ECON 2100 TEST 2

Product Charge

- A unit charge or fee or tax, added to the price of a good whose production generates a negative externality - Induce firms to internalize the externality by taking account of the MEC (marginal external cost) into their production decisions.

Firm can reduce pollution at the source

- Change inputs - Change production process - Abate individual polluter's emissions

Benefit Cost Analysis (BCA)

A measure of the efficiency of an environmental regulation or program. •An analytical tool used extensively in environmental policy making •Compare benefits with costs over time •Involves comparison of alternative policies

Command-and-control (CAC) Approach

A policy that directly regulates polluters through standards.

Annuity and Perpetuity

Annuity - the same payment is made every year, for fixed number of years Perpetuity - an annuity is made in every year, forever!

Other applications include systems used to promote responsible disposal of used tires, car hulks, and lead-acid batteries.

In US, average bottle container recycle rate 33% • In the states with bottle bills, the rate is 77% MI has the highest recycling rate: 94%!!

rate of inflation

annual percentage increase

Firms are unlikely to undertake abatement on their own

- More cost - Less benefit

Coase theorem provides a private market solution

- Not a perfect solution - Assumptions don't hold in practice

After pollution presents in the environment

- Reduce victim's exposure to pollutants - Clean up pollutant in the environment

Regulator's problems

- Uncertainty • about the potential damage on human health or on environment • about the pollution sources - Consideration on fairness - Budget constraints - Require international cooperation - The practically policy objectives can vary (remember the three generally defined objectives we learned in chapter 1?)

Two Regulating criterion

1. Allocative efficiency criterion 2. Cost effectiveness criterion

Three Types of Environmental Standards

1. Ambient standard - a standard that designates the quality of the environment to be achieved, typically expressed as a maximum allowable pollutant concentration 2. Technology-based standard - a standard that designates the equipment or method to be used to achieve some abatement level 3. Performance-based standard - a standard that specifies a pollution limit to be achieved but does not stipulate the technology

Understand Marginal Social Costs of Abatement

1. An aggregation of the marginal costs of every polluter's abatement activities. 2. Government's marginal cost of monitoring and enforcing activities Represents society's marginal cost for improving the environmental quality.

Six Criteria Pollutants

1. Carbon monoxide 2. Nitrogen Dioxide 3. Sulfur Dioxide 4. Lead 5. Ozone 6. Particulate Matter

Two Approaches to solve environmental problems

1. Command-and-control (CAC) Approach 2. Market based incentive (MBI) Approach or Market Approach

Static allocative efficiency is hard to achieve in the reality

1. Legislative Constraints Legislatively some standards are set to improve society's well-being with no consideration for the associated cost. 2. Imperfect information Hard to quantify Social Benefits and/or Social Costs. Benefit: how to monetize intangibles? Cost: how to obtain each polluter's cost information? 3. Regional differences (example on next slide) Even if the efficiency is identified at the national level, it is not likely to be efficient at regional level. 4. Nonuniformity of pollutants Even within the same region, polluters are very likely to generate different amount of emissions. Besides polluters are at different distances from populations or ecosystems. So MSB would vary largely by locations.

Four major types of market instruments

1. Pollution charge 2. Subsidies 3. Deposit/refund systems 4. Pollution permit trading systems (cap and trade)

Cap and Trade has two key components

1. The issuance of some fixed number of permits on a pollutant in a region. The "Cap". 2. A provision of trading these permits among polluters within that region. The "Trade".

How the market works?

1.Permit Trading market will provide the market mechanism for polluters to figure out the best way to save costs by either selling or buying permits! 2.The government does not have to set up a standard, nor have to impose a tax. Their job is just to maintain a good market place! 3.At the end, a cost-effective solution is obtained: when the MAC1 = MAC2 the same EquimarginalPrinciple of Cost effectiveness -Just this time it is achieved by private behavior from polluters in a market!

Pollution Charge

A fee charged to the polluter that varies with the quantity of pollutants released. - Based on "Polluter-Pays Principle". - Internalize the cost of environmental damages by pricing the pollution-generating activity. • Two types of Pollution charges (fees) - Product charge (is also called a Pigouvian Tax) - Emission charge (is also called a Effluent charge)

Real value

A magnitude adjusted for the effects of inflation 𝑅𝑒𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑥=(𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑥+𝑡)/(1+𝑝)^𝑡

Nominal value

A magnitude stated in terms of the current period 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑥+𝑡=𝑅𝑒𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑥(1+𝑝)𝑡

Area of a trapezoid

A=(a+b)*1/2*h

Market based incentive (MBI) Approach or Market Approach

An incentive-based policy to motivate abatement and conservation with market forces.

Understand Marginal Social Benefits of Abatement

As pollution is abated, the social gains are all the benefits associated with a cleaner environment. • Improvement in health, ecosystem, aesthetics, and property It is equally correct to think MSB of abatement as the reduction in damages or costs caused by pollution (i.e., reduction in MEC of pollution) Represents society's willingness to pay for the environmental quality.

BCR's importance

BCR is useful when NPVs from multiple projects are the same.

All three CAC standards are imposed uniformly across groups of polluting sources.

By definition, these standards potentially prevent firms from selecting and using the least-cost abatement method. As long as the abatement cost conditions differ among polluters, the use of uniform standards will waste economic resources

deflating

Converting a nominal value to its real value

Deposit/Refund in Practice

Deposit/refund systems are used worldwide. - Many nations use these systems to encourage proper disposal of beverage containers.

BCR's major shortcoming

Dilemma: one project has two different BCRs! NPV does give consistent results.

Government as regulator

Environmental protection is still a major government function. • How should government approach an environmental problem?

Subsidies in Practice

Environmental subsidies typically are implemented as grants, low-interest loans, tax credits or exemptions, and rebates in the reality.

Compounding

FV(t) = PV(1+ r)^(t)

Cost effectiveness criterion

If the 'Optimality' is too hard to get, the second-best option is 'Cost effectiveness'. • In most real-world settings, the chance of finding and reaching the efficient abatement is low or the expense of finding it is too high.

Dynamic Efficiency.

If the allocation of public goods across n time periods, we need to maximize the Dynamic Efficiency.

Example: Groundwater nitrate contamination

If the objective is to make all places achieve same groundwater quality; or if the goal is to protect human health; policies could be quite different.

Subsidy (Pigouvian Subsidy)

Instead of punish polluters who pollute, • Rewards polluters who do NOT pollute or can reduce emission. Two major types of subsidies:

Real interest rate

Interest rates adjusted for inflation

Nominal interest rate

Interest rates not adjusted

To achieve allocative efficiency

Maximize present value of net benefits for all periods, among all feasible alternatives.

Allocative efficiency criterion

Maximize the net benefits of abatement at where Marginal Social Benefit (MSB) of abatement equal Marginal Social Cost (MSC) of abatement in the society. - Benefits could be very difficult to identify and to quantify.

To achieve cost-effectiveness

Minimize present value of costs for all periods, among all feasible alternatives that can achieve a predetermined benefit level (not the allocative efficient level!).

Cost effectiveness criterion

Minimize the total costs of abatement at where Marginal Costs of Abatement are equalized among polluters. - Need to be technologically feasible.

Why need both NPV and BCR?

NVP: tells the absolute dollar value of net benefits. BCR: shows the net benefit in a 'per dollar of cost' format.

Private projects

Net Present Value is calculated by using market interest rate, which is decided by activities in the financial market

1+nr = (1+rr)(1+p)

Nominal interest rate = nr Inflation rate = p Real interest rate = rr

Benefit Cost Analysis (BCA)

Once Benefits and Costs in Environmental regulation are identified and estimated, then the estimates must be adjusted and compared in order to arrive at a decision.

Abatement equipment subsidy

Polluters get paid if install certain abating equipment.

Pollution reduction subsidy

Polluters get paid if reduce certain amount of emissions. Government pays the polluter a subsidy for every unit of pollution removed below some pre-established level of pollution (E)allowed cap

Single Polluter Case

Producer will choose the option with a lower cost. 1. Abate emission and pay MAC (marginal abatement cost) when MAC < T 2. Do not abate emission and pay the Tax when T < MAC

Adjustments

Purpose of these adjustments -Benefits and costs do not accrue to society at the same time -Benefits and costs often accrue in the future Two types of adjustments:

Benefit Cost Ratio

Ratio = PV of Benefits / PV of Costs •If BCR > 1 the policy is feasible. •If BCR < = 1, the policy is not feasible. An equivalent way is to check the Net present value: NPV = PV of Benefits - PV of Costs •If NPV > 0 the policy is feasible. •If NPV < = 0, the policy is not feasible.

Production Process Chain

Reduce individual Pollution at source After the pollutants are combined, it is hard to pinpoint the sources. Reduce combined Pollution From production to damage, regulation can intervene at different stages in the production chain.

Technology standards example

Scientists developed a new technology called "bioremediation", which relies on bacteria to consume waste materials.

total social benefits (TSB)

TSB= Shadowed Area below MSB curve = the trapezoid area

total social costs (TSC)

TSC = Shadowed Area below MSC

Static Efficiency

The allocation of public goods (environmental quality) where the net benefit is maximized. Net benefit is maximized when marginal social benefit equals marginal social cost.

BCA in practice

The difficulties: •Need judgmental calls in the practice. •Confront distributional issues. •Different discount rate can lead to very different conclusions. •Future benefits/costs involve great uncertainty. •Data may be incomplete, inaccurate, or unavailable. The policy making procedure in the reality involves more than just the benefits/costs with economic and environmental impacts. •Tradeoff between efficiency and equity •Election and Reelection consideration •Influenced by lobbyists

Pollution Permit Trading System

The establishment of a market for rights to pollute, using either credits or allowances. -Pollution credits: tradable permits issued for emitting below an established standard. -Pollution allowances: tradable permits that indicate the maximum level of pollution that may be released. -We will just use "Tradable permits" to make it simple. •It is also referred as the Cap and Trade policy. -Theoretically it is based on the Coase theorem

With a fixed amount of annuity, if other things stay constant....

The greater number of time periods of the cash flows, the higher present value. The lower interest rate, the higher present value.

Internal Rate of Return

The interest rate that make net present value (NPV) equals zero is called IRR

Present value determination cont

The procedure that discounts a future value into its present value by accounting for the opportunity cost of money.

Discounting

The reverse of compounding. How much money a person must invest now to achieve a specific value in the future? The interest rate used in discounting is called Discount rate PV=(FV)/(1+r)^(t)

Time Value of Money

Today's $1 does not worth the same as Tomorrow's $1. People prefer to receive benefits soon. • Money received now can be invested. • The later a benefit comes, the more likely that you will not live to receive it or less able to enjoy it.

Static Efficiency

When an allocation of resources satisfy the static allocative efficiency, it means that the net social benefit from that allocation is maximized.

Inflation correction

accounts for changes in the general price level (purchasing power)

CAC - Standards

are the fundamental basis of most environmental policies. setting standards follows a lengthy set of procedures involving scientific research and a series of formal reviews. - EPA develops and makes formal recommendations about how standards are defined - Standards are legislated by Congress - Standards then are monitored and enforced by EPA.

Social discount rate (Social interest rate)

discount rate used for public policy initiatives based on the social opportunity cost of funds.

Equimarginal principle of cost effectiveness

if each polluter were to abate to the point where the corresponding level of marginal abatement cost is equal across all polluters, the cost effectiveness is achieved!

Inflation rate

p=(CPIt+1)/(CPIt))-1 p is the inflation rate between period t and period t+1.

Secondary standard

protect other aspects of public welfare such as family wealth, provide protection against damage to animals, crops, vegetation, and buildings.

Primary standards

provide public health protection, including protecting the health of "sensitive" populations such as asthmatics, children, and the elderly.

Public projects

providing public goods, environmental protection or reduce pollution. Projects seek for benefits, but not necessarily profits. Nonmarket benefits should be included, market interest rate is not appropriate.

Market approach

refers to incentive-based (or marketbased) policy that encourages conservative practices or pollution reduction strategies

Cost effectiveness

requires the least amount of resources to achieve a certain objective.

Ambient (quality) standard

set legal ceilings (maximum) on the allowable concentration of the pollutant in the outdoor air over a specified time period. Has two levels:

Inflation Correction

the adjustments for movements in the general price level over time.

Ambient Quality

the concentration of a pollutant in the environment. Often measured by PPM (parts per million)

Inflation

the increase in the general level of prices for goods and services over time.

Regulator's Goal

the ultimate goal is to reduce the environmental damage.

Emission Charge

• A charge or fee or a tax, imposed directly on the actual discharge of pollution • Pricing the pollution (emission) instead of the product. • Government sets a fee and also an abatement standard at some "acceptable level" AST • Since producers know their Marginal Abatement Cost (MAC), they will make a cost-minimizing decision. - Choose either Tax or MAC, whichever is lower!

Deposit/Refund Systems

• A market instrument that imposes an up-front charge to pay for potential damages and refunds it back for returning a product for proper disposal or recycling. • Targets the potential polluters. • The deposit is intended to capture the external marginal cost of improper waste disposal in advance. - Preventive and Incentive

Abatement Equipment Subsidy cont.

• Defined as a payment aimed at lowering the cost of abatement technology. • Internalize the positive externality associated with the consumption of abatement equipment. • If the subsidy equals the marginal external benefit (MEB) at the social efficiency, it is called a Pigouvian subsidy.

When the environmental services (quality) are produced without tangible inputs, don't forget that our costs should be measured as the opportunity costs

• Preserving 5 miles of river = do NOT use the river for any usage = no tangible inputs costs • However the Opportunity costs of NOT using the river includes forgone opportunity for real estate development, or factory construction, or maybe just simply building a dam to generate hydro power

BCA in practice CONT

•Feasibility decision on one project. •Do it or not •Decide the order of many projects. •When multiple feasible projects compete with each other for the same funding, sorting out the projects becomes important. •Allocative efficiency or Cost effectiveness? •Decision on whether now or later on. •Uncertainty in future (estimate the probability of Benefits and Costs) •May want to wait to collect more information to make a better decision.

A reliable Benefit cost analysis depends on

•Good estimates of benefits and costs. Benefits: area under marginal benefit curve (i.e., marginal willingness to pay curve, demand curve) -Could be market good, could be non-market good Costs: include explicit costs and implicit costs -Such as opportunity cost, deadweight loss from tax distortion, adjustment for externality •A clearly defined baseline of not conducting any project. •A full range of possible alternatives. •A reasonable social discounting rate for time value.

Present value determination

•accounts for the opportunity cost of money