Abstract
Now we know how market-based instruments can be used—at least in theory—to restore the efficiency of markets. However, efficiency may not be the relevant target in the real world, for several reasons. As we have seen, it is very difficult to ascertain just how much benefit we get from these policies; indeed, it may even be hard to estimate the actual costs. But without knowing costs and benefits, we cannot determine the efficient level of pollution. Even if the marginal benefits and costs of pollution control are known, moreover, there is no guarantee that the government will set the efficient target as the goal. Distributional equity and other worthy social goals may be at odds with efficiency. And of course the political process in the real world is driven by interest group competition and the desires of legislators to satisfy their constituents as much as (or more than) by an objective attempt to maximize social welfare.
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Reference
Although minimizing costs is not the same thing as maximizing net benefits, the two are closely related. If the benefits of pollution control depend only on the total amount of abatement (in other words, if the damages from pollution depend only on the total amount of pollution), and two policies achieve the same objective, the one with lower costs must be more efficient than the other (even if the goal itself is not fully efficient). Cost minimization is a necessary (though not sufficient) condition for efficiency. In other words, it is necessary to minimize costs in order to maximize benefits minus costs.
Two other things are worth noting about the equal marginal abatement cost condition for cost-effectiveness. First, it is necessary but not sufficient. It is possible to imagine scenarios in which firms’ marginal costs are equated but total costs are not minimized—for example, if the capital costs of abatement were very high. Second, we have been careful to state that the equal-marginal-costs principle applies only to all firms that abate pollution. It is possible that some firms with very high marginal abatement costs ought not to control pollution at all (at least from a cost minimization standpoint).
Recall that a supply curve in a product market makes sense only in a competitive industry, because it embodies the assumptions that individual producers are price takers and that they seek to maximize profit. The same is true with an aggregate marginal abatement cost curve: It makes sense only in a context in which all regulated firms take the price of abatement (e.g., the tax) as given and seek to minimize compliance costs. Indeed, the aggregate curve essentially has cost-effectiveness built in: It can be thought of as tracing out the cost of abating pollution on the margin, when abatement is allocated cost-effectively between firms. In other words, the cost being measured corresponds to the least-cost allocation of abatement between firms. For this reason, it doesn’t make much sense to think about the aggregate marginal abatement cost curve under uniform standards, because (as we have already seen) uniform standards are not cost-effective in general.
In fact, we have seen this result already, in the Coase Theorem, discussed in Chapter 8. Saying that the equilibrium allocation of tradable allowances is unaffected by the initial allocation, as long as transactions costs are small, is just a restatement of Coase’s insight that private bargaining in the absence of transaction costs will lead to efficient outcomes regardless of the assignment of property rights.
The cost of adoption—the capital cost of installing or building new control equipment—will remain implicit in our analysis. This cost is what the firm must balance against the potential cost savings from using the new technology to decide whether to adopt it. Note that we can safely assume that the cost of installing a particular technology does not depend on whether a firm faces a tax or a standard. Therefore, it will not affect our comparison between various policy instruments.
We have glossed over two subtle points. First, we have implicitly treated more technology as a good thing. In fact, from the perspective of economics, the question we should ask is not “Which policy leads to more investment in new technologies?” but rather “Which policy leads to more efficient investment in new technologies?” Answering this question turns out to be harder than it seems (which helps explain why we tackled the easier question in the text). Nonetheless, there are strong reasons to believe that market-based instruments will be superior to performance standards on efficiency grounds in the face of technological change. The real question is which market-based instrument—an emission tax or a cap-and-trade policy—is preferable. The answer depends in large part on the relative slopes of marginal cost and benefit, as in the case of uncertainty over marginal cost discussed in Chapter 8. Indeed, you might be able to see the intuitive connection between “cost uncertainty” and technological change. Second, we have assumed that the regulator does not anticipate the adoption of the new technology. You can think of this as corresponding to a scenario in which the form and stringency of regulation remain set in stone over a reasonably long duration—long enough for new technologies to arise.
For the story of the longitude prize, see Dava Sobel, Longitude (New York: Walker & Company, 2005).
See Richard G. Newell and Nathan E. Wilson, “Technology Prizes for Climate Change Mitigation,” Resources for the Future Discussion Paper 05-33 (2005).
Two nuances are worth noting. First, because we are assuming a fixed market price for fish and have equated net benefits with net revenues, maximizing net benefits is equivalent to minimizing cost. We make the distinction here mainly for the purposes of intuition. Second, it might appear at first that by introducing quotas with a market price, an IFQ policy would reduce the net benefits to fishers. In fact, however, that is true for a particular fisher only to the extent that she must buy more IFQs than she sells. Moreover, from the perspective of society as a whole, the value of IFQ transfers is a wash; what matters is the difference between the total value of the harvest (reflected in its market price) and the real costs of catching it.
Nicholas Z. Muller and Robert Mendelsohn, “Efficient Pollution Regulation: Getting the Prices Right,” American Economic Review 99(5): 1714–1739.
Nonuniform mixing and regional transport of air pollution have garnered significant attention since 2008, when the U.S. Federal Court of Appeals ruled that the Clean Air Act’s emission trading programs did not adequately address this problem, particularly for the transport of air pollution from midwestern power plants to the East Coast. These issues will be discussed in greater detail in Chapter 10, in the section that describes the U.S. sulfur dioxide market.
Meredith Fowlie and Nicholas Muller, “Market-Based Emissions Regulation When Damages Vary across Sources: What Are the Gains from Differentiation?” NBER Working Paper 18801 (Cambridge, MA: National Bureau of Economic Research, 2013).
The following example is from R. Scott Farrow, Martin T. Schultz, Pinar Celikkol, and George L. Van Houtven, “Pollution Trading in Water Quality Limited Areas: Use of Benefits Assessment and Cost-Effective Trading Ratios,” Land Economics 81(2): 191–205 (2005).
The Minnesota River Basin Trading program and the Long Island Sound Nitrogen Credit Exchange are good examples. See Karen Fisher-Vanden and Sheila Olmstead, “Moving Pollution Trading from Air to Water: Potential, Problems and Prognosis,” Journal of Economic Perspectives 27(1): 147–172 (2013).
Further Reading
Aldy, Joseph E., Alan J. Krupnick, Richard G. Newell, Ian W. H. Parry, and William A. Pizer. 2010. “Designing Climate Mitigation Policy,” Journal of Economic Literature 48(4): 903–934.
Anderson, Terry L., and Gary D. Libecap. 2014. Environmental Markets: A Property Rights Approach, Cambridge University Press, New York.
Farrow, R. Scott, Martin T. Schultz, Pinar Celikkol, and George L. Van Houtven. 2005. “Pollution Trading in Water Quality Limited Areas: Use of Benefits Assessment and Cost-Effective Trading Ratios,” Land Economics 81(2): 191–205.
Jaffe, Adams B., Richard G. Newell, and Robert N. Stavins. 2003. “Technological Change and the Environment,” in Karl-Göran Mäler and Jeffrey Vincent, eds., Handbook of Environmental Economics, Vol. I, Elsevier Science, Amsterdam.
Muller, Nicholas Z., and Robert Mendelsohn. 2009. “Efficient Pollution Regulation: Getting the Prices Right,” American Economic Review 99(5): 1714–1739.
Newell, Richard G., and Nathan E. Wilson. 2005. “Technology Prizes for Climate Change Mitigation,” RFF Discussion Paper 05-33, Resources for the Future, Washington, DC.
Tietenberg, Tom H. 2006. Emissions Trading: Principles and Practice, 2nd ed., Resources for the Future, Washington, DC.
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Keohane, N.O., Olmstead, S.M. (2016). The Case for Market-Based Instruments in the Real World. In: Markets and the Environment. Island Press, Washington, DC. https://doi.org/10.5822/978-1-61091-608-0_9
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