PPPM 415 Externalities and the Environment Part 2

Cap and Trade Allocation End Result/Summary

-Allocation: -The end result, in terms of how many emissions are produced by each firm, will be the same regardless of initial allocation. -Between firm payments, however, will depend on intial allocation. -Firms benefit from having more allowances given to them. -Takeaway: Cap-and-trade leads to lower costs relative to a quantity regulation.

Tax vs. Cap and Trade

-At least on surface, Pigouvian tax and cap-and-trade lead to very similar incentives for firms -Price under Pigouvian tax: the tax -Optimal tax: set tax=marginal damages -Price under cap and trade: the price of an allowance -optimal cap and trade: -Set cap such that marginal abatement cost = marginal damages -After trading: Marginal abatement cost = market price of an allowance -These two conditions imply: Price of allowance = marginal damages So price under Pigouvian tax = price under cap-and-trade -Assuming optimal design and complete knowledge by policymakers (more on this upcoming)

Tradeable permits based on what ideas

-Based on Coase's idea that parties can trade with one another to come to an acceptable level of externalities.

Pigouvian subsidy

-Corrective subsidy -Impose on producers of positive externalities -increases output If subsidy equals the marginal external benefit, then the steel firm will increase production to the socially optimal level.

Placing a price on pollution

-Creates incentive to find new, inexpensive ways reduce emissions -Can sell your allowances if you find a way to cut pollution

Firms are allowed to buy and sell permits according to their needs.

-Firms with high benefit of polluting (or high cost of cleaning up) can buy more permits -Firms with low benefit of polluting (or low cost of cleaning up), they can sell permits -Market transactions guarantee that MC=MB of pollution

Regulate a level of Pollution P

-Need to know both the Social Marginal Benefit (SMB) of pollution reduction and the Social Marginal Cost (SMC) of pollution reduction.

Tradeable Permits-Advantages

-Pollution reduced in lowest-cost manner: Those who can reduce emissions at low cost have incentive to do so and sell their allowances to others. -Enforcement tasks are similar to those for regulatory standards; estimates and spot checks sufficient. -Additional task--keeping track of coupon trades -Mechanism for pollution reduction: government (or other groups) can reduce number of permits available by buying them up. -Permits are favored by environmentalists (compared to taxes_; they specify quantity of pollution reduction.

When allowing trading (i.e. use of an emissions market), :

-Pollutions cuts are made by firms that can do so most inexpensively -Firms that can cheaply cut pollution sell their allowances on the market to firms that find it expensive to reduce their own emissions.

To achieve optimal pollution level P

-Set a tax on pollution (or pay a subsidy for pollution reduction) -Need to know the Social Marginal Benefit of pollution reduction (size of the externality or the Marginal Damage); this equals the tax.

Tax vs. Cap and Trade continued

-Under either system, firms will cut back on emissions until it is more expensive to cut back than it is to pay to release emissions Again: -In tax system, firms "pay" by paying a tax -In cap-and-trade system, firms "pay" by buying anallowance -If two systems have same "price" (which theyshould, if designed appropriately), then firms will react similarly to both.

Pigouvian tax

-corrective tax -lower output -Reduces deadweight loss -If tax equals the marginal damage from producing steel: steel firm will reduce output to the socially optimal level.

Tax vs. cap and trade big takeaway

A big takeaway: -If cap-and-trade and a Pigouvian tax are designed perfectly and policy makers have complete knowledge of costs and benefits of reducing pollution, then: -In terms of overall pollution control costs and environmental effects, cap and trade and tax are identical. -Both approaches lead to least-cost pollution control

Tradeable permits: Firms are initially

Allocated permits for polluting

Trading is better because

As with a tax, trading is better than quantity regulation because it achieves pollution reduction at lower cost.

Tradeable Permits: Allocation Issues

Can be allocated: -To existing polluters for free (grandfathering in), in based: -Existing levels of emissions -Random lottery -Other eligibility criteria -By auction to highest bidders (public receives proceeds) -Can be allocated to shareholders in some other fashion Efficiency of system does not depend on initial allocation -Permit allocation can address distributional issues without affecting efficiency Determining initial allocation has been major source of conflict -It is an allocation of property rights -Grandfathered permits create windfall gains for shareholders (who are concentrated in high-income groups) -If you don't grandfather in existing producers, you take away an asset that they previously 'owned'.

Questions to ask when choosing between taxes and regulations

Critical to account for different information requirements and transactions costs associated with different policies: -How much information is needed to set an efficient level of a tax vs. an efficient level of a regulation? -What does it take to determine compliance with rules and regulations versus quantities on which taxes and subsidies depend? -How effective will mandates be vs. incentives? -Does the design of a tax or regulation depend on technical knowledge or information that will change and need to be reassessed? How hard will it be to reassess it? -Politically feasibility - regulations may appear to be more even handed than taxes.

iclicker quiz: True or False: The socially optimal level of production is the quantity that sets social marginal costs equal to social marginal benefits

False: SMC=SMB-economically optimal but not socially optimal If no externality: SMC=PMC + Ex. (0) SMC=PMC Same for benefit: SMB=PMB +Ex. (0)

Quantity regulation

Government can impose quantity regulation, rather than relying on the price mechanism

Policies to address positive externality

Subsidy Quantity regulation Command-and-control Goal: More production of the good

Policies to address negative externality

Tax quantity regulation (command-and-control) Cap-and-control Goal: less production of good

Tradeable permits provide

a market and quantity based policy instrument

Markets lead to socially optimal outcomes

absent of externalities

Tradeable permits: Total number of permits equals

amount of pollution desired by society.

When externalities are present, governmental policies

necessary to achieve the optimal outcomeP