Government Intervention in Market Failure Chapter 3 © 2004 Thomson Learning/South-Western.

Government Intervention in Market Failure

Chapter 3

© 2004 Thomson Learning/South-Western

2

Topics in Chapter 3

1. Should the Government Intervene? Are there private solutions that will work?

2. Types of Government Intervention – general introduction

3. The “optimal” level of environmental quality4. Government intervention: Command and

Control policies5. Government intervention: Economic

incentives

3

Should the Government Intervene? Pigouvian Taxes A.C. Pigou (1938) argued that an externality

cannot be mitigated by contractual negotiation between the affected parties.

Pigou argued that direct coercion by the government or judicious use of taxes should be used against the offending party.

These taxes are referred to as Pigouvian taxes.

4

Pigouvian Taxes

The basic principle behind the use of externality taxes is that the tax eliminates the divergence between the Marginal Private Cost (MPC) and the Marginal Social Cost (MSC).

Q1 represents the market equilibrium (where MPC=MPB), and

Q* represents the optimal level of output (where MSC=MSB).

5

An Externality Tax on Output

6

An Externality Tax on Output

MPC1

Demand

MSC = MPC + MDpollution

Quantity of steel

$

Q1Q*

a

b

7

Pigouvian Taxes An externalities tax equal to the divergence between

MPC and MSC would raise the steel firms’ private costs.

The tax would shift the MPC curve by an amount equal to the distance from a to b in Figure 3.1.

The market would arrive at an optimal equilibrium of Q*.

This is known as internalizing an externality. More precisely, the tax should be placed on the

externality itself (the amount of pollution emissions) rather than on output (amount of steel).

8

Coase Theorem

Ronald Coase (1960) argued that not only is a tax unnecessary, it is often undesirable.

Coase argued: The market will automatically generate the

optimal level of the externality. This optimal level of the externality will be

generated regardless of the initial allocation of property rights.

9

Coase Theorem One example to illustrate his theory is based on the

interaction of a cattle rancher and a crop farmer. Cattle occasionally leave rancher’s property and

damage farmer’s crop. Coase argued that the farmer and rancher will reach

an agreement that will make them both better off. Either the rancher will accept payment to reduce the

size of the herd or farmer will accept payment to cover cost of crops lost.

And this will happen without government intervention.

10

Another example: Dorm room stereos and studying

MC loudness to you

D = MB loudness to partier

Loudness

$

QLQ*Q0

11

If property rights belong to partier, where is initial noise level? QL

But there are gains from trade until move back to Q*

If property rights belong to partier, where is initial noise level? Q0

Again, gains from trade until get to Q* Gains to be split between two parties are

denoted “A” and “B” in diagram

Dorm room stereos and studying

12

Another example: Dorm room stereos and studying

MC loudness to you

D = MB loudness to partier

Loudness

$

QLQ*Q0

A

B

13

Coase Theorem If there are no transaction costs and property rights

are well defined, then voluntary transactions will eliminate any distortions in resource allocation stemming from an externality and the outcome is independent of the property rights

This version of the “theorem” is from Baumol and Oates text “The Theory of Environmental Policy.”

Emphasizes private behavior and importance of transaction costs

14

Coase Theorem What happens if impose a Pigouvian tax on the

generator of the externality, would this result in an efficient outcome?

Set a tax equal to marginal damage at the optimal to shift the demand for loudness

After the tax, are there still gains from trade? Would tax be a good idea? This is basis for Coase’s argument that government

intervention could make things worse

15

Coase with a tax per unit of Loudness

MC loudness to you

D = MB loudness to partier

Loudness

$

QLQ*Q0

D = MB loudness to partier - tax

QN

tax

16

Criticisms: Coase Theorem

Two important assumptions: transactions costs are insignificant and property rights well defined.

Transactions costs are costs associated with arriving at an agreement (the costs of negotiation).

These may be small for a 2 party agreement but would be very large for an externality such as sulfur dioxide emissions across North America.

17

Coase Theorem The number of participants makes transactions

costs important. One way to reduce transactions costs is to

appoint an agent who acts in behalf of a large number of people.

The use of agents is associated with its own problems: Free riders – don’t share in cost, but share benefits. Often it is difficult for individuals to identify the agent

that will best represent their view point.

18

Coase Theorem

Another problem associated with the Coase example can occur when the allocation of property rights would signal entry and exit in response to those rights.

If ranchers have the right to let their cattle roam without worrying about paying damages, then there can be an increase in the number of ranchers, and more damage.

19

Bottom Line on Coase arguments Probably are cases where private

negotiations can be effective In those cases, government should stay out But, probably plenty of cases where

transaction costs and other issues lead to need for intervention

20

Types of Government Intervention There are five broad classes of government

intervention: Moral suasion Direct production of environmental quality Pollution prevention Command and control regulations Economic incentives

Each of these represents a different philosophy toward the role of government in society.

21

Moral Suasion

This term is used to describe government attempts to influence behavior without actually stipulating any rules.

Effectiveness depends upon the extent to which individuals believe it is in their collective interest to do so.

Successful programs include Woodsy Owl’s “Give a hoot, don’t pollute” and Smokey Bear’s “Only you can prevent forest fires.”

22

23

Direct Production of Environmental Quality Includes

reforestation, breaching of dams, stocking of fish, creation of wetlands, treatment of sewage, and toxic waste site cleanup.

These are sometimes ameliorative actions.

24

Pollution Prevention

Designed to address market failure of imperfect information, in some cases there may be technologies that could be developed that save firm’s money and improve environment

Basic premise is that combined efforts of government agencies, national laboratories, university and private firms can lead to development of innovative and beneficial technologies.

These programs emphasize being proactive in reducing pollution, encourage R&D and adoption of “green technologies” .

25

Command and Control Regulation These place constraints on the behavior of

households and firms. Constraints generally take the form of limits

on inputs or outputs in the consumption or production process.

Examples include: Requiring sulfur-removing scrubbers on the

smokestacks of coal-burning utilities. Prohibitions against dumping of toxic substances.

26

Economic Incentives Economic incentives make self interest

coincide with social interest. Examples include:

Pollution taxes Pollution subsidies Marketable pollution permits Deposit-refund systems Performance bonds Liability systems

27

Choosing the Correct Level of Environmental Quality Zero pollution is not possible/desirable for two

reasons: The reduction of pollution will have opportunity costs. The Law of Mass Balance makes a choice of zero

physically impossible. The Law of Mass Balance states that the mass of

outputs of any activity are equal to the mass of inputs.

Any consumption or production activity must produce waste.

28

Choosing the Correct Level of Environmental QualityDefinitions first: Stock pollutants: pollutants for which

environment has little ability to absorb: non biodegradable bottles, heavy metals, toxics

Fund pollutants: environment has some ability to absorb, pollutant doesn’t accumulate indefinitely; organic pollutants, CO2 absorbed by plants, etc.

Focus now on Fund Pollutants

29

Choosing the Correct Level of Environmental Quality The desired level of pollution will be a

function of the social costs associated with pollution.

The first of these is the damage that pollution creates by degrading the physical, natural, and social environment.

The second is the cost of reducing pollution and includes the opportunity costs of resources used to reduce pollution and the value of foregone outputs.

30

The Marginal Damage Function The marginal damage function represents the

damages that pollution generates by degrading the environment.

Even if these impacts are not quantifiable, the marginal damage function is useful for thinking about the relationship between environmental change and social welfare.

31

Figure 3.3 Marginal Damage Function

32

Marginal Damage Function

The marginal damage function specifies the damages associated with an additional unit of pollution.

The total damages generated by a particular level of pollution is represented by the area under the marginal damage function.

33

Marginal Damage Function

The increasing slope of the marginal damage function indicates how damage changes with each additional unit of pollution.

An upward sloping marginal damage function indicates that as the level of pollution becomes larger, the damages associated with the marginal unit of pollution become larger.

34

Marginal Abatement Cost Function Abatement Costs are those costs associated

with reducing pollution to a lower level so that there are fewer damages.

Abatement costs include: Labor Capital Energy needed to lessen emissions Opportunity costs from reducing levels of

production or consumption.

35

Marginal Abatement Cost Function The marginal abatement cost function

represents the costs of reducing pollution by one more unit.

In the following figure, Eu represents the level of pollution that would be generated in absence of any government intervention.

As pollution is reduced below Eu, the marginal abatement cost increases.

36

Marginal Abatement Cost Function

37

Marginal Abatement Cost Function Marginal abatement costs rise as cheaper

options for reducing pollution are exhausted and more expensive steps must be taken.

The decreasing slope indicates that the costs of reducing pollution increases at an increasing rate.

A high vertical intercept indicates that the cost of eliminating the last few units of pollutants would be extremely high.

38

The Optimal Level of Pollution Optimal level of pollution minimizes the total

social costs of pollution (the sum of total abatement costs and total damages).

This level occurs at the point where marginal abatement costs are equal to marginal damages.

39

The Optimal Level of Pollution

40

The Optimal Level of Pollution If the level of emissions is less than E1, then the

marginal abatement costs are greater than the marginal damages that the unit of pollution would have caused.

It doesn’t make sense to reduce pollution.

If the level of emissions are greater than E1, then the marginal damages are greater than the marginal abatement costs associated with reducing pollution by one unit.

Society is better off eliminating that unit of pollution.

41

Social Costs When Pollution Level is Greater than Optimal

42

Social Costs When Pollution Level is Greater than Optimal The optimal level of pollution is E1.

The actual level of pollution is E2.

Total costs associated with pollution have been increased by the area of triangle abc.

This represents marginal damages greater than marginal abatement costs for the range of pollution emissions between E1 and E2.

43

Social Costs When Pollution Level is Less Than the Optimal

44

Social Costs When Pollution Level is Less than Optimal The optimal level of pollution is E1.

The actual level of pollution is E3. Total costs associated with pollution have

been increased by the area of triangle ade. This represents marginal abatement costs

greater than marginal damage for the range of pollution emissions between E1 and E3.

45

Optimal Level of Pollution, an alternative graphical representation

MAC

MDF = MB abatement

Abatement

damages, costs, $

A1

46

Optimal Level of Pollution, an alternative approach Plot functions against “abatement” instead of

pollution Abatement is the amount of pollution reduced These are analagous approaches, just

sometimes more convenient to think in terms of abatement vs. pollution

Answers are the same.

47

Optimal Level of Pollution, two approaches on one graph

= MB emissions

= MB abatement

abatement

48

Optimal pollution (abatement) levels and costs of control Two goals of environmental policy

1. Get the optimal amount of pollution (abatement) – just discussed

2. Achieve that level at the lowest possible cost

Goals are actually inter related, but helpful to think about them in two steps, once have identified optimal amount of pollution, how to achieve it at least cost

49

Optimal pollution (abatement) levels and costs of control Suppose optimal to control (abate) 100 units

of pollution that are generated by two firms How much control should each firm

undertake to minimize total costs Plot abatement levels by the two firms

against each other with a total of 100 units of abatement

Cost of control is at a minimum when the marginal abatement costs are equal

50

Least cost allocation of abatement between two sources (firms)

MAC2

MAC1

Abatement firm 1

Abatement firm 2

damages, costs, $

0 10 20 30 40 50 60 70 80 90 100

100 90 80 70 60 50 40 30 20 10 0

a b

51

Optimal pollution (abatement) levels and costs of control In this example firm 1 should control 40

units and firm 2 should control 60 to achieve least cost of control

This solution takes into account the fact that different firms have different costs of control

Can consider both goals on one graph Can see both that optimal abatement is 100

and efficient (least cost) allocation is 40, 60

52

Optimal pollution and least cost allocation of abatement

MAC2

MAC1

Abatement

damages, costs, $

0 10 20 30 40 50 60 70 80 90 100 110 120 130

MAC = MAC1

+ MAC2

MB

53

Pursuing Environmental Quality with Command and Control Policies One way to achieve an optimal level of

pollution is to mandate action to achieve the desired level of pollution.

Critics have argued that command and control regulations generate more abatement costs than necessary.

Suppose there is a desire to reduce pollution by half, each firm might be required to control half of its emissions, would this be the least cost way to accomplish this reduction?

54

Pursuing Environmental Quality with Command and Control Policies

55

Pursuing Environmental Quality with Command and Control Policies Recall, the aggregate marginal abatement cost

function is the horizontal summation of the individual marginal abatement cost functions.

Note we are back to plotting against emissions With no environmental regulation, polluter 1

would emit 10 units and polluter 2 would emit 6. A requirement to reduce emissions by 50%,

regardless of cost, would reduce polluter 1 to 5 units and polluter 2 to 3 units.

56

Pursuing Environmental Quality by Equating Marginal Abatement Costs When both polluters are required to reduce

emissions by 50%, regardless of marginal abatement costs, polluter 2 incurs a higher cost ($3) than polluter 1 ($2).

Society’s total abatement costs can be lowered by keeping total emissions constant, but reallocating level of emissions by marginal abatement costs.

The optimal level of emissions will be where marginal abatement costs are equal, for a given level of emission.

57

Pursuing Environmental Quality by Equating Marginal Abatement Costs

58

Pursuing Environmental Quality by Equating Marginal Abatement Costs Since polluter 2 has higher marginal abatement

costs, polluter 2 should be allowed to emit more, and polluter 1 will be required to pollute less.

Polluter 1 reduces pollution by one half unit (to 4 ½) and polluter 2 increases pollution by one half unit (to 3 ½).

Polluter 1’s marginal abatement costs increase and polluter 2’s marginal abatement costs decrease.

Total abatement costs are minimized.

59

The Role of Command and Control Policies

Despite their typical inability to equate marginal abatement costs across polluters, command and control policies may still be the most desirable policy instrument under the following circumstances: When monitoring costs are high. When the optimal level of emissions is at or near zero. During random events or emergencies that can

change the relationship between emissions and damages.

60

The Role of Command and Control Policies While it might be possible to achieve an

optimal amount of litter through the use of a tax or per person allocation, this would require the “litter police”.

It is easier to make ALL littering illegal and establish a punitive fine for those caught littering.

The fine multiplied by the probability of being caught would be factored into the choice to litter.

61

The Role of Command and Control Policies When the optimal level of pollution is zero or at zero,

direct controls make sense. This is the case for extremely dangerous pollutants,

such as heavy metals and radioactive waste. Damages associated with these pollutants are quite

severe. Direct controls also make sense in other cases where

initial damages are quite high compared to initial marginal abatement costs. An example is CFC’s, where accumulated amounts are

dangerous but there are low cost alternatives.

62

The Role of Command and Control Policies Emergency situations may make direct

controls the preferable policy instrument. These events occur in random and

unpredictable fashion. Examples include smog alerts and droughts.

63

Pursuing Environmental Quality with Economic Incentives Economists advocate policies based on

economic incentives for two primary reasons: Economic incentives minimize total abatement

costs by equating marginal abatement costs across polluters and encouraging a broader array of abatement options.

Economic incentives encourage more research and development into abatement technologies and alternatives to the activities that generate the pollution.

64

Economic Incentives and Minimized Total Abatement Costs Consider the following graph. A polluter is polluting at an unregulated level of 10

units. The government imposes a tax equal to t dollars per

unit of pollution. The polluter compares the tax of t dollars to the

marginal abatement cost (MAC) of reducing pollution. As long as the MAC is less than the tax, polluter will

reduce level of emissions. Each polluter will chose an emission level which

equates MAC and the tax.

65

Economic Incentives and Minimized Total Abatement Costs

66

Economic Incentives and the Certainty of Attaining a Target Level of Pollution If the aggregate marginal abatement cost

function is know, then achieving a targeted level of pollution is easily accomplished.

If the aggregate marginal abatement cost function is not known, the appropriate tax level is much harder to determine.

Consider Figure 3.16, where evidence suggests that the true MAC function lies between an upper and lower bound set of MAC’s.

67

Economic Incentives and the Certainty of Attaining a Target Level of Pollution

68

Economic Incentives and the Certainty of Attaining a Target Level of Pollution Suppose policymakers believe MAC1b is the true MAC. In

an effort to achieve an emissions level of E1, they impose a tax of t1.

However, if MACt describes how polluters will respond, the emissions level will be E2.

E2 is higher than the desired level of pollution.

Because the choice of pollution abatement and production technologies is sensitive to specific tax structures, it may not be easy to change the tax to achieve the desired level of pollution emissions.

69

Economic incentives and incentives for research If a firm is faced with a tax on its pollution, it

has the incentive to find ways to reduce its pollution cheaply

The motivation that taxes provide for technology development is an advantage of taxes over command and control

70

Economic incentives and incentives for research for a firm

MAC after R&D

MAC initially

Abatement

damages, costs, $

t

ab

cd

Firm cost initially =

a + b + c (tax bill) +

d + e (abatement cost)

Firm cost after R&D =

a (tax bill) +

b + e (abatement cost)

e

71

In summary:

Pollution taxes are preferable to command and control techniques since pollution taxes minimize abatement costs and provide incentives for R&D

But, taxes do not put the level of pollution under direct control so when there is uncertainty in abatement costs one might not get the desired level of pollution.

Marketable permits might achieve both…?

72

Marketable Pollution Permits

Marketable pollution permits are permits which give a firm the right to emit a specific number of units of pollution.

Polluters are free to buy and sell these rights to pollute.

A marketable pollution permit system can both minimize total abatement costs, provide flexibility in the choice of mechanisms used to meet pollution goals, and achieve the desired level of pollution emissions.

73

Marketable Pollution Permits

A system of marketable pollution permits begins with the determination of the target level of pollution.

The next step is to allocate pollution across polluters.

This allocation can be based on historic pollution levels, auctions, a lottery, or some other allocation scheme.

The buying and selling of pollution permits will reallocate the emission rights.

74

Marketable Pollution Permits Marketable pollution permits equate marginal

abatement costs across polluters. Each polluter compares his/her marginal abatement

costs with the price of a permit. If the marginal abatement costs are higher than the

price, they have an incentive to buy. If the marginal abatement costs are lower, they have

an incentive to sell. Buying and selling will continue until the equilibrium

price is reached which equates marginal abatement costs across all firms.

75

Marketable Pollution Permits and Geographic Considerations Geographic location of emissions can have a

profound impact on the damages the pollution generates for some categories of pollution.

Central to the importance of location of emissions is the manner in which the pollution disperses when it enters the environment.

Pollution controls must take into consideration the geographic variation in the effect of pollution on society.

76

Marketable Pollution Permits and Geographic Considerations A pollution control system based on taxes

could take variation into account by charging higher taxes in areas where emissions are more damaging.

A marketable pollution permit system must divide the overall region into subregions.

These subregions can account for geographic variability in one of two ways: development of a receptor-based system or development of separate markets for subregions.

77

Marketable Permits and Geography: Ambient-based Permit System A receptor-based or ambient-based system allocates pollution

receptors across the subregion. Locations relatively close to, and downwind from, the polluter

may require more permits. Dispersion coefficients are used to help define the terms of

trade in this type of marketable pollution permit market. In the following figure, the location of a particular polluter is

denoted by a star and receptors are designed by letters. This polluter may have to buy some combination of 15 different types of permits.

78

Marketable Pollution Permits and Geographic Considerations:

Ambient-based Permit System

79

Marketable Permits and Geography: Emissions-based Permit System An alternative to the ambient-based system is to

divide the subregions into separate markets. Polluters need only purchase permits for the

subregion in which they are located. The inability to trade across subregions may mean

that firms with lower abatement costs will not be able to trade permits with higher abatement cost firms in another subregion.

A compromise would be to have one type of permit and allow trade across all regions, as long as the trade does not result in ambient quality standards being violated at any receptor point.

80

Marketable Pollution Permits and Geographic Considerations:Emissions-based Permit System

81

Other Types of Economic Incentives Deposit-refund systems are a good way of

employing economic incentives when monitoring costs are high.

This system is based on requiring a payment up front for undesirable acts and then building in a refund when a desirable action occurs.

The most common example of this is the deposit-refund system in place for beverage containers.

This system has also been used for cars and batteries in other countries.

82

Other Types of Economic Incentives Bonding systems are closely related to deposit-

refund systems. A bonding system requires a potential degrader of

the environment to place a large sum of money in an escrow account.

This money is returned if the environment is undamaged (or returned to its original condition) and will be forfeit otherwise.

Bonds need to be large enough to provide an incentive to use appropriate safeguards and/or cover the cost of clean up if damage occurs.

83

Other Types of Economic Incentives Liability systems are based on defining legal liability

for the damages caused by certain types of pollution discharges and facilitating collection of these damages.

The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) defines legal rights to natural resources for local, state and federal governments and defines how damages can be recovered.

A related system defines legal liability and then requires potential polluters to obtain full insurance against any damages. There is a potential moral hazard problem with this option.

84

Other Types of Economic Incentives A system of pollution subsidies would pay each

polluter a fixed amount of money for each unit of pollution reduced.

The polluter would reduce pollution to the point where the subsidy is equal to the marginal cost of abatement.

While the outcome is the same as a tax on polluters, there are distributional effects, problems with political acceptability and the possibility that strategic behavior would lead to higher initial levels of pollution in order to obtain the subsidy. In addition, the subsidy could potentially attract more polluters into the industry.

85

Conclusion

Market failures associated with environmental externalities generate losses in welfare.

Command and control policies are the basis of current policy but do not equate marginal abatement costs across polluters.

Economic incentives, such as taxes or marketable pollution permits do equate marginal abatement costs.

While there are some problems with economic incentives, they do create additional motivation for technological innovation to reduce pollution.