Perman et al.: Ch.

6
Pollution control: instruments

Outline of lecture
[Previous: Ch. 5. What is the socially optimal pollution level?]

Ch. 6. Pollution control instruments

Focus on cost-effectiveness of control instruments

Cost-Effective Pollution Abatement

Cost-effective pollution abatement involves using abatement
instruments that can achieve
target levels of pollution abatement

at the lowest social cost.

Consider two firms, A and B

with marginal abatement costs of 60 and 100 respectively
If B were to reduce abatement by 1 unit and
A were to increase abatement by 1 unit

Then total abatement would be unchanged

but the total cost of abatement would be reduced by 40 units.

Efficiency condition
Equal marginal abatement costs

Costs are minimised when

marginal abatement costs are equal for the two firms A and B

This means that A will undertake more abatement than B

to achieve a given aggregate level of pollution abatement.

The total cost of pollution abatement for each firm is

the area under its marginal cost curve (Fig. 6.1).

The total cost of pollution abatement for society is

the sum of the areas under each firms marginal cost curve.

Two firms, A and B

Politically specified total abatement (A+B) target=40
MC
200

For least-cost solution:

necessary to find levels of ZA and ZB which add up to Z= 40
and which satisfy least-cost condition: MCA=MCB

MCB = 5ZB

MCA = 3ZA
100

75

A undertakes more abatement than B

because MCA<MCB

10

15

20

25

30

35

40

Pollution abatement

Figure 6.1 Marginal abatement cost functions for the two firms.

6.3 Instruments for achieving pollution abatement targets

Table 6.2 Classification of pollution control instruments

Instrument category
Institutional approaches
to facilitate internalisation of externalities

Command and control instruments

Economic incentive (market-based) instruments

6.3.1 Voluntary approaches

6.3.1.1 Bargaining

6.3.1.2 Liability

6.3.1.3 Social responsibility

Command and Control Instruments (6.3.2, p 188)

Most regulators use direct controls to reduce pollution.
These instruments can be classified according to what they target.
Figure a illustrates the relationships that link production to pollution.

Figure b names the instruments used to control pollution according to the

stage of production that they target.

It is generally best to direct controls

at the points closest to ambient pollutions levels, which is the target of the
regulation.

Ambient pollution
levels

Emissions output
Quantity of goods produced

Location of
emissions
For non-UMPs

Production technique

Start here

Inputs used

Fig 6.4a The pollution process

Ambient pollution
requirements
Zoning

Emissions
licenses

For non-UMPs

Output quotas

Technology controls
Start here

Best practicable means (BPM)

Best available technology (BAT)

Input restrictions

Fig. 6.4b Command and control instruments

Command and Control Instruments

Inefficient

Least-cost solution requires that

marginal abatement costs are equal for all polluters

Normally, a regulator cannot acquire information about MC of individual

polluters
Information costs prohibitive
Information asymmetries

Therefore, mandatory obligations/restrictions on behaviour of firms and

consumers
Are not generally least-cost solutions to a pollution control problem.

Economic Incentive Instruments

Incentive-based instruments create economic incentives
for polluters to voluntarily change behaviour.

Incentive-based instruments may be

Taxes/levies
Subsidies
Transferable/tradeable pollution permits.

Using incentive-based instruments create

Opportunity costs* of pollution
Which profit maximising firms will take into account.

-----------* The opportunity cost is the value of the best foregone alternative.
Captures the idea that the cost of something is not just its monetary cost but also the value of what you didnt get.

Input tax on nitrogen fertilizer

Uncontrolled farmers will use nitrogen fertilizer
until the marginal benefit of fertilizer application per hectare is zero.

An input tax can be designed to achieve an socially efficient level of

fertilizer application
the marginal social costs of pollution abatement are
equal to the marginal social benefits of pollution abatement (Figures 6.5- 6.6).

Marginal social damage

Marginal benefit (for firm) before tax

Marginal benefit
after tax

Efficient
emissions tax

Unregulated profit max. emission level

*
0

M*

Emissions, M

Figure 6.5 An economically efficient emissions tax

Marginal cost of abatement

Socially efficient abatement level

and optimal for firm at tax rate *

Marginal benefit of abatement

Z* =

M*
M

Emissions abatement, Z

Figure 6.6 The economically efficient level of emissions abatement (Uniformly mixed pollutant)

Pollution tax on emissions

A tax on emissions at a constant rate per unit of emissions
Shifts the marginal benefit curve down

Polluters will again emit pollution until the marginal benefit of emitting pollution is
zero
at a lower pollution level.

Each firm is free to choose what methods to use to reduce emissions

and (cost minimizing firms) will use the cheapest methods to do so.

Emissions tax/subsidy
Marginal damage unknown

Suppose EPA does not have sufficient information

to deduce the economically efficient level of emissions
or it wishes to set an overall emissions target on some other basis.

Figure 6.7 shows that

to attain ANY specific emissions target using a tax or subsidy instrument,
knowledge of the aggregate marginal benefit of emissions (= marginal abatement
costs) function would be sufficient
This due to the fact that polluting firms behaviour is determined by marginal benefits.

Pre-tax or pre-subsidy marginal benefit

Post-tax or post-subsidy marginal benefit

.
.

~
M

Emissions, M

Figure 6.7 Emissions tax and abatement subsidy schemes when marginal damage is unknown, or
when a target is being set on grounds other than economic efficiency

Abatement Subsidies versus Pollution Taxes

Abatement Subsidies
versus
Pollution Taxes
If an industry is given a subsidy at a fixed rate (*) per unit of
pollution abated
then the same level of emissions reductions would be achieved
As in the situation where an equivalent tax was imposed.

Subsidy might enlarge the industry

Partially or wholly offsetting short run emissions reductions.

The distributional effects of the tax and subsidy are different

With subsidy, the industry gains income
With tax, the industry loses income (Figure 6.8)

Marginal benefit
(before tax)

Marginal social damage

Efficient abatement level

at tax rate or subsidy rate = *

*
0

S3

S5
S6
S4

M*

S2

S1

Emissions before tax/subsidy

Tax costs firms * times M*= S3, S4, S5, S6

+ foregone profits from reducing output = S2
Subsidy gives firm payment = * times (M M*) = S1 and S2
minus foregone profits from reducing output = S2
Net gain (payment minus foregone profits from reducing output) = S1

Figure 6.8 Emissions tax and abatement subsidy schemes: a comparison

Emissions (M)

Tradable Emissions Permits

Emissions Permits
Allocated through auction
We consider tradable permits on quantity of emissions
Regulator determines total quantity of missions allowed
Permits are allocated between polluters through a market.

Emissions permits may be initially allocated through an auction.

(Figure 6.9)

Marginal abatement cost (aggregate)

= demand curve for permits

Equilibrium price for permits

0
Supply of emission permits determined by regulator

M*

Total reduction in emissions = M M*

Figure 6.9 The determination of the market price of emissions permits.

Emissions Permits
Distributed at no charge

If tradable permits are initially allocated arbitrarily to emitting firms,

initial allocation will not be profit maximising for the firms

Firms with low abatement costs will reduce their emissions and sell the
excess emissions permits
at a price higher than their marginal abatement costs

Firms with high abatement costs will buy permits

o so long as the price of a permit is below their marginal cost of abating
emissions.

Marginal cost of abatement will be equal for all firms (Figure 6.10)

Supply of permits
by firms

Demand for permits

Price of a permit will be equal to the
marginal cost of pollution abatement

EP*

Emission permits
(EP)

Figure 6.10 The determination of the market price of emissions permits:

free initial allocation case.

Relative advantages of different control systems

Cost-efficiency
A command and control regulation instrument
To be cost-efcient
the regulator must know each polluters marginal cost of
abatement function
very unlikely that this requirement will be met.
For a ow pollutant and a uniformly-mixing stock pollutant

an emissions tax, abatement subsidy or marketable permit system

can achieve any emissions target at least cost
the regulator needs not know the individual polluters marginal
cost of abatement function.
The market mechanism will reveal that information.

Second-best world
Policy instrument choice takes place in a second-best world,
where results are much less clear

absence of markets (including those for externalities and public

goods)
asymmetric information, moral hazard and other instances of
market failure

point to possible benets of command and control-based public

intervention
in particular circumstances.

Non-UMP stock pollutant

For a non-UMP stock pollutant
Cost-effective tax and subsidy instruments
require knowledge of individual rms marginal cost of
abatement functions.

only transferable permit schemes do not require that knowledge.

Costs of
monitoring, administering and enforcing compliance
These costs can be substantial.
The prevalence of minimum technology requirements may be due
to the fact

that these costs can be low

relative to those of instruments that try to regulate emissions
output levels.

6.6.3 Long-Run Effects of Regulation

The long-run effects of pollution control depend on
net income effects and
technological innovation effects.

Market based pollution abatement regulations create a dynamic

incentive structure
which continually reward the development of improved pollution
abatement technology.

Taxes remove income from the targeted industry,

which will cause it to shrink in the long-run.

Subsidies will have the opposite effect.

Figure 6.13 Dynamic incentives under emissions tax controls.

New technology reduces marginal cost

of abatement from MC1 to MC2

MC1

MC2
Firm will save:
due to lower MC of abatement
+ due to reduced tax payment

Emission
tax/subsidy

Z1*

Z2*

At lower MC:
firms abatement level will increase from Z1* to Z2*

Z
Level of abatement