Benefit of Abatement of Emission Energy Economics Question

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Rough Notes Externalities and Optimal Pollution Policies Spring 2016 Externalities, Pollution, and Policies for the Optimal Level of Pollution One way to look at externalities like pollution is to consider the cost and benefits of the pollution (a negative externality.) To see how energy pollution affects society's welfare and to investigate what policies we may use to mitigate environmental problems, we begin our analysis with Figure 8.1. D equals the demand or the marginal benefits in the oil market. MCpv represents the private marginal costs of the private supply curve. Assume that the production and transportation of oil creates oil spills and other pollution. With the included external costs of such pollution, the supply curve representing private and external costs or all social costs would be MCsc. The private market allocation would be where D=MCpv at Ppv and Qpv. At the private market solution, Qpv, the true social costs are greater than the benefits with the area abc representing the social losses in this case. If we could internalize the externality, then the social costs would equal the private costs and the market price and quantity would be Psc and Qsc. Acknowledgements: These notes come an upcoming version of Carol Dahl's book. Page 1 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 Externalities, Pollution, and Policies for the Optimal Level of Pollution One way to look at externalities like pollution is to consider the cost and benefits of the pollution (negative externality.) We often approach thinking about equalizing the Marginal Benefits to the Polluter to Marginal Damages to sufferer of pollution Or Marginal Costs of Pollution Abatement to Marginal Benefits from Abatement See the diagram 8.2 below. The left hand side or the benefit side we see that the marginal benefits are high for the first units of pollution. This suggests that it is very difficult to emit almost no pollution. However, as the amount of pollution increases it becomes increasingly easier to not emit or to clean up the pollution. Alternatively, the cost of not polluting the initial (or any) amount is very difficult. The Marginal Abatement cost is very high as more pollution is abated. The marginal abatement cost falls as the pollution restrictions are eased. Page 2 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 On the right hand side a small amount of pollution may cause no damage. The natural environment is able to absorb or has some tolerance for pollution. However, as the pollution increases we exceed the carrying capacity of the environment and marginal damages or the damage of the last unit of pollution gets larger as the pollution increases. Thus, the environment becomes less able to cope as pollution increases. Alternatively, the Marginal Benefits from Abatement are very low initially, but rise as the level of pollution gets larger. Property Rights, Pollution, and Outcomes: Introduction to Coase Theorem Coase in the 1930s noted that given • well defined property rights, • with no party having excessive market power, and • in the absence of transaction costs, an optimal level of pollution would be arrived at by bargaining between polluter and sufferer no matter who had the original property rights. Transaction costs in this context include the money costs as well as the time and effort required to conduct the transaction. If those who suffered the damages of the pollution have the rights to the water, the pollution will be at B. With less pollution than B, they will suffer no damage and so won't mind the pollution. However, with more pollution than B, they will suffer damages and won't permit the pollution. If the polluters have the rights to the water, the pollution level will be at D. Since they don't benefit from pollution beyond D, they will not pollute more than D. Since there are benefits for all pollution less than D, they will pollute up to point D. Alternatively, if property rights are not well defined, the pollution level would likely be at D as well as those having no recourse will not be able to stop the pollution. Page 3 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 Property Rights, Pollution, and Outcomes: Introduction to Coase Theorem From an economic point of view, the optimal quantity of pollution or what economists would call an efficient level of pollution is at point C. At pollution levels less than C, the benefits of pollution are greater than costs, so society benefits from pollution. After C the costs are greater than the benefits, so society loses if we pollute more than C. If the polluter is large and the one suffering the damages is also large, the two are likely to get together and negotiate an optimal solution. For example, suppose the polluter is a coal mine whose runoff makes a local river more acidic. A refinery downstream uses the water in its processes. But when the water is acidic, it has to be cleaned up or it corrodes the refinery equipment. Suppose that initially the coal mine or the polluter has the property rights and pollution is at D. For the last unit of pollution, the refinery would be better off if it paid anything less than EA to get the coal mine not to pollute. Similarly for the next to the last unit of pollution, there is some payment from the refinery to the coal mine to not pollute that would make both the refinery and the coal mine better off. Through negotiation the firms could come to some payment schedule that would make them both better off until we reach point C. For less pollution, there is no payment between them that would make them both better off. Similarly we could start at B and make the same arguments why the firms should end up at C. However, transaction costs are often very high. Take the example of a refinery polluting a low income neighborhood. Although the residents as a whole may suffer more damages than the refinery gains by polluting, it may be difficult and costly to organize and negotiate a better solution with the refinery. Further, they may not have access to any market where they can convert the health damages they will suffer into the cash to make payments to the refinery. In such a case we think markets will fail and most economists agree that the government should intervene. Page 4 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 Pollution Policies for Optimal Level of Pollution Four different policies could be implemented in the above case. The government could 1) set a pollution standard permitting pollution at level C, 2) set a unit tax on pollution of AE, 3) sell pollution permits equal to AC, or 4) set a unit subsidy on clean up or abatement of AE. Setting standards and enforcing them tends to be the way that U.S. environmental policy has been implemented and is called command and control. If the regulation were obeyed the firm would pollute C and abate or no longer pollute amount CD. The polluter's losses would be the cost of abatement or area CFD in Figure 8.2. The last three more market oriented policies, often called incentive based policies, include a tax on pollution, selling pollution permits, or a subsidy to help abate pollution. Back in Figure 8.2, if a unit tax equal to AE were set, then the optimal level of pollution would also occur. For pollution before C, the benefits are greater than the tax. It is beneficial to pollute and pay the tax. After C, the benefits of pollution are less than the tax, and therefore they are better off not polluting. The production decision under unit taxes is given by: Q S  0 when Costs  MC + unit tax Q S = 0 when Costs = MC + unit tax Q S  0 when Costs  MC + unit tax The distribution effects of the policy indicate the gains and losses from the policy. The total tax the polluter would pay would equal AEFC and the cost of abatement would be CFD. If pollution had been at D before the policy, the benefits to society would be equal to FGD. For pollution permits, the government would have to give out or sell permits equal to AC. If they auctioned off permits, firms (and consumers or conservation groups ) would have to buy them in order to pollute. If the price of permits was less than AE, then firms would want to pollute up to the point where the permit price was equal to the marginal benefits of pollution. Before that point, pollution Page 5 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 would yield more benefit than the permit would cost, so firms would want to buy a permit and pollute more. However, if they wanted to pollute more than AC, there would not be enough permits, and the price of permits would be bid up: Similarly if the price of permits were higher than AE, firms would want to pollute too little. They would buy fewer permits than AE. With excess permits on the market, the price of permits would be pushed down. Thus, the market should push the permit price to the same level as the optimal tax. Q S  0 when Costs  MC + Permit price Q S = 0 when Costs = MC + Permit price Q S  0 when Costs  MC + Permit price The distribution effects are the same as in the tax case if the government auctions off the permits. If the government gives away the permits the polluter only loses CFD from the policy and the government receives no revenues. The distribution effects are the same as for the comand-and-control system. The third incentive would be to subsidize the polluter not to pollute. Suppose the subsidy was AE or we paid a firm AE for each level of pollution that they abated. a. Explain why this policy would get us the optimal level of pollution. b. What would this policy cost the government? c. Although all policies, if properly enforced, could get us to the optimal level AC, they have different income distribution effects. Compare the costs to the firm of all four policies - a standard, a tax, a marketable permit, and a subsidy. Economists do not favor a subsidy policy, or having victims pay to reduce pollution, but rather recommend the "polluter pays principle." Another term for this is "source based pollution taxes or fees." Although having victims or the government pay to reduce pollution could in principle get us to a social optimum, economists believe that having the polluter pay is likely to be more efficient for a couple of reasons. Victims are usually a more diverse group than polluters. Thus, collecting fees from them has higher transaction costs and there are incentives for each victim to want to free ride and let others pay. Page 6 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 Also if either the government or victims pay polluters to not pollute, it could cause polluters to exaggerate how much they would like to pollute to increase their payments. It could also lower costs in polluting industries and encourage entry into the industry, which would further raise the desired level of pollution and the subsidy costs to the taxpayers. Having the polluter pay also appeals to society's sense of fairness. The higher costs will be reflected in higher goods prices in polluting industry, causing consumers to pay the full cost of the product. Varying Pollution Benefits or Abatement Costs The third reason to not favor standards is that pollution control benefits are not the same for all polluters. To see why, remember that the benefits of pollution are the benefits of not cleaning up pollution or the costs of abatement. For example, let the benefits of pollution above be MBQ = 10 - 2Q. The optimal quantity of pollution (Q) from the firms point of view would be where the marginal benefits of pollution would be 0 = 10 - 2Q or Q = 5. If the firm abates (A) then quantity of pollution would be Q = 5 - A.. Since the cost of abatement is the benefit from polluting MBQ = MCA 10 - 2Q = 10 - 2(5 - A) = 2A. Now let's look at control from a different angle and focus on these costs of abatement across two firms. Let the amount we need to abate be the distance CD from Figure 8.2. Page 7 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 Suppose that Figure 8.4 below represents the costs of SO2 abatement for two electric power producers that are polluting in the above diagrams. The costs of abatement are the costs of stack gas scrubbers and other pollution control devices as well as any foregone output that results from abatement. These costs are a reflection of the benefits in the above pollution model. In the figure, read the amount abated for firm one from the left hand axis and the amount abated for firm two from the right hand axis. The horizontal axis represents the amount that the law requires to be abated and is the optimal amount of abatement or the amount CD from Figure 8.2. Suppose the allocation of abatement is at point "a" with firm 1 abating A1 and firm 2 abating A2. Notice at this allocation, the cost for firm 1 to abate the last unit is "ab" and for firm 2 it is "ac. It would be cheaper for society, if firm 1 abated more and firm 2 abated less. This would be true until we arrived at the point where MC1 crosses MC2. Beyond that point it would be more expensive for firm 1 to abate than firm 2. Thus, from a social point of view, if the government set the same standard for both firms at "a", the losses would be "cbd". Page 8 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 The government could set the abatement rate for each firm with firm 1 required to abate more than firm 2, or if it knew cost it could pick a tax rate to get the optimal level of abatement for each. This would, however, require that the government know the abatement cost for each firm. Since such information is proprietary it is unlikely that the government could get the targets or the taxes right. Each firm has an incentive to try to inflate abatement costs so as to be required to abate less. In addition, it would seem politically difficult to impose different standards on different firms. For these reasons, economists tend to favor marketable permits. Based on early work in the 1960s John Krutilla and Allen Kneese at Resources for the Future. Such permits require that the government make a decision on the optimal level of pollution. Once that is decided, permits to pollute are auctioned off. If the price of permits is too low, firms will want to pollute too much resulting in a shortage of permits and their price will be bid up. Similarly too high a price will result in a surplus of permits. The market will determine the price of the permits. Then firms with low abatement costs will abate more and firms with high abatement costs will abate less as is socially efficient. Note again that to make auctions truly competitive all stakeholders should be permitted to bid for the licenses to permit. Thus polluters (say firms), consumers (those harmed), and conservation groups should be permitted to participate in the market. This may yield a better estimate for the value of the negative externality and its impacts on society. Page 9 of 10 Rough Notes Externalities and Optimal Pollution Policies Spring 2016 Permits vs Pollution Standards or Command and Control Early U.S. pollution regulations favored pollution standards or the command and control approach. However, with the high cost of this approach and the urging of economists, more and more market incentives have been introduced into the regulations. Argument for using marketable permits comes from the SO2 regulations in the Clean Air Act of 1990. This act set up a market for SO2 emission permits beginning in 1995. Permits were tried on a local basis back in the 1970s and 1980s in southern California. Before the act was passed, estimates of compliance cost, which would determine permit price, were between $170 and $1000 dollars a ton with a few even higher. Once implemented in 1995, permits averaged around $80 per ton. (Economic Report of the President 1997 ). Thus, by allowing firms to decide on their own abatement strategy - the costs of the program were much lower than expected. Page 10 of 10 1. The marginal benefit of abatement of emissions is 240 - 2.5 A. Draw a graph of the MBA with MB on the vertical axis and Abatement (A) or tons of emissions on the horizontal axis. a) What is the level of abatement and emissions, if there is no environmental policy? b) The Green Scientists argue the marginal cost of abatement is 60. How much abatement will occur? What will be the level of emissions? Show the new price and quantity of A in your diagram above. c) Big Stink Scientists argue the marginal cost of abatement is 20. How much abatement will occur? What will be the level of emissions? Show the new price and quantity of A in your diagram above. d) Clearly, there is disagreement and the true social marginal cost is unknown. EEE2199, Energy-Economics- Environment-2199 Consultants are brought in to analyze the issue using the reports from the Green Scientists and the Big Stink Economists. Anvitha Flagg, Head of the EEE2199 Research Team reports to the Environment Ministry that both analyses have merit. Based on the evidence, she recommends that the Green Scientists are correct with a probability of 40% and the Big Stink Scientists are correct with a probability of 60%. Based on the advice, what is the expected marginal social cost of abatement or E[MSC]? Using this value, what is the socially optimal level of abatement? What will be the socially optimal level of emissions?
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NAME OF THE STUDENT:
INSTRUCTORS NAME:
COURSE TITLE:
DATE:
ENERGY
DEFINITION
Energy is the ability or capacity to do work
The benefit of abatement of emission is 240-2.5, below is the graph of the MBA with MB

Vertical axis

marginal benefits

MB
240

Marginal abatement cost

MBA=MB
A

G

BF
CD
2.5
Abatement e emission e=0
A.The level of abatement and emissions if there is no environment policy
Firms pollute the environment because there is a benefit to pollution and production which implies that
pollution and production allow firms to generate more returns in a much-unregulated world. Indeed
most production firms can maximize their profits by using the most and cheapest productions
techniques available.it is unreasonable to say the most economical production methods is likely the
dirtiest one. The production firms weighing the MB of pollution against the MC in the unregulated
world. If the MC of pollution is zero, firms will then emit the maximum level of conta...


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