Pigouvian fees Making Prices Work for the Environment

Chapter 7 Pigouvian FeesMaking Prices Work for the Environment... The Welfare Economic Point of Prices • Market prices should reflect marginal cost of production and marginal willingness

Chapter 7 Pigouvian Fees

Making Prices Work for the

Environment

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)

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

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

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

• 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)

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

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.”

Chapter 8 Regulation

Assessing regulatory regimes

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

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)

Chapter 9 Fees and Permits

Complications

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 a ij, then we must specify this e.g by y = Ax where A is a

m×n matrix with elements a ij

Example – Acid Rain

• Min ∑iCi(xi) subject to Ax = y y*

• Gives rise to FOC: Ci’(xi) = ∑ji a ij

• The optimal marginal cost is therefore location specific

Emission trading – a market based

approach

• n polluters pollute x=∑x i

• Decouples efficiency and welfare

maximisation

– How to choose x

– Given x, how to choose x i

• Two different questions The first is hard, but emission trading makes the second

easy

Emission trading

• Efficient allocation of x i 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