Chapter Five: Economics of pollution control and

environmental policy

5. • Pollutant Taxonomy
1

• Efficient Allocation of Pollution

5.2

5
. • Environmental Policy Instruments
3

1
Introduction

Economic Activities

Non- Absorbed Emission flows into

emission flow the environment
Absorbed emission flows
into harmless forms

Accumulations of Flow pollution

pollutant stock damage
Stock
Degradation of pollution
stock into damage Pollution
harmless
2
forms damage
3
 Pollutant Taxonomy Absorptive
 Capacity .
The amount of waste products emitted of Environment
determines the load upon the
environment. Emission
Load
 The damage done by this load depends
on the capacity of the environment to Pollutant
Accumulation W
assimilate the waste products
a
 We call this ability of the environment s
to absorb pollutants, its absorptive
t
capacity, or "assimilative capacity".
Pollution e
 If the emissions load exceeds the Damage
absorptive capacity, then the pollutant
Economic
accumulates in the environment. Activities

4
Cont.........
 Pollutants for which the environment has little or no absorptive
capacity are stock pollutants. Stock pollutants accumulate
over time as emissions enter the environment.
 Pollutants for which the environment has some absorptive
capacity are fund pollutants.
 For these pollutants, as long as the emissions rate does not
exceed the absorptive capacity of the environment, the
pollutants do not accumulate.
 Flow Pollutants: Pollutants that are introduced into the
environment at a certain rate and do not accumulate. Typically
have a shorter-term impact; can be managed through treatment
and disposal.

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In environmental science,
Fund pollutants: refer to pollutants that the
environment has some capacity to absorb, meaning
they can be broken down or diluted to a less
harmful level.
Stock pollutants" accumulate in the environment
over time because the environment has very little,
or no capacity to absorb them.
 Flow pollutants are substances that cause damage
only while they are actively being released, with
their impact ceasing once the emission stops.
6
Cont……
 Pollutants can also be classified by their zone of
influence, defined both horizontally and vertically.
 The horizontal dimension deals with the spatial domain
over which damage from an emitted pollutant is experienced.
 The damage caused by local pollutants is experienced near the
source of emission, while the damage from regional pollutants
is experienced at greater distances from the source of
emission. In fact, it can be Local Pollutants, Regional
Pollutants and Global Pollutants.
 The vertical zone of influence describes whether the damage
is caused mainly by ground-level concentrations of pollutants
or by concentrations in the upper atmosphere. It can be
Atmospheric Pollutants, Aquatic Pollutants, and
Terrestrial
7 Pollutants.
 5.2. Efficient Allocation of Pollution
 Pollutants are the residuals of production and consumption.
 These residuals must eventually be recycled or returned to the
environment.
 Their presence in the environment may depreciate the service
flows received.
 An efficient allocation of resources must take this cost of
depreciation into account.
 The efficient allocation of pollution depends on the nature of
the pollutant.

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 Stock Pollutant
 The damage caused by its presence increases and persists as
the pollutant accumulates.
 The efficient allocation must take into account the pollutant
accumulates in the environment over time.
 Production involves the generation of a proportional amount
of a stock pollutant.
 The amount of pollution can be reduced, but that takes
resources away from the production.
 The damage caused by the presence of this pollutant in the
environment is further assumed to be proportional to the size
of the accumulated stock.
 As long as the stock of pollutants remains in the environment,
the
9 damage persists.
 Cont……..
 The dynamic efficient allocation, by definition, is the one that
maximizes the present value of the net benefit.
 In this case, the net benefit at any point in time, t, is equal to
the benefit received from the consumption of goods minus the
cost of the damage caused by the presence of the stock
pollutant in the environment.
 This damage is a cost that society must bear, and in terms of
its effect on the efficient allocation.
 The damage cost associated with a stock pollutant rises with
the cumulative amount deposited in the environment.
 Stock pollutants create a burden for future generations by
passing on damages that persist.

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 Fund Pollutants
 To the extent that the emission of fund pollutants exceeds the
assimilative capacity of the environment, they accumulate
and share some of the characteristics of stock pollutants.
 When the emissions rate is low enough, the discharges can be
assimilated by the environment, the link between present
emissions and future damage may be broken.
 Efficient allocation of pollution involving the minimization of
two different types of costs: damage costs and control or
avoidance costs.
 The marginal damage caused by a unit of pollution increases
with the amount emitted.
 Marginal control costs commonly increase with the amount of
pollution being controlled.
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 Cont…….
 Emissions have both control cost and damage costs.
 These damages can be thought of as a negative
(adverse) externality.
 For simplicity, we suppose that damage is independent
of the time and the source of the emissions, and that
emissions have no effect outside the economy being
studied. An efficient level of emissions is one that
minimize total cost of pollution, where total cost of
pollution defined as pollution control plus pollution
damages.

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 Cont…….
 In the case of flow pollution, damage (D) is dependent
only on the magnitude of the emissions flow (Q):
TDC = D(Q) and TCC = C(Q)
dTCC/dQ is the marginal control cost of pollution
dTDC/dQ is the marginal damage cost of pollution
 Total damage rises at an increasing rate with the size of
the emission flow, and so the marginal damage will be
increasing in Q
 The total control cost will rise at a decreasing rate as
emissions increase, because per-unit emissions control
costs will be more expensive at greater levels of emissions
reduction, the marginal control cost would fall as their
flow
13
increases.
 Total damage cost

Total Total control cost

Cost

Unit of pollution
emitted

Marginal
Cost

Q* Unit of pollution
emitted
14
 Control left of Q*
. Marginal are inefficient.
costs Marginal Further increase in
damage cost avoidance costs
Marginal
(MDC) would exceed the
reduction in
control cost damages.
(MCC)
Control right of Q*
would result in a
lower cost of control
but the increase in
damage costs would
be larger, yielding an
increase in total cost.
TDC TCC
0 Hence, Q* must be
Q* efficient.
Q*= optimal unit of emission Unit of
TDC= Total damage cost pollution
TCC=Total control cost emitted
Total cost= TDC+TCC
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 5.3. Environmental Policy Instruments
 Efficiency is achieved when the marginal cost of control
(MCC) = Marginal damage cost (MDC) caused by the
pollution of each emitter.
 However, the efficient levels of policy instruments (by
setting Q*) are very difficult to implement in practice.
 To implement, we must know the level of pollution at which
the two marginal cost curves cross for every emitter.
 It imposes an unrealistically high information burden on
control authorities.
 Control authorities typically have very poor information on
control costs and little reliable information on marginal
damage functions.
16
Cont……..
 Control authorities should select specific legal levels of
pollution based on some criterion.
 Once these thresholds have been established by whatever
means, only half of the problem has been resolved.
 The other half deals with deciding how to allocate the
responsibility for meeting predetermined pollution levels
among the large numbers of emitters.
 Once the objective is stated in terms of pollution level at
minimum cost, it is possible to derive the conditions that any
cost-effective allocation of the responsibility must satisfy.
 Environmental authorities prefer the cost or the cost-
effectiveness criterion.
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Consider two emission sources currently emitting a total 30 units of
emissions.
 Assume the control authority o In the cost-effective allocation,
the first source cleans up 10
determine 15 units of pollution
units, and second cleans up 5
can be assimilated by the units.
environment so that reduction of o The TC of control = A+B.
15 units is necessary o Any other allocation would
result in a higher total control
cost.
o Plant managers have full
information as to how they
determine the least cost
technique of pollution control.
o But, environmental authority are
not likely to have this
information because plant
managers would give biased
18 information.
The policy instruments to reduce pollution are:-
Emission Standard
(Command and
Control)
Emission Charges
(Imposition of Taxes)
Transferable
Emission
Permits-"cap-and-
trade" systems
Liability Rules

19
 Command and Control
 These involve setting specific limits on the amount of pollution
that can be emitted (e.g., emissions standards for industries).
 An emissions standard is a legal limit on the amount of the pollutant
an individual source is allowed to emit.
 In the absence of information on control costs, how these limited
units are to be allocated between the two sources?
 Pollution control would be simply to allocate each source an equal
reduction but this strategy would not be cost-effective.
 Compared to a cost-effective allocation, total costs would increase if
both sources were forced to clean up the same amount.
 There is no reason to believe that the authority will assign the
responsibility for emissions reduction in a cost-minimizing way.
 Some policy instruments do allow the authority to allocate the
emissions reduction in a cost-effective way even it has no
information.
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Incentive-based instruments
 Incentive-based instruments work by altering the structure
of pay-offs that agents face, thereby creating incentives for
individuals or firms to voluntarily change their behavior.
 The pay-off structures are altered by changing relative
prices. This can be done in two ways.
1. By the imposition of taxes on polluting emissions, or by
the payment of subsidies for emissions control.
2. By the use of tradable emission permit (or allowance)
systems in which permits command a market price.
Those prices are, in effect, the cost of emitting pollutants.

21
Emission Charges or Imposition of Taxes
 An emissions charge is a fee, collected by the government,
levied on each unit of pollutant emitted into the environment.
 Emissions charges reduce pollution because paying the fees costs
the firm.
 To save money, the firm seeks ways to reduce its pollution.
 Each firm would then control its emissions until its marginal
control cost equaled the emissions charge.
 Since all firms face the same emissions charge, they will
independently choose levels of control consistent with equal
marginal control costs.
 This is precisely the condition that yields a cost-minimizing
allocation.
22
 How much pollution control would the firm choose?
It would pay the firm to reduce emissions until the marginal
cost of reduction is equal to the emissions charge.

23
Cont……..
 As long as the control authority imposes the same
emissions charge on all firms, the resulting incentives are
automatically compatible with minimizing the costs of
achieving that level of control.
 Without having the requisite information on control costs,
the control authority cannot establish the correct tax rate
on the first try.
 It is possible, however, to develop an iterative, trial-and-
error process to find the appropriate charge rate.
 This process is initiated by choosing an arbitrary charge
rate and observing the amount of reduction that occurs
when that charge is imposed.
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Cont……..
 If the observed reduction is larger than desired, it means
the charge should be lowered; if the reduction is smaller,
the charge should be raised.
 The new reduction that results from the adjusted charge can
then be observed and compared with the desired reduction.
 This process can be repeated until the actual and desired
reductions are equal.
 At that point the correct emissions charge would have
been found.
 The charge system also stimulates the development of
newer, cheaper means of controlling emissions, as well as
promoting technological progress.
25
Cont……
 With an emissions charge system, the firm saves money
by adopting cheaper new technologies.
 As long as the firm can reduce its pollution at a marginal
cost lower than T, it pays to adopt the new technology.

26
Imposition of Taxes and subsidy
Marginal damage
. Marginal benefit (before tax)

Marginal benefit (after tax)

Tax rate=unit subsidy
*

M* Ḿ Emissions, M
MCC
Marginal control cost is mirror image of marginal benefit before tax

Marginal benefit of control

* Or unit subsidy of control

0
Z* =M̂  M* Z
Emissions Control, Z
27
 Cont….
 The tax instrument at rate * brings about a socially efficient
aggregate level of pollution
 It will also achieve that aggregate target in a cost-effective way.
 Cost-efficiency requires that the marginal control cost be equal
over all controllers.
 Under the tax regime all firms adjust their firm-specific control
levels to equate their marginal control cost with the tax rate.
 But as the tax rate is identical for all firms, so are their marginal
costs.
 Knowledge of both the aggregate marginal pollution damage
function and the aggregate emissions control cost function are
necessary for achieving a socially-efficient emissions target at least
real resource cost to the economy as a whole.
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 Emissions tax and abatement subsidy schemes: a
comparison
 An emissions tax and an emissions abatement subsidy (at the same
rate) differ in terms of the distribution of gains and losses.
 This has important implications for the political acceptability and
the political feasibility of the instruments.
 It also could affect the long-run level of pollution abatement
under some circumstances, via alteration of the size of the
industry. Pre-tax or pre-subsidy
marginal benefit Marginal damage
Post-tax or post-subsidy
S8 marginal benefit
S7

* S4
S6 S1
S3
S5 S2
0 Ḿ
29 M*
Marketable Emissions Permits
 Marketable permit systems are based on the principle that
any increase in emissions must be offset by an equivalent
decrease elsewhere.
 There is a limit set on the total quantity of emissions
allowed, but the regulator does not attempt to determine
how that total allowed quantity is allocated among
individual firms.
 A total quantity of emissions of some particular type (the
‘cap’) that is to be allowed by a specified class of actual
and potential emitters over some period of time.

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Cont…..
 The creation of a quantity of emissions permits that in sum
equal, in units of permitted emissions.
 A mechanism by which the total quantity of emission
permits is initially allocated between potential polluters.
 A rule which states that no firm is allowed to emit pollution
beyond the quantity of emission permits.
 A system whereby actual emissions are monitored and
penalties of sufficient deterrent power are applied to firms
which emit in excess of the quantity of permits they hold.
 A guarantee that emission permits can be freely traded
between firms at whichever price is agreed for that trade.

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 Marketable Emission Permit
. Firm 2
MCC
Firm 1
MCC
MC2 MC1
A

C C
B

0 15 20 30 0
10

Initially each firm emitted 40 units (80) unit in total, but the assimilative capacity of the environment is 40
unit of emission.
The remaining 40 unit should be controlled by the two firms (20 unit each) the unit cost of control given by
the vertical axis and controlled emission given by horizontal axis
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 Cont……
 The marginal cost of control for the first firm(A) is substantially higher
than that for the second (B).
 The first firm could lower its cost if it could buy an allowance from the
second firm at a price lower than A.
 Meanwhile, the second firm would be better off if it could sell an
allowance for a price higher than B.
 Because A is greater than B, grounds for trade certainly exist.
 A transfer of allowances would take place until the second firm had
only 15 allowances left (and controlled 25 units), while the first firm
had 25 allowances (and controlled 15 units).
 At this point, the allowance price would equal C, because that is the
marginal value of that allowance to both sources, and neither source
would have any incentive to trade further.
 The allowance market would be in equilibrium.
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Liability rules
 Liability rules are set in such a way that there is an
incentive for a producer to follow some prescribed
mandate, technological restriction or acceptable behavior.
 Liability rules can be set so that the producer pays a bond
in advance and is repaid if there is no harm committed or
pays a non-compliance fee after the harm has occurred.
 Liability rules attempt to reduce the level of shirking on
environmental pollution control by raising the costs of
misbehavior.

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Types of liability rule

Non-compliance fee

Deposit refund systems

Performance bonds

35
 Non-Compliance Fee
 A producer is fined if his actions lead to a level of pollution that
exceeds some set standard.
 This system has an incentive mechanism to induce polluters to
supply the target level of pollution control.
 If total emission exceeds the target standard at a common site, the
regulator selects at least one producer at random and fines him.
 The regulator then redistributes a portion of this fine minus the
damages back to the other producers.
 The random penalty mechanism increases the expected costs of
shirking.
 If designed properly, will induce the target control level without
actually having to monitor the actions of any producer.
36
Deposit Refund Systems
 Under these systems purchasers of potentially polluting
products pay a surcharge, which is refunded to them when
they return the product or its container to an approved
center for recycling or proper disposal.
 This instrument rewards good environmental behavior.
 The systems provide economic benefits for good
environmental behavior and impose costs for bad behavior
(those who would not return the materials).
37
 Performance Bonds
 With a performance bond, a producer posts a bond before
operations begin, or feting the bond if his activities cause
environmental harm or if he pollutes in excess of acceptable
levels.
 The bond increases the costs of shirking, thereby reducing the
incentive for malfeasance.
 Bonds can reduce the incentive to shirk with perfect
monitoring the value of the bond should equal or exceed the
value of damages.
 The value of the bond is determined by the potential
environmental impact of the producer’s actions.

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Trans-boundary Environmental Problems
 Many of the best-known examples of pollution involve the
actions of more than one country.
 Obvious examples include acid rain, (greenhouse effect),
global warming, ozone layer depletion, biodiversity,
international waters, etc.
 Global environmental problems possess the characteristic of
being reciprocal externalities.
 Each country’s action has a spillover effect on the other’s
country utility.
 Trans-boundary pollution is best characterized as a problem
of international externalities, which arises from a lack of
property rights in the global commons.
39
Trans-boundary Pollution and Game Theory
 Consider a game with two countries (X & Y) as players and two
strategies representing their possible courses of action
concerning pollution control(control/not control).
 Assume that the two countries are equal in terms of population
size, income and pollution levels, pollution damages and
pollution control costs.
 Dominant strategy exists for one player whenever one choice is
best for ‘him’ irrespective of the choice made by the other player.
 There is a strong incentive operating on the other’s pollution
control.
 The incentives to free-ride reflect the fact that this is a public
good

40
 Cont……
If country Y and X do not control Sometimes player may not have a
pollution their total benefit will be 0; dominant strategy.
if Y and X control pollution they will In a dynamic context the results may
reap benefits of 6 (i.e. 3 for each). be different.
The first number goes to Y and the The Nash equilibrium or the outcome
second to X in each cell. of the game is co-operation, i.e.,
Not control is the dominant strategy of both countries abate pollution and
each player will get benefits of 7 for each.
Country X
Country X
Country Not Contro
Country Not Control Y control l
Y control
Not (0,0) (5,-3) Not (0,0) (5,-3)
control control
Control (-3,5) (3,3) Control (-3,5) (7,7)

41
Cont……..
 But in practice it is difficult to arrive at such result
(agreement) because:
 Number of countries are large so it is very convenient for
each country to be a ‘free-rider’,
 Unevenly distributed bargaining power among countries
(because some are poor and the rest are rich),
 Expected games are differ,
 The definition of the property right is not clear
 The cost of bargaining is high.

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