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Evaluate proposals for reducing environmental air pollution by energy taxation and emissions trading

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Evaluate proposals for reducing environmental air pollution by energy taxation and emissions trading. Pollution is created as a by-product of output in most industries. It can be described as an external cost to the economy as its existence causes a loss of welfare to the population as a whole, and, in a free market, this loss of welfare will generally go uncompensated. However, that does not mean that the optimal level of pollution is zero, contrary to the environmentalist presumption, as this would mean that economic activity would have to be zero and this is illogical. Therefore, an optimal level of pollution and corresponding economic activity has to be found. According to the Pareto efficient, the (Diagram 1) ideal allocation of resources occurs when nobody can be made better off without making someone else worse off. In the case of pollution production, this can also be defined as the point of production where the marginal net private benefit (MNPB) of the polluter is equal to the marginal external cost (MEC) as a whole, as shown on diagram 1, at the level of economic activity Q*. The polluter's total net private benefit from production is illustrated on diagram 1 as the area below the MNPB curve and total external cost is the area below the MEC curve. Using this analysis, we can see that 'A' is the largest area of net benefit available, thus confirming that Q* is the optimal level of activity. ...read more.


Because of the nature of the permits being tradable, this means that those firms with a low MCA curve can reduce emissions more efficiently and therefore sell some permits, whilst those firms with a high MCA will find it more cost effective to buy more permits, so the trading scheme means that a firm can either use permits to either help meet their target or to sell over achievement in reducing emissions. This idea is demonstrated in diagram 3. (Diagram 3) We can see that firm 1 is able to reduce emissions more cheaply than firm 2. If the government gives each firm permits to produce 10 units of emission. The market price after trade of the permits will be at the point where the total supply of permits (20) is equal to the total demand to pollute2. At this level, Firm 1 will prefer to produce 8 units of emissions, whilst firm 2 would rather produce 12 units of emissions, therefore, firm 2 can buy the 2 permits that firm 1 does not need at the market price. This means that the total optimal level of emissions is achieved and both firms face an equal marginal cost of reduction. This method is popular in America, with three multi-pollutant bills being introduced recently, all adopting a cap and trade approach to controlling emissions, so that each unit of emissions produced by a firm has to be accompanied by the surrender of an emission allowance. ...read more.


Firstly, we do not observe many examples of this bargaining taking place. Also, it is likely that there will be obstacles to bargaining present, such as transaction costs. If transaction costs are high it is likely that the cost of bargaining will outweigh the benefits. Finally, if all property rights are not allocated fully then this bargaining will not occur. It is obvious that the socially optimal level of economic activity does not coincide with the private optimum if emissions are produced; therefore an optimum where MNPB is equal to MEC needs to be achieved somehow. If the market is left without any form of intervention then arguments for relocation and the Coase theorem suggest that this optimum will be reached automatically through trade and bargaining. However, there are limitations to these ideas when applied to the real world, as we have seen. Therefore, government intervention and the use of taxation and emissions trading to reduce environmental air pollution may be thought necessary. Taxation is effective as it will encourage firms to reduce their emissions in order to minimize their costs. However, for those firms with a high MCA curve, financial penalties, such as taxation, could increase a firm's production costs to the extent that economic activity falls. Emission's permits are also effective in lowering emissions, but only if they are auctioned off and tradable in the market. If there is grandfathering (giving permits only to established firms in the industry) or output based allocation present then this would incur a greater cost to the economy than auctioning off permits, thus increasing the optimum level of emissions. ...read more.

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