(Diagram 2)
the government could tax polluters based on the estimated damage they have done (referred to as a Pigovian tax). This tax on production will shift the MNPB curve left, as shown, and, if tax is equal to t* the new production will be at Q* as this will be where the polluter maximizes private net benefits. Therefore, for the tax to be successful it should be set at the level of MEC at the optimum level of production. Governments may also argue that tax should be used as a way of controlling pollution levels as revenue from this could pay for cuts in income tax and potentially help increase employment as well as helping the environment. For example, in the US, if carbon emissions were taxed at a rate of $75 per ton then revenue raised per year would be equal to one sixth of all federal receipts from personal income taxes. However, there are also some problems with this form of tax, for example, it is difficult to get the right level of tax as you have to know the MNPB and MEC curves and therefore, it is difficult to predict the exact emissions reduction a given tax will induce. Also, the main effect of a tax will be to alter pollution levels just by altering production levels rather than encouraging pollution abatement.
An alternative method of achieving an optimal level of pollution is the use of tradable emission’s permits. With this method the government will issue a number of permits out to companies allowing them to pollute, and the number of permits issued will ration this level of pollution so that desired level of emissions is achieved. This is effective as each firm must have a permit to pollute and are unable to pollute over the level stated. However, these permits are tradable and can be bought and sold on a permit market. If there is a large number of firms then this will make the market for permits a competitive one, so, in equilibrium, the price of the permit will be equal to the marginal cost of abatement (MCA) for all firms, and therefore the government will be able to achieve their optimum level of emissions at a minimum and efficient cost. 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 pollute. 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. This scheme has also been adopted in the UK with the launch of the world’s first economy wide greenhouse gas emissions trading scheme in April 2002, with the belief that “EU emissions trading scheme is central to our strategy to tackle climate change…it will create a strong incentive to industry and business to use less and cleaner energy”. The targets set by this scheme are predicted to save 1.1Mtc of carbon equivalent by 2006.
However, there are arguments against government intervention and the use of taxes and tradable permits in order to achieve optimal levels of emissions. One argument is that the problem can be sold by relocation of industry between countries. Theoretically, two countries could improve their position by trading production and pollution with gains to trade in goods and bads. For example, countries which have a very low economic activity and consequently tend to have a clean environment may benefit from an increase in manufacturing activity, and those countries which suffer from dirty environments due to a high level of economic activity could benefit from less activity. Therefore, those industries operating in areas with dirty environments may choose to relocate part of their industry to an area with a cleaner environment that would benefit from an increase in economic activity. A good example would be for a rich manufacturing industry to partly relocate to Africa where the atmosphere is one of the cleanest in the world but where income per head is one of the lowest in the world, so the benefit of extra economic activity would outweigh the cost of an increase in emissions.
Another argument against the need of government intervention stems from the Coase Theorem, which states that ‘if the party imposing diseconomies of scale and the party suffering them are willing to negotiate to their mutual advantage, state intervention is unnecessary to secure optimum resource allocation’. To explain the Coase theorem it is necessary to refer back to diagram 1 and also consider the issue of property rights. If the sufferer has property rights (i.e. has the right not to be polluted) then they would rather production was at point 0 on the diagram, however, they may bargain with the polluter over the acceptable level of emissions. For example, if production was at the optimum Q*, the sufferer would lose an amount equal to the area B and the polluter would make a gain of area A compared to when there was no economic activity. Since area A is larger than area B the polluter is able to compensate the sufferer by an amount greater than B but smaller than A, so that the polluter will still have a net profit and the sufferer will be better off than when there were no emissions. However, any move right of Q* would not be feasible as the polluter’s net gain is smaller than the sufferer’s losses and therefore they cannot be compensated. If it is the polluter who has property rights, this bargaining will take place again. The polluter will initially want to be at Qπ, but if they move back to Q* the sufferer will gain areas D and C, and will therefore compensate the polluter an amount less than this and an amount greater than the profits they will surrender (area C) so, once again, both parties are better off. This shows that with bargaining there is an automatic tendency to the optimum of Q* regardless of who has property rights and therefore no need for government regulation. However, there are a number of limitations associated with this theory. 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.
Bibliography
-
Banzhaf, Burtraw & Palmer, Capping Emissions: Where Efficiency and Public Interest Intersect, Public Utilities fortnightly, 1st Dec 2002
-
Pearce & Turner, Economics of natural resources and the environment, Harvester Wheatsheaf, 1990
-
Pindyick & Rubinfeld, Microeconomics – 2nd edition, Macmillan, 1992
-
Parry. I, Are Tradable Emissions Permits a Good Idea? Resources for the future Issue Brief 02-33
-
DTI, Energy White Paper, TSO, Feb 2003
(word count = 2050)
Figures taken from p.2 of I.Parry’s paper, Are Tradable Emissions Permits a Good Idea?
This is found by adding together the marginal cost curve of each firm.
Quote from Patricia Hewitt, Secretary of state for trade and industry.
Figures taken from p44 of the Energy White Paper
