Environmental Economics Midterm

Concepts +

Free markets that are efficient (7)

1- Markets exist for all goods and services
2- All markets are perfectly competitive
3- All transactors have perfect information
4- Private property rights are fully assigned in all resources and commodities
5- to externalities exist
6- There are no public goods
7- Well-behaved utility and production functions

Market Failure

When the market economy will deliver an outcome that does not
maximize efficiency (our Net Benefits)

Common Market Failures

-Externalities

-Public Goods

Externalities

-when the production or consumption decisions of one agent have an impact on the utility or profit of another agent in an unintended way, and when no compensation/payment is made by the generator of the impact to the affected party

-actions of one economic agent directly affect another economic agent outside of the market mechanism

Negative production externalities

when a firm’s production reduces the well-being of others who are not compensated by the firm

MPC- Marginal Private Cost

The direct cost to producers of producing an additional unit of a good

Marginal external cost (MEC)

additional costs associated with the production of the good that are imposed on others but that are not paid by producers

Marginal social cost (MSC=MPC+MEC)

The marginal private cost to producers plus any marginal external cost

Coase Theorem

-Externalities are not outside of the market

-We can internalize them to make them inside the market

Internalizing the externality

– When either private negotiations or government action lead the price faced by the source of the externality to fully reflect the external benefits or costs of its actions

Solving social costs with Coase Theorem

-allocation of property rights (either to the source or the recipient of the externality) will facilitate private bargaining between individuals to overcome market failure caused by the externality and arrive at an efficient outcome

1) Bargaining between parties can achieve social optimum
2) Efficient quantity of externality-associated good does not depend on initial allocation of property rights (ignoring income effects)

Coase Theorem Issues

1) Assignment problem: When externalities affect many agents (e.g., air pollution), assigning property rights is hard/impossible
2) Holdout problem: Shared ownership of property rights gives each owner power over all others (due to agreement needed to achieve Coasian solution)
3) Transaction costs and negotiating problem: Costly to organize large parties for assignment and negotiation

Kahneman, Knetsch, and Thaler (1990) Challenge w/

-Tested the Coase theorem—which asserts that resource allocation is independent of the initial assignment of property rights when trade is costless—by examining the gap between willingness to pay (WTP) and willingness to accept (WTA)

-Endowment effect

Endowment Effect

-increased value of a good to an individual when the good is owned by individual

-Lab experiments using real exchanges of tokens and various consumption goods with random allocation used to test for endowment effect

Determining how much of a negative externality (pollution) there should be

– Policymaker should have complete information
– Compliance with environmental regulation
– Partial equilibrium framework (single market in isolation)
– Single time period

Types of pollution

1) Flow-damage pollution
2) Stock-damage pollution

Flow-damage pollution

damage results only from the flow of emissions

- damage will instantly drop to zero once the
emissions rate becomes zero (energy pollutants)

-sometimes when residuals have very short lifespans

Stock-damage pollution

damages depend only on the stock of the pollutant in the relevant environmental system at any point in time

stock of the pollutant to accumulate, residuals must have a positive lifespan and emissions must be produced at a rate that exceedthe ability of a natural environment (suchas air, soil, or a body of water) to absorb, dilute, or break down pollutants)

Benefits of pollution

Avoided abatement costs within polluting firm/industry

Damages from pollution

-monetized health and environmental impacts of pollutant exposure

Efficient level of flow-damage pollutant

– MDF, the marginal damage function, is the monetized value of the damages due to pollutant exposure /
– MAC, the marginal abatement cost, is the cost of reducing emissions from their unregulated level \

Mechanisms for pollution control

-Direct Regulatory Intervention: require certain behavior from
firms in the regulated industry

-Incentive-Based Mechanisms: alter the tradeoffs facing firms in the regulated industry and allow them to adjust their behavior accordingly

Factors for choosing pollution control mechanism

– Economic efficiency
– Cost effectiveness
– Distribution of benefits and costs (income groups, regions, generations, etc.)
– Political feasibility

Efficient compliance costs of regulated firms

-make sure that the marginal abatement cost (MAC)—the cost of cutting the next single unit of pollution—is exactly the same for everyone, everywhere.

-Firms, production, households

-Various channels available for abatement

Costs are efficient when:

all economic actors face a common price, at the margin, for their contributions to emissions

-every firm in every sector has an incentive to pursue abatement until MAC equals emission price

-abatement costs will be passed forward into the prices of final goods and services, so consumers face prices reflecting emissions associated with consumed goods and services

Emissions price options

-Incentive-based mechanisms, Emissions taxes and tradable emissions allowance systems, Subsidies for pollution abatement, Taxes on inputs or goods associated with emissions

-Direct regulatory instruments, Technology mandates, Performance standards (output must meet certain conditions)

Cap-and-trade marketable emissions permit decisions

-Cap

-# of permits

-method of allocation

-prohibiting rule

-monitoring/enforcement

-free trading in permits

Equimarginal Principle

Costs of abatement are minimized when marginal abatement costs are equalized across emissions sources

Permit allocation

– The regulator sells permits to firms via auction
– The regulator allocates all permits at no charge

Permits to firms via auction

In competitive auction, individual firms submit bids to the
regulator revealing the price that they are willing to pay for
permits

Allocation of permits at no charge

Following initial allocation, some firms will have more permits than their unregulated emissions level and some will hold an insufficient number of permits to achieve their unregulated (desired) level of emissions

Achieving the targeted level of emissions (efficient or otherwise) in a cost-effective manner requires

– Industry MAC curve for cap-and-trade and an emissions tax
– Firm-level MAC curves for an emissions quota (to get allocation correct)

Emissions offsets

-allow controlled emitters to generate greater emissions than the
number of permits that they hold, if they can negotiate with an uncontrolled emitter to reduce its emissions by a corresponding amount

-emissions = permits+offsets

Double-dividend hypothesis

-Environmental regulation takes place with multiple sources of market failure

-Address two market failures simultaneously

– First dividend: the environment is improved (achieve efficient emissions level)
– Second dividend: efficiency gains accrue to the economy as a whole through a reduction in the pre-existing distortionary tax

Environmental policy with distortionary tax

– Efficiency gain of increasing activity in competitive market by lowering bad tax(Revenue-recycling effect)
– Policies shift costs to consumers increasing relative prices (e.g., real wages), which raising the cost of
environmental policies if this trade off is unequal. (Tax-interaction effect)

Factors in mechanism choice

Cost-effectiveness
Long-run effects

Dynamic efficiency
Ancillary benefits
Equity

Uncertainty Factors

Dependability

Flexibility

Cost of use under uncertainty

Information requirements

Dependability

An instrument is dependable if it can be relied upon to achieve a predetermined target
– All instruments discussed so far are dependable if the regulator has full information

-The amount of emissions resulting from a given rate of tax will
not be known with certainty, as it depends upon the unknown
position of the MAC curve

Flexibility

With uncertainty, the regulating agency might need to learn adaptively by trial-and-error methods and to change the rates or levels at which instruments are applied as new information arrives

Common assertion that price-based incentive instruments (e.g., tax or subsidy schemes) are inflexible, as there is inherently strong resistance to changes in tax or subsidy rates

Uncertainty costs

-Costs incurred as a result of the selection of incorrect targets (efficiency
losses / welfare losses)

– These costs are incurred due to the regulator’s inability to ensure that
emissions halt at the point at which MAC=MDF

Expected value

The expected value can be thought of as the “average” value attained by the random value; in fact, the expected value of a random variable is also called its mean

= 6[1+2+3+4+5+6]

Low MAC curve is the true curve

-emissions tax allows too few emissions (EtL<EL*)

-emissions quota allows too many emissions (EQ<EL*)

High MAC curve is true curve

-emissions tax allows too many emissions (EtH>EH*)

-emissions quota allows too few emissions (EQ<EL*)

When the MDF is steep relative to the MAC

(DW loss w/ quota vs emission tax)

The deadweight loss caused by an emissions quota is smaller than that
caused by an emissions tax

When the MDF is flat relative to the MAC (DW loss w/ quota vs emission tax)

The deadweight loss caused by an emissions quota is larger than that
caused by an emissions tax

Why are net benefits maximized at E*?

Net benefits are maximized at E* because units of pollution associated with greater marginal damages than abatement costs are not emitted

Finding efficient emissions level requires balancing

Pollution damages and abatement costs: increasing costs to producers will have an impact on market prices of resultant products

Impact of customers depends on

(ratio of real wages to price of consumed goods)

How environmental regulation can benefit firms

-Innovation, awareness,

-improvement in the way that firms acquire and use resources

-Reduce chance of costly risks

-Make environmental investments certainly valuable

-Help advance tech

Porter Hypothesis

More stringent environmental regulations will make firms more competitive (i.e., more profitable)

Technology forcing, whereby more stringent policies encourage firms to develop more productive manufacturing methods by setting standards they must achieve
• Favors more forward looking firms that anticipate trends
• Speeds investment in modern technology
• Encourages R&D

Public Disclosure Laws

-Designed to provide the public with information that is not normally available in the free exchange of goods and services

-Cals on menu

Toxic Release Inventory (TRI)

The Emergency Planning and Community Right to Know Act (EPCRA) created the Toxic Release Inventory (TRI), which requires certain firms to report annual emissions of toxic chemicals

1989-1999, emissions in the US have fallen 40%

Presenting info wo/ misperception

-Units

-Charts

-Wording

Environmental justice

-Distributive justice

-Procedural Justice

Distributive justice

distribution of environmental burdens

Procedural Justice

decision-making processes that lead to those distributions

Environmental Injustice can look like

-Disproportionate siting
-Coming to the hazard
-Coasean bargaining
-Political economy and the government

Disproportionate siting

– Firms intentionally place toxic facilities in under-represented communities

Coming to the hazard

– Low-income households are out-bid in the market for environmental quality, prioritizing necessities

Coasean bargaining

Firms have preferences over where to locate industrial facilities and households have a tolerance for pollution and some willingness to accept compensation for nearby industrial activity

Political economy and the government

– Regulators prioritize regulation and remediation across various sites while facing resource and time constraints, raising the possibility that regulators could be a source of inequitable exposure

Environmental gentrification

Cleaning up locally polluted areas may increase the demand for local housing, bidding up housing prices

Hamilton Economic justice theories

-Pure discrimination

-Coasean bargaining

-Theory of collective action

Pure discrimination

the higher the minority population, the more likely to site there

Coasean model

private parties can bargain to a Pareto efficient and socially optimal outcome when dealing with externalities, regardless of how property rights are initially assigned

Collective action

Firms want to avoid political pushback, litigation, and delays. They look for paths of least resistance, avoiding neighborhoods with a high propensity for collective action

race should not be statistically significant after controlling for Coasean variables and probability of collective action

Unit-hazard approach

-assumes that exposure to hazards is distributed equally within a geographic unit

-approach ignores exposures in adjacent areas

-Distance based is better

Governments affect the distribution of pollution w/

– Legislation
– Bureaucratic monitoring and enforcement patterns
– Court enforcement patterns

Benefit Cost Analysis

-BCA starts with a policy and considers whether or not it
promotes efficiency

-Used as a tool not a rule

Pareto Efficient

An allocation at which no one can be made better off without making someone worse off

Pareto Improvement

A change in the allocation that makes someone better off without making anyone worse off

Potential Pareto Improvement (Kaldor-Hicks Criterion)

-A change in the allocation such that there are winners and losers, and the winners could compensate the losers to make them no worse off, and still be better off themselves so overall B-C=positive

-Social BCA is based off this for net benefits

NPV

PV(B) – PV(C)

Benefit-cost ratio

𝑃𝑉(𝐵) /𝑃𝑉(𝐶)- The higher the more B

The internal rate of return

-i, at which the NPV of a project is zero

(-𝐵0 − 𝐶0)+ (𝐵1−𝐶1/1+𝑖 )+ (𝐵2−𝐶2/1+𝑖 2) + ⋯ + (𝐵𝑇−𝐶𝑇/1+𝑖 𝑇) = 0

Ecosystem Services

The conditions and processes through which natural ecosystems sustain and fulfill human life

Use WTP to

value improvements in environmental quality

Use WTA

to value reduction in environmental quality f(variables that seek to explain or validate WTP responses)

Use WTA

to value avoidance of environmental reductions (implying entitlement to lower utility level)

Pr(yes) = f (Bid, variables that seek to explain or validate WTP responses)

Direct use value (DUV)

can be consumptive or non-consumptive (e.g., hunting, fishing, bird watching, photography)

IUV- Indirect use value

reading about, viewing movies

Option value (OV)

may want to take advantage of DUV and/or IUV at some point in the future

EV- Existence value

no past, present, or future use, value simply knowing the resource exists (e.g., grand canyon, ANWR)

Bequest value (BV)

concern about future generations, want them to have the same options

Total value

Total value = use value + nonuse value

Revealed-preference

Based on actual market behavior
Examples
– Travel cost method (TCM)
– Hedonic price method

Stated-preference approaches

Based on hypothetical market behavior

Examples
• Contingent valuation method
• Choice experiments

TCM- Travel cost method

Cost per unit of travel

Derive a demand curve for visits to the area

Hedonic price method

Ex w/air quality

Hp = a + bQ
– b is the marginal effect on price of a unit change in air quality

Contingent Valuation

1. Survey- detailed context, payment, how q’s worded

2. Collect Data- – Personal interview, person to person, Online surveys, Mail questionnaire, Telephone interview

3. Estimate Bid Function- payment vehicle

4. Estimate Aggregate WTP/WTA

Types of bias

Hypothetical bias
Strategic bias
Starting point bias (anchoring)
“Yea-saying”
Payment vehicle bias
General information bias

Hypothetical bias

– Inflate responses because don’t really have to pay

Strategic bias

– Policy context may influence incentive to over(under)-state responses
(e.g., expect response to influence individual tax liability)

Anchoring bias

– Initial value in bidding game / payment card may influence responses

“Yea-saying”

– Avoidance of embarrassment from saying no

Payment vehicle bias

– Likes or dislikes for payment vehicle may influence responses

General information bias

– Responses may be sensitive to the information provided in the
description of the good being valued

Plassmann Wine experiments

Contingent Variation

BCA of spotted owl habitat

– Benefits are the use and non-use values for spotted owls
estimated via contingent valuation study
– Costs are the opportunity costs of reduced forestry sector
• Short-run: net value of foregone timber harvests and employment
costs
• Long-run: just net value of foregone timber harvests (employment
shifts)

Could levy a tax and redistribute payments to adversely affected individuals (benefits are large enough to easily compensate losers and still be better off)