different emission industries. Steep MSC Suppose emission level is abated by 1 unit (6 to 5 units) Steep MSC – Small changes in abatement add greatly to benefits (A to B = great reduction in costs = great increase in benefits) C A Flat MSC Flat MSC – Small changes in abatement add very little to benefits (A to C) B 0 2 4 6 8 10 12 14 16 Emission level (units) 22
  • 23. Policies for Reducing Emissions  Emissions standards  Legal limit on emission level Pigovian  Emissions fees  Charge levied on each unit of emission  Transferable emission permits  Government determines the socially efficient/optimal level of emissions – standard is set  Government issues a number of permits that Coasian will achieve this standard – fees have to be paid to purchase permits  Permits are transferable among firms 23
  • 24. Policies for Reducing Emissions: How do we Evaluate each Option? The best policy option will depend on:  How the cost of abatement changes as emissions levels are reduced  How the benefits of abatement change as emissions levels are reduced  Whether the MCA of firms are similar or different  What information is available or can be accurately determined 24
  • 25. Policies for Reducing Emissions Fees Emission fee = charge levied on each unit of a firm’s emissions. The emissions fee can be at a flat rate, or progressive 25
  • 26. Policies for Reducing Emissions: Suppose the government wants to reduce total Fees emissions by 16 units and impose a fee on each unit of emissions=$3 Dollars per unit of Scenario emission 1. Flat MSC - Small changes in abatement MCA1 add very little to benefits (to simplify, assume a horizontal MSC) 2. 2 firms, each with a different MCA (Firm 1 - MCA2 MCA1; Firm 2 - MCA2). Fee at F=$3 Firm 1 (higher MCA) reduces emissions by 6 units Firm 2 (lower MCA) reduces emissions by 10 units Total = 16 units 3 0 2 4 6 8 10 12 14 16 Emission level Fees - Firm 1 (units) Fees - Firm 2 26
  • 27. Policies for Reducing Emissions Standards A standard is a legal limit on the emissions of a firm. Significant monetary penalties are imposed if the legal limit is exceeded. 27
  • 28. Policies for Reducing Emissions: Standards Dollars per unit of emission MCA1 Scenario 1. Flat MSC - Small changes in abatement MCA2 add very little to benefits (to simplify, assume a horizontal MSC) 2. 2 firms, each with a different MCA (Firm 1 - MCA1; Firm 2 - MCA2). Standard at E=8 units Both firms reduce emissions Standard - Firm 1&2 by 8 units each (total = 16) 0 2 4 6 8 10 12 14 16 Emission level (units) 28
  • 29. Policies for Reducing Emissions Comparing Standards & Fees Objective: To reduce total emissions by 16 units from the current level of 32 units. Policy Alternatives: 1) Standards: A legal limit of 8 units per firm 2) Fees: A flat fee of $3 per unit of emissions. 29
  • 30. Policies for Reducing Emissions: Scenario The Case for Standards over Fees 1. Flat MCA – Small changes in abatement add little to costs MSC 2. Steep MSC – Small changes in abatement add greatly to benefits C 3. All firms have identical MCA Optimal fee is $8 Fee per unit of emission What if the fee is wrongly set at F=$7 E (12.5% error)? MCA 10 ABC is the net social cost caused by the error A 8 Optimal standard is E*=8. B D What if the standard is wrongly set 6 at E=9 units (12.5% error)? ADE is the net social cost caused 4 by the error 2 ADE<ABC 0 2 4 6 8 10 12 14 16 Emission level (units) 30
  • 31. Policies for Reducing Emissions: The Case for Standards over Fees Standards are preferable over fees when … 1. When the MCA curve is flat (Small changes in abatement add very little to costs) 2. When the MSC curve is steep (Small changes in abatement add greatly to benefits) 3. Firms have the same/similar MCA 4. When you are more concerned about the reduction in emissions (set standard at 8 units in this case) than with the cost of abatement when there is general uncertainty
  • 32. Policies for Reducing Emissions: The Case for Fees over Standards Dollars per unit of Fee at $3 emission Cost-minimising: emissions are reduced to the required level at a cost of $3 per unit MCA1 – Firm 1 (higher MCA) reduces less emissions – Firm 2 (lower MCA) reduces more emissions MCA2 Standard at E=8 units 4.5 Achieves the same reduction in emissions but at a higher cost: – Firm 1 incurs costs=$4.5 3 per unit to move from 10 to 8 2 – Firm 2 would incur a cost of only $1 per unit to move from 8 to 6 0 2 4 6 8 10 12 14 16 Emission level (units) 32
  • 33. Policies for Reducing Emissions: The Case for Fees over Standards Fees are preferable over Standards when … 1. Firm have different MCAs => Achieve same reduction in emissions as standards at lower cost 2. When the MCA curve is steep (Small changes in abatement add greatly to costs) 3. When the MSC curve is flat (Small changes in abatement add very little to benefits)
  • 34. Policies for Reducing Emissions: The Case for Fees over Standards Fees are preferable over Standards when … 4. When you want to give firms an incentive to install new equipment to reduce emissions 5. When the cost of abatement is a more important consideration than the reduction in emissions that is achieved when there is general uncertainty
  • 35. Policies for Reducing Emissions: Transferable Permits  Transferable permits grant property rights over emissions. The policy maker must decide on the total level of emissions and ensure that sufficient numbers of permits are issued to achieve the efficient emission level  They are preferable when…  The values of the MCA or MSC are uncertain  The MCA of firms are different  Firms with high MCA will purchase permits from firms with low MCA – results in cost minimisation (similar to fees)  Transaction costs are low (e.g. Permits can be traded) 35
  • 36. Policies for Reducing Emissions: The Case for Transferable Permits In the case of both fees and standards, we need to know:  The benefits of abatement (MSC)  The costs of abatement (MCA)  The cow example:  MSC or benefit of abatement is equivalent to the value to the crop producer of using the land  MCA is the cost borne by the cattle producer if it reduces its use of the land  To achieve an efficient outcome using fees or standards the policy maker would need to know the MCA and MSC 36
  • 37. Policies for Reducing Emissions: The Case for Transferable Permits  In an transferrable permits system the producers may be allocated permits relating to the use of the land.  They can trade these according to the value they place on the land  If there are no transaction costs this should result in an efficient use of the resource/ level of “emissions”  The policy maker doesn’t need detailed knowledge of MCA and MSC 37
  • 38. Application: Transferable Permits Imagine there are only 2 firms in the local area. The government has decided on the total level of pollution for the area=11,000 units of emissions and plans release this number of permits 38
  • 39. Application: Transferable Permits Firm A has a strong demand for the permits (Qd=10,000-10P) Firm B’s demand is weaker (Qd=10,000-20P) Total ‘market’ demand for permits is the sum of individual demand (Qd=20,000-30P) The price of permits will be determined where supply=demand ($300) 39
  • 40. Application: Transferable Permits •At the market price: •Firm A’s demand for permits will be 7000: •Firm B’s demand for permits will be 4000 •If the government initially allocated the firms an equal number of permits each (5,500), trading in permits is likely to occur between the firms •Similar to fees, differences in emissions will occur between firms according to their costs of abatement 40
  • 41. Learning Outcomes  Understand the concept of externalities and why they are a source of economic inefficiency  Positive externalities  Negative externalities  Policies to reduce emissions  Emission standards  Emission fees  Transferable emission permits 41
  • 42. A Past Exam Question on Externalities  a) Compare and contrast the following three mechanisms for treating pollution externalities when the costs and benefits of abatement are uncertain: (i) an emissions fee, (ii) an emissions standard, and (iii) a system of transferable emissions permits. (15 marks) 42
  • 43. A Past Exam Question Given the question is 15 marks you should attempt to draw diagrams on Externalities to get the full marks Fees Standards Transferable permits Charge levied Legal limit Level of emissions on each unit of on emission specified; marketable Define emission level permits allocated among firms; firms with high MCA purchase permits from firms with low MCA When small changes When small changes When both cost and The case in abatement add in abatement add benefits are uncertain for… greatly to costs and little to costs and little to benefits greatly to benefits When firms have When firms have When firms have varying MCA identical MCA varying MCA Need to Value of MCA & Value of MCA & Total level of know ... MSC MSC emissions Conclusion Among the 3 options, transferable permits are the best solution when costs and benefits are uncertain 43

Editor's Notes

  1. The fee may be wrongly set due to political economy reasons – difficult to get parties to pay high fees.