Eco 615 Graphs, Tables, and Definitions

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Eco 615 Graphs, Tables, and Definitions

David L. Kelly1

1Department of Economics, University of Miami

[email protected]

Fall, 2020

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Introduction

Introduction

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Legal Framework

Legal framework: students learn the legal requirements,constitutional issues, and the legislative process.

The firm must maintain a minimum wage of $15 per hour.

CAFE standards: average fuel economy for all light truckswith footprint (wheelbase times track width) less than 41square feet sold by a manufacturer in the year must be atleast 38.15 miles per gallon.

Is carbon covered under the Clean Air Act?

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Economic Framework

How the firm complies with regulation is a strategic decision,as each regulation creates a set of economic incentives thatthe firm responds to.

Definition 1

Managing Regulation Compliance: how regulation changesincentives at the firm and how the firm responds.

Definition 2

Economics is the study of the allocation of scarce resources.

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Minimum wage: Reduce the size of the low skill workforce(perhaps through automation) and/or pay existing workershigher wages? Should the firm reduce health care benefits anduse that money to increase wages?

CAFE Standards: Fuel economy improves by loweringweight. Consumers prefer heavier vehicles. Should the firmraise prices of heavier vehicles to deter purchase of low MPGcars? Should the firm change the size of the wheel base tomake the standard easier to attain? Should the firm innovate?Should the firm merge with another firm that has a betteraverage?

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Sustainability

Regulation often increases the incentives for firms to besustainable.

Definition 3

Sustainability: Meeting the needs of the present withoutcompromising future generations ability to meet their needs.

Definition 4

Sustainable Business: Voluntary actions taken by firms whichcreate social/environmental benefits while at the same timebenefiting the firm.

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Examples

Minimum wage:

Since other firms must raise their wage, the firm has anincentive to raise it’s wage as well, to maintain a reputationthat it is doing more than the minimum.The cost of becoming sustainable rises, given the higher wage.If sustainability program provides health insurance to workers,minimum wage creates an incentive to reduce health insurancecontributions, to keep total compensation down.

CAFE Standards:

Exceed minimum fuel economy standard, earns credits whichcan be sold.Car sales are unpredictable. Exceeding the minimum reducesthe likelihood of accidentally missing the standard.

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Increasing Marginal Cost

Minimum Wage:

A few low skill workers could be replaced via automation orself service at relatively low cost. More complex jobs requireexpensive machines.The cost raising the wage of low skill workers by $1 is $1.However, this dollar has to be obtained from some otheralternative use in the firm. At first, it is easy to find smallamount of money which are not being used efficiently at thefirm. But as the wage rises, the firm must obtain more dollarsfrom valuable alternative uses.

CAFE Standards: The cost of achieving an average level offuel economy increases with the level of fuel economy.

Small improvements in fuel economy can be obtained by usingsmaller tires.Higher levels of fuel economy require more expensive additions,such as turbo chargers and hybrid engines with regenerativebrakes.

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Opportunity Costs

Definition 5

Accounting Cost Costs that appear on an accounting statement.

Definition 6

Opportunity Cost Accounting costs plus the value of using inputsin their next best alternative.

Opportunity costs are higher than accounting costs.

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Marginal Costs

marginal costs: the cost of one additional unit of compliance(e.g. a higher wage or lower carbon emissions).

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Sustainability

1 Direct marginal costs associated with forgone opportunities,diverted labor, investment in new equipment, etc.

2 Marginal benefits by making the firm more attractive tosustainability minded consumers.

Greater product demand.Product differentiation.Market entry.

3 Marginal benefits in terms of lowering the firm’s cost ofcapital by making the company more attractive tosocially responsible investors.

4 Marginal benefits in terms of regulation incentives.

Tradeable Permit Regulation. Sell credits.Taxes. Tax savings.

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Sustainability

5 Marginal benefits in terms of lower risk.

Over-complying reduces the risk of accidents, which hurts thefirm’s reputation.Over-complying reduces the risk of accidentalunder-compliance.

6 Marginal benefits of innovation and long term focus.

Innovations build off each other and sometimes spill over intoareas other than regulation compliance.Sustainability minded firms keep a long term focus.

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Poorly Designed Regulation

1 Generates political resistance.

2 Results in more cheating and non-compliance.

3 Results in more decisions made solely to (legally) evaderegulations.

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1 Efficiency: the regulation should achievesocial/environmental goals at the least possible cost.Corollary: regulation that does not create perverse incentives.

2 Equity: the compliance costs should not be distributed in away such that low income households pay most of the cost.

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Business Roundtable

Socially responsible investors push companies to have asustainable workforce. But socially responsible investors alsovalue profits and dividends. They will push companies tomaintain a balance.

Consumers want products produced by responsible companies,but also value products that are reasonably priced. They willpay more for a responsible product, but not tremendouslymore. In turn, this guides the firm to strike a balance betweenthe interests of consumers and other stakeholders, such ascommunities.

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SO2

1980 1985 1990 1995 2000 2005 2010 20150

50

100

150

200

250

300

350

mean10th percentile90th percentilecurrent standard

Figure 1 : Sulfur Dioxide concentrations in parts per billion. Includesnatural (e.g. volcanoes) and anthropogenic sources.

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PM2.5

2000 2002 2004 2006 2008 2010 2012 2014 2016 20184

6

8

10

12

14

16

18

mean10th percentile90th percentile

Figure 2 : Small particulate matter concentrations in parts per billion.Includes natural (e.g. forest fires) and anthropogenic sources.

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Criteria Air Pollutants

1980 1985 1990 1995 2000 2005 2010 20150

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Figure 3 : Criteria air pollutants. Includes natural and anthropogenicsources.

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Criteria Air Pollution Standards

Pollutant Standard 2018 Value Last Revised

CO 35 ppm 1.56 ppm 1971

Pb 0.15 µg/m3 0.015 2008

NO2 100 ppb 43.95 2010

O3 0.07 ppm 0.07 2015

PM2.5 12 µg/m3 8.16 2013

SO2 75 ppb 13.78 2010

Table 1 : Criteria air pollutant standards.

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Thoughts

1 Achieving the national standard is apparently more difficult insome regions versus others.

2 Does it make sense to have a uniform national standard?

3 Other forces must be at work besides national regulation.What are the incentives to reduce air pollution that are notregulation based?

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Greenhouse Gases

1990 1995 2000 2005 2010 20150

1000

2000

3000

4000

5000

6000

7000

8000

Figure 4 : Emissions of Greenhouse Gases in the US. CO2-equivalentunits.

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Emissions Intensity

Definition 7

Emissions Intensity or Emissions Efficiency: Emissions dividedby real GDP.

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Nominal and Real

Definition 8

Nominal: not adjusted for inflation. Units are current dollars.

Definition 9

Real: adjusted for inflation, so that each dollar over time has thesame purchasing power. Units are constant dollars.

Emissions intensity uses real GDP.

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Emissions Intensity

1980 1985 1990 1995 2000 2005 2010 20150

0.5

1

1.5

2

2.5

Figure 5 : Emissions Intensity of Criteria Air Pollutants.

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GHG Emissions Intensity

1990 1995 2000 2005 2010 20150

1

2

3

4

5

6

7

Figure 6 : Emissions Intensity of GHGs.

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Minimum Wage

1940 1950 1960 1970 1980 1990 2000 20100

2

4

6

8

10

12

Nominal Federal minimum wageFederal minimum wage (2019 dollars)

Figure 7 : Real and Nominal Federal Minimum Wage.

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Life Expectancy

1950 1960 1970 1980 1990 2000 201064

66

68

70

72

74

76

78

80

82

femaleBoth sexesmale

Figure 8 : Life expectancy at birth in the US.

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Rules

Definition 10

Economically Significant Rules: have an annual effect on theeconomy of $100M or more or adversely affect in a material waythe economy, a sector of the economy, productivity, competition,jobs, the environment, public health or safety, or State, local, ortribal governments or communities.

Definition 11

Significant Rules: create a serious inconsistency or otherwiseinterfere with an action taken or planned by another agency;materially alter the budgetary impact of entitlements, grans, userfees, or loan programs or the rights and obligations of therecipients thereof; or raise novel legal or policy issues arising out oflegal mandates, the President’s priorities, or the principles setforth. Includes economically significant rules.

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Rules

Definition 12

Major Rules: one that has resulted in or is likely to result in (1)an annual effect on the economy of $100M or more; (2) a majorincrease in costs or prices for consumers, individual industries,federal, state, or local government agencies, or geographic regions;or (3) significant adverse effects on competition, employment,investment, productivity, or innovation, or on the ability ofUS-based enterprises to compete with foreign-based enterprises indomestic and export markets.

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Economically Significant Rules

1985 1990 1995 2000 2005 2010 20150

10

20

30

40

50

60

70

80

90

100

Figure 9 : Annual number of economically significant rules published.

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Significant Rules

1995 2000 2005 2010 201550

100

150

200

250

300

350

400

Figure 10 : Annual number of significant rules published.

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Major Rules

1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 201830

40

50

60

70

80

90

100

110

120

130

Figure 11 : Annual number of major rules published.

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Markets and Market Failures

Markets and Market Failures

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Perfect Competition

Definition 13

Perfect Competition: firms have no ability to influence input oroutput prices.

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Examples

Commodity markets.

Many Retail markets.

The market for Iphones is not competitive.

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Competitive Markets Characterization

1 Non-differentiated products. The same product is produced byall companies.

2 A large number of producers exist.

3 Customers have full information about prices.

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Marginal Cost

Definition 14

Marginal Costs: The cost of one additional unit of production.

MC =∆TC

∆Q

Definition 15

Average Costs: Total costs divided by production.

ATC =TC

Q

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Optimal Market Production

P > MC : produce the unit.

P = MC : stop here!

P < MC : do not produce the unit.

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Average vs Marginal Costs

Typical Data Calculate this!

Oil Produc-tion (Q)

Total costs(TC)

AverageTotal costs(ATC)

MarginalCosts (MC)

MarginalProfit(P −MC)

10 120 – –

12 168

15 228

18 336

20 424

25 674

30 974

Table 2 : Average and marginal costs in the oil industry.

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Average vs Marginal

Typical Data Calculate this!

Oil Produc-tion (Q)

Total costs(TC)

AverageTotal costs(ATC)

MarginalCosts (MC)

MarginalProfit(P −MC)

10 120 120/10 =$12

– –

12 168 14 (168 −

120)/(12 −

10) = 24

40 − 24 =16

15 228 15.2 $20 $20

18 336 18.7 $36 $4

20 424 21.2 $44 -$4

25 674 27.0 $50 -$10

30 974 32.5 $60 -$20

Table 3 : Average and marginal costs in the oil industry.

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Equilibrium

Definition 16

Equilibrium: A set of quantities and prices such that no one hasan incentive to change behavior.

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Equilibrium in the Oil Market

Demand

Q∗

$

$10

P

Supply =MC

Saudi

ProductionFracking

Q

North Sea

Figure 12 : Saudi and fracking wells are active in equilibrium.

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Allocations

Definition 17

An Allocation specifies who produces what and who gets what.

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Pareto Criteria

Definition 18

An allocation a′ is Pareto Preferred to another allocation a if atleast one individual strictly prefers a′ and no individual strictlyprefers a.

Definition 19

An allocation a is Efficient or Pareto Optimal if no Paretopreferred allocation exists.

The Pareto criterion is a minimum standard for social choice.

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Surplus

Definition 20

The Consumer Surplus associated with consumption Q is thearea between the demand curve and the horizontal axis over theregion zero to Q, less the price paid.

Definition 21

The Producer Surplus for Q units is the profit: the differencebetween revenue and cost of providing Q units. It equals the areabetween the supply curve and the horizontal line through the price,over the region zero to Q.

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Surplus

SurplusProducer

ConsumerSurplus

Q∗

P∗

Q1 Q2

S=MC

D=MWTP

Q

P

P1

P2

Figure 13 : Consumer and Producer Surplus.

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Efficiency

1 Production takes place at the lowest cost producers.

2 The production goes to the consumers who value thatproduction the most (measured by their willingness to pay).

3 There is no Pareto preferred allocation to Q∗.

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Welfare Theorems

Theorem 22

First Fundamental Theorem of Welfare Economics: Thecompetitive equilibrium of a market economy is ParetoOptimal/Efficient.

Theorem 23

Second Fundamental Theorem of Welfare Economics: Anyefficient allocation can be achieved by a market economy providedresources are appropriately distributed before the market operates.

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Assumptions

1 Complete Markets and Property Rights. No public goodor externalities exist.

2 Atomistic Participants. No monopolies/oligopolies.

3 Complete Information.

4 No Transaction Costs.

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Market Failures?

Clean air

Water

Safe working conditions

Gender pay equality

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Externality

Definition 24

Externality: Production or consumption activity which affects athird party without compensation.

Negative Externality: Production or consumption whichreduces a third party’s utility or profits without compensation.

Positive Externality: Production or consumption whichincreases a third party’s utility or profits withoutcompensation.

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Equity

Efficiency and Equity are different.

The market produces efficient allocations (subject to theconditions above), but does not ensure equity.

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Climate Change External Costs

1 Health costs.

2 Productivity costs.

3 Sea level rise costs.

4 See the 4th National Climate Assessment for a completelisting (22 total).

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Social Costs

Definition 25

Social costs: All production costs including those paid bysomeone other than the firm producing the good. Equals privatecosts plus externality costs.

Definition 26

Social Cost of Carbon (SCC): total marginal social costs ofcarbon (equals the externality cost).

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Market and Efficient Production of Oil

Demand=MWTP

Market Oil Production

Q∗

Externality cost $15.48

Efficient Production

$25.48

Q (barrels)

Private MC

MSC

$10

Q

$

P = $40

Figure 14 : Efficient Versus Market Production of Oil.

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Market and Efficient Production of Oil with Surplus

Surplus$60

Q

S=MC

Externality cost $15.48

MSC = MC+15.48

Q∗

P

D=MWTP

Q

Figure 15 : Market and Efficient Consumer and Producer Surplus. Redindicates negative surplus.

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Marginal Cost of Reducing/Increasing

Definition 27

Marginal Cost of Reducing: the marginal cost of reducing a badcausing an externality.

Definition 28

Marginal Cost of Increasing: the marginal cost of increasing agood causing a positive externality.

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Marginal Rate of Technical Substitution

Definition 29

The Marginal Product is the additional output from an additionalunit of an input.

MPx =∆Q

∆x.

Definition 30

The Marginal Rate of Technical Substitution (MRTS) is therate at which one input is substituted for another while keepingproduction constant. It is the ratio of the marginal products.

MRTS =MPx

MPy

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Sustainability Costs and benefits

1 Direct costs

2 Cost of capital

3 Regulatory costs

4 Risk costs

5 Customer loss

6 Innovation/long term focus.

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Excludable

Definition 31

A good (bad) is Excludable if it is practical to selectively allowconsumers to consume (avoid consuming) the good.

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Examples

1 Electricity is excludable

2 A park is somewhat excludable

3 Beaches are less excludable

4 Clean air is non-excludable

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Rival

Definition 32

A good (bad) is Rival if consumption of a unit of the good (bad)by one person diminishes the amount of the good (bad) availableto others to consume.

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Examples

1 Electricity is Rival

2 A park is somewhat rival

3 Beaches are less rival

4 Clean air is non-rival

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Public Good

Definition 33

A Pure Public Good is non-rival and non-excludable

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Public Good Provision

P

Q

1

2

3

4

5

6

7

Total Marginal Willingness to Pay (demand)

Jack’s Demand

10

Supply

April’s Demand

21 3 4 5 6 7

Figure 16 : Optimal Provision of A Public Good.

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Free Riding

Definition 34

Free Riding: Getting the benefits of, but not paying for, anon-excludable good.

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Market and Optimal Provision of a Public Good

10

P

Q

1

2

Market4

5

6

7

10

SupplyMWTP

4 6 752 31

3Demand

Figure 17 : Market and optimal provision of a non-rival good.

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Regulation

Regulation

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Questions

1 Does the regulation result in an efficient allocation?

2 What are the unintended consequences and perverseincentives?

3 Can the regulation be designed so that compliance costs donot fall excessively on low income households (equity)?.

4 How does the regulation affect the firm’s sustainabilitypolicies?

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Taxes and Incentives

Income taxes: discourages working in favor of leisure.

Tariffs: discourages buying imported products in favor ofbuying domestic products.

Corporate Profits Taxes: discourages savings in favor ofconsumption.

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Pigouvian Tax

Definition 35

A Pigouivan Tax is a tax paid per unit of an external bad exactlyequal to the marginal damage caused by the pollution whenevaluated at the efficient level of pollution. The tax is paid to thegovernment.

Definition 36

Marginal Damage is the externality cost: the cost of a particularbehavior borne by third parties.

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Any Tax Vs. Pigouvian Tax

1 Indirect tax. Tax goods related to the bad. (gasoline tax).

2 Direct tax. Tax bad, but not equal to marginal damage.Carbon tax $10/ton

3 Pigouvian Tax. Tax bad, equal to marginal damage. Carbontax exactly $36/ton.

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Examples

1 Carbon Tax. A Pigouvian tax is a tax on CO2 emissionsequal to MD = $36 per ton CO2. Carbon taxes in practice:

Australia: $10 per ton CO2 (repealed).British Columbia, Canada: $30 per ton is close to Pigouvian.Washington State: $25 per ton (rejected by voters).Argentina: currently $6 per ton. Covers only 20% of emissions.Chile: currently $5 per ton. Covers 39% of emissions.

2 Soda Tax. MD = 0.0085 per ounce. Berkeley, CA has a taxof one cent per ounce.

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Key Equations

1 Produce until P = MC + t, where t is the tax.

2 Pigouvian tax: t = MD, where MD is the marginal damage orexternality cost,

3 Produce until P = MC +MD = MSC , which is efficient.

4 Note also that t = MD = MCR . It is efficient to reducecarbon emissions until the marginal damage from carbonemissions equals the marginal cost of reducing emissions.

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Oil plus Pigouvian Tax

Production with Pigouvian Tax

$25.48

D=MWTP

Q

S=MC

P Tax of t = $36 per tonor $15.48 per barrel

Q∗

MC+15.48

$10

Figure 18 : Oil production given a Pigouvian tax on carbon.

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Pigouvian Tax on Carbon

t = $36

E∗

MD=SCC

MCR

CO2 EmissionsE

$

Figure 19 : Pigouvian tax on carbon emissions.

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Indirect Taxes

We tax alcohol, but would like to tax drunk driving.Responsible drinkers are taxed.

We tax gasoline, but not (for the most part) tailpipeemissions. Catalytic converters reduce tailpipe emissions butdo not affect fuel economy. The tax on gasoline does notincentivize converters.

Non-source point pollutants such as fertilizer runoff aredifficult to tax. Taxing fertilizer does not incentivize methodsto keep fertilizer from leaking into water.

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Multiple Victims

MCR

$

E emissions

t∗

E∗

MD = MD1 +MD2 +MD3

MD3

MD2

MD1

Figure 20 : Pigouvian tax with multiple victims.

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Firm Decisions

MCR1 < t: reducing is cheaper, so reduce.

MCR1 > t: paying the tax is cheaper, so pay the tax.

MCR1 = t: the firm is indifferent. Stop here.

But now firm 2 will make the same calculation, and soMCR2 = t and so on.

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Equal marginal costs

The Pigouvian tax equalizes marginal costs.

t = MD = MCR1 = MCR2.

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Equi Marginal Principle

Definition 37

The Equi-Marginal Principle requires the marginal cost ofreducing to be equalized across producers to achieve emissionsreduction at the lowest possible cost.

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BOD Example

Industry Sub-Industry MCR

Poultry Duck-small plants 3.15Cane Sugar Crystalline refining 1.40Paper NSSC ammonia process 0.22Poultry Fowl-large plants 0.10

Table 4 : Marginal treatment costs of biological oxygen demand (BOD)removal. Marginal cost of reducing is in dollars per kg of BOD removed.

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Graphically Multiple Firms

MCR

t

EE1

MCR1MCR2

MD

E

t∗

E∗

E∗

2E∗

1E2

Figure 21 : Pigouvian tax with two polluters.

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Other Benefits

1 Tax regulation encourages innovation.

2 Tax regulation does not favor incumbent firms or newentrants.

3 Carbon tax revenues can be used by the government to reducetaxes on productive activities.

4 Carbon taxes are often regressive. in the sense that the poorpay a greater share of income in carbon taxes. Solution:include a “dividend” where revenues are given back to lowincome households.

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Firm Behavior

As prices rise:

1 The company loses customers, due to the higher prices.

2 The makes higher margins, from existing customers.

3 Costs fall, as the firm is producing less.

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Implications

From the point of view of the regulator, it is best to regulatethe monopoly price by anti-trust regulation, then charget = MD.

From the point of view of the sustainability officer, if theindustry is imperfectly competitive, restricting output canboth increase profits and reduce pollution.

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Graphically

E

P

MC+MD

P∗

Demand= MWT P

MR

Et

MCPm

Em E∗

Pm + t

Figure 22 : Electricity production with a monopolist electricity producer.

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Single Standard?

1 Training cost are higher.

2 Some capital costs are higher, such as software.

3 The company might lose volume discounts.

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Single Standard?

Definition 38

A Tradeable Permit Regulation or Cap and Trade Systemgives companies which own a permit the legal right to pollute acertain amount. The permits are issued by the government andmay be traded in a securities market.

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Graphically

Permit

Price

MC

ee1

MC1

e

P∗

e

e∗

2

MC2

Permit Supply

MD

e∗

e2e∗

1

Figure 23 : Equilibrium permit price and emissions in the tradeablepermit market.

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Cap and Trade Examples

1 European Emissions Trading System (ETS): covers 46% ofEurope’s carbon emissions. Current price: Pe = 24 Euro perton CO2 (about $27).

2 California’s Cap and Trade Program Pe = $17 per ton CO2.

3 New Zealand (NZ ETS): covers about 43% of emissions.Currently around 25 New Zealand dollars ($16.40) per tonCO2.

4 US SO2 and NOx regulations both use permit markets.

5 China recently announced an emissions trading program to beimplemented by the end of 2020.

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ETS Prices

2012 2013 2014 2015 2016 2017 2018 2019 2020

Date

0

5

10

15

20

25

30

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Initial Allocation

1 Hold an auction. Government revenue can fund green energyinvestments, be rebated back (a “dividend”) to households, orused to reduce other taxes.

2 Give away some/all permits. This is often done to helpreduce political opposition.

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Imperfect Competition

1 The political process. Large firms will lobby for more permits

2 New entrants are typically not allocated permits.

3 Large firms can manipulate the price of permits. The largefirm can restrict the number of permits sold to drive up theprice.

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Other Benefits

1 Cap and trade regulation encourages innovation.

2 Cap and trade regulation does not favor incumbent firms ornew entrants, if the government auctions the initial permitallocation.

3 Auctioned permits can be used by the government to reducetaxes on productive activities (more later).

4 Auctioned permits are often a regressive way to generaterevenue. Can create a “dividend” again.

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Standards based on total emissions

1 Clean Power Plan required FL to limit CO2 emissions toabout 122M tons.

2 Minimum Wage. The federal minimum wage is $7.25 perhour.

3 Renewable Portfolio Standards (RPS) specify the whatpercent of electricity must come from renewable sources. 29states have RPS.

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Standards Based on Intensity (bad per unit of production)

1 CAFE Standards specify a minimum average miles per gallonfor each automobile manufacturer. Equivalent to a maximumgallons (bad) per mile (output).

2 Clean Power Plan offers an alternative intensity standard.For FL, the standard was about 1026 lbs CO2 per megawatthour.

3 Light Bulb Standards 45 lumens per watt is the currentstandard.

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Command and Control

Definition 39

Command and Control regulation specifies how pollution is to bereduced.

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Emissions Standard

An emissions standard requires every player to achieve thesame level of emissions.

Definition 40

Emissions Standard: require emissions for every player not toexceed a standard.

The players could be firms, states, counties, plants, or otherentities.

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Standard Picture

FACTORY 2 FACTORY 3 FACTORY 4Emissions=50Cost=$20/ton

Emissions=25Cost=$15/ton

Emissions=25Cost=$5/ton

Emissions=100FACTORY 1

Cost=$40/ton

Cost of reducing Emissions by 75:

=$40*75=$3,000

Emissions by 25:Cost of reducing

=$20*25=$500

Cost of reducing Emissions by 0:

=$15*0=$0

Cost of reducing Emissions by 0:

=$5*0=$0

TOTAL COST=$3,000+$500=$3,500 EMISSIONS REDUCTION=75+25=100 COST PER TON=$3,500/100 = $35

E=25 tons E=25 tons E=25 tons E=25 tons

Figure 25 : Cost of an emissions reduction standard.

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McKinesy Study

Figure 26 : Marginal Cost of Reducing from McKinsey study.

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Standard

e

$MD$

Cost of emissionsreductionfirm 1

1

2

3

4

6

5

1 2Std=2

3 5 6 7

Cost of

9 108

emissionsreductionfirm 2

e∗= 4

e

MC

e2

MC2

MC1

e1

t∗

P

Figure 27 : Cost of emissions reduction under an emissions standardequal to 2 tons with two firms.

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Tax

e

$MD$

Cost of emissionsreductionfirm 1

1

2

3

4

6

5

1 2Std=2

3 5 6 7 8

Cost of

109

emissionsreductionfirm 2

e∗= 4

MC

ee2

MC2

e1

t∗

P

MC1

Figure 28 : Cost of emissions reduction under a tax of $2 per ton withtwo firms.

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Other considerations:

1 Emissions standards reduce the incentive to innovate. Once acompany meets the standard, no further action needs to betaken. So there is no incentive to innovate further.

2 Emissions standards do not favor new entrants or existingfirms. Everyone must meet the same standard.

3 Standards generate no government revenue. Governmentrevenue from auctioned permits and taxes allow thegovernment to make the program less regressive, reduce othertaxes on good activities like savings, or help the program passCongress by compensating firms likely to pay large costs ofcompliance.

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Issues

1 No incentive to innovate exists. Coming up with a bettertechnology is not helpful since the government requires aparticular technology.

2 The technology is unlikely to be the low cost option for allfirms. The government usually does a poor job “pickingwinners.”

3 Sometimes a technology standard can help firms coordinatearound a single technology, in cases where it helps to haveeveryone using the same technology.

4 Technology standards can hamper new entrants, if the fixedcosts are very high. For example, DuPont lobbied for methanescrubbers on nylon production. These scrubbers wereexpensive to install, hindering new entrants without a lot ofcapital.

5 Technology standards are easy to verify for regulators.Emissions can change on a daily basis and requires morecostly monitoring.

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Intensity Standards

Intensity standards specify a maximum level of emissions per unitof output.

Definition 41

Intensity Standard: requires emissions per unit of output forevery player not to exceed a standard.

The players could be firms, states, counties, plants, or otherentities.We can also define an intensity standard as the minimum good perunit of output. A maximum gallons per mile is the same as aminimum miles per gallon.

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Issues

1 Like emissions standards, intensity standards do notsatisfy the equi-marginal principle. For example, it mightbe less expensive for Toyota to improve average fuel economythan for Ford to do so.

2 Firms have no incentive to innovate once the intensitystandard is met.

3 Intensity standards do not raise government revenue.There is no easy way to make an intensity standard lessregressive, or to reduce taxes on productive activities.

4 Intensity standards subsidize production. See below.

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The Effect of Standards on Sustainability Incentives

Standards offer less rewards for being sustainable.Once thestandard is met, no further regulatory incentive exists forbeing more sustainable.

A standard makes it more difficult to obtain the benefitsof being sustainable. Companies want to let consumers andinvestors know they are being more sustainable thancompetitors.

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Subsidies

Definition 42

An Environmental Subsidy compensates firms for using, orconsumers for purchasing, a low emissions technology.

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Examples

1 Solar subsidies. 72 subsidies for solar roof installations in FLalone. Including sales tax exemption and the ability to financeby adding to your mortgage.

2 Electric vehicle (EV) subsidies. Consumers receive a $7,500tax rebate for purchasing an EV. Once any car company sells200K vehicles, the rebate for that company falls to $3,750 forthe next six months, then $1,875 for the next six months,then zero.

3 Wind subsidies. Estimated at $56 per mwh.

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Issues

1 Subsidies pick a particular technology which is unlikely to bethe low cost option in all situations.

2 Firms can capture some of the subsidy by raising prices. Thiscapture reduces sales, which reduces the effectiveness of thesubsidy.

3 Consumers get subsidies even if they would have made thepurchase anyway. Giving a subsidy in this case results in nochange in emissions. Called Additionality Problem.

4 Subsidies reduce the incentive to innovate. New innovationsare not subsidized and must compete against the subsidizedtechnologies.

5 Subsidies impose costs on the government.

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Example: raising prices

Tesla reached 200K in sales in July 2018. Subsidy declined by$7, 500 − $3, 750 = $3, 750.

Tesla dropped prices by $2K.

Reverse the argument: an increase in prices by $3,750 causesa $2K increase in prices.

Tesla captures $2K/$3, 750 = 53% of the subsidy throughhigher prices.

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Example: Additionality

Georgia eliminated an EV subsidy and sales fell by 80%.

Reverse the argument: 20% of EV buyers would havepurchased an EV without a subsidy, but got the subsidyanyway.

These subsidies did not reduce any emissions.

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Offsets

Definition 43

Carbon Offset: A market in which individuals and companies canbuy and sell credits for reducing carbon emissions.

Note the difference between permits and offsets. Permits are theright to emit 1 ton, and offset is a credit for reducing 1 ton.

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Why might an individual or firm want to buy an offset?

1 Many cap and trade programs (such as Europe’s ETS) allowcompanies to buy an offset instead of a permit. Alternatively,some cap and trade systems allow companies to trade anoffset with the government for an additional permit.

2 Many companies and individuals voluntarily buy offsets tolower their net emissions.

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Additionality

Key principle: emissions reduction must only occur if fundedby the offset.

Definition 44

Additionality Problem: Difficulty verifying that emissionsreduction are being done in addition to baseline emissionsreduction.

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Offset Markets

Market VCS Gold VCS and CCB CDM CAR

Price $2.30 $4.60 $3.90 $1.60 $3.00

Volume 25 10 9 6 5

Table 5 : Largest carbon offset markets. Volume is millions of tons ofCO2 equivalent, price is average dollars per ton. Data is from 2017.

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Notes

Cap and trade with offsets is equivalent to regular cap andtrade if the right amount of permits are allocated to thedeveloping country.

Typically, the developed country does not reduce permitsupply to get the efficient allocation.

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Offsets and Sustainability

1 Does buying offsets generate the same goodwill as reducing?Many consumers and investors prefer reducing.

2 The cost of offsets makes reducing more attractive. Like apermit, one must add the cost of offsets to the cost of fueland other carbon emitting activities. This makes reducingmore attractive.

3 Companies sometimes voluntarily buy offsets even wherecarbon is not regulated. In this case, the company is hopingto get credit for being more sustainable in terms of betterrelations from customers and investors. There is nooperational efficiency gain from buying offsets.

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Renewable Energy Certificates

Definition 45

A renewable energy certificate (REC) is a tradeable asset thatcertifies that 1 mWh of electricity was generated from a renewablesource and fed into the grid.

An REC is a method of subsidizing renewable energy, it does notmean the company actually used renewable energy.

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Critical Assumptions.

1 The REC price is large enough change the decision toproduce renewable energy (no additionality problem).Some companies get around this by paying for a wholenew solar installation.

2 The increase in solar does not cause electricity prices tofall.

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Regulator is Uncertain About Firm MCR

When regulator is uncertain about firm MCR , taxes and capand trade are no longer equivalent.

This is common. in the SO2 market, firms said MCR = $300per ton, environmentalists said MCR = 0. Actual MCRturned out to be $16.

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Pigouvian Tax given uncertainty

Firms set t = MCR .

If MCR is high, most firms pay the tax and too littleemissions reduction occurs.

If MCR is low, most firms reduce and too much emissionsreduction occurs.

A welfare loss occurs, shown on the graph.

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Welfare loss taxes with uncertainty.

E

t

MD

t

E∗

H

MDH

MDL

Welfare loss:MCH

MCL

E∗ EH E0

MC MCH

E∗

L

Welfare loss:MCL

EL

Figure 29 : Welfare losses from tax regulation when marginal costs areuncertain.

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Cap and Trade with Uncertainty

Firms set Pe = MCR .

If MCR is high, the price of permits is high and too manyfirms reduce. Firms face expensive cost of compliance.

If MCR is low, the price of permits is low and more reduction(fewer permits is optimal).

A welfare loss occurs, shown on the graph.

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Welfare loss cap and trade and uncertainty.

MD

P

EE∗

H

Welfare loss:MCH

PL

E∗

L

PH

P∗

Welfare loss:MCL

MCL MC

MCH

E0E∗

captionWelfarelosses from permit regulation when marginal costs are uncertain.

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Taxes vs Permits I: MD Sensitive to Emissions.

Suppose a small increase in emissions causes huge increases inmarginal damages. An example would be a tipping pointwhere temperatures cause the ice caps to melt. At a certainlevel of CO2, temperatures cause the ice to melt causing hugedamages.

It is important to get the quantity of emissions right.

Permits are better, since the quantity is certain with permits,but not taxes.

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Taxes vs Permits I: MD sensitive to E

t

E

t

MD

MDP

E

E∗

H

MDL

MDH

PL

PH

Welfare loss:MCH

Welfare loss:MCH

E∗

L E∗

H

E∗

L

MCL

E∗

P∗

E0

EL E∗ EH E0

MC

Welfare loss:MCL

MC

MCH

MCH

MCL

Welfare loss:MCL

Figure 30 : Welfare losses from tax and permit regulation when marginaldamages are vertical.

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Taxes vs Permits II: MCR Sensitive to Emissions.

Suppose a small increase in emissions causes huge increases inmarginal costs. If MCR is greater than expected, the amountof permits is fixed and so the price of permits risessubstantially.

The price is fixed with a tax. Firms always have the out ofpaying t.

It is important to get the price of emissions right.

Taxes are better, since taxes fix the price.

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Taxes vs. Permits II MCR Sensitive to E .

t

E

t

MD

MD

P

EE∗

L

PH

PL

Welfare loss:MCH

MDH

Welfare loss:MCH

MDL

E∗

H

P∗

E∗

Welfare loss:MCL

MCL

MCH

MCL MC

MCH

EL E∗ EH

Welfare loss:MCL

MC

Figure 31 : Welfare losses from tax and permit regulation when marginalcosts are nearly vertical.