Regulatory Options & EfficiencyWhy regulate?Types of questions in regulationProblemBOD Removal, Costs of US RegulationsPrinciple of efficiencyMore Generally: The “efficient” amount of pollutionRecall example from 1st weekWith mixed high and low cost firms abating, we couldIf costs aren’t constant: two firms (eg, NOx emissions)How much abatement from each?How did he do that?The “equimarginal principle”Control costsCommon Instruments for regulationWeitzman on carbon taxesExample 1: Taxes in ChinaA creative quota: bubble policyExample 2: Bubble policy in RIExample 3: SO2 AllowancesSO2 Allowance Prices, 1994--2004How big the tax or how many permits?Slide 23Slide 24Problem: How to reduce VOC emissions in LA without increasing costs?Problem: Too many houses being built in SB; want to slow growth. How?Regulatory Options & EfficiencyGoal: Generate regulatory tools to fix environmental problemsWhy regulate?Does free market efficiently provide goods and services? Market failure (externalities, public goods, etc.)Market power (monopolies inefficiently restrict production to raise prices)Information problems (damages uncertain, food safety, env quality)Types of questions in regulation1. What is the “optimal” amount of pollution? 2. To reduce by X%, who should reduce and by how much?3. What regulatory instrument(s) should be used to achieve that level?ProblemEPA has regulations to control biological oxygen demand (BOD). EPA would like your advice on how to improve water quality (lower BOD) without increasing costs.What is your advice?BOD Removal, Costs of US RegulationsIndustry Subcategory Marginal CostPoultry Duck-small plants $3.15Meat Packing Simple Slaughterhouse $2.19Cane Sugar Crystalline Refining $1.40Leather tanning Hair previously removed $1.40Paper Unbleached Kraft $0.86Poultry Chicken – small plants $0.25Raw Sugar Processing Louisiana $0.21Paper NSSC – Sodium Process $0.12Poultry Chicken—large plants $0.10Source: Magat et al (1986); units: dollars per kilogram BOD removedPrinciple of efficiencyMost common approach: uniform burden (eg, everyone cuts pollution by x%)Two possible resultsToo much pollution for the total amount of pollution control costsToo much cost for a fixed level of pollution reductionBurden of pollution control should fall most heavily on firms with low costs of pollution controlMore Generally:The “efficient” amount of pollutionMarginalControlCostMarginalDamageCost$/unitUnits of pollutionQ*TotalDamageCostTotal ControlCostRecall example from 1st week60 firms, each pollute 100 tons30 low abatement cost ($100/ton)30 high abatement cost ($1000/ton)Everyone reduces 1 ton: Cost=$33,000Total reduction = 60 tons.For same cost how many tons could we have reduced?With mixed high and low cost firms abating, we couldEither:Reduce more pollution for the same amount of money…orReduce the same amount of pollution for less money.So we always want low-cost firm to shoulder abatement.If costs aren’t constant: two firms (eg, NOx emissions)AbatementCost($/unit)NOx ReductionMCAMCBWho should abatethe 1st unit of NOx?How much abatement from each?MCAMCB0040408080$ (A)$ (B)2555A:B:Loss from equalreductionHow did he do that?1. Determine how much total abatement you want (e.g. 80)2. Draw axis from 0 to 80 (A), 80 to 0 (B)3. Sum of abatements always equals 80.4. Draw MCA as usual, flip MCB5. Lines cross at equilibrium6. Price is MC for A and for B.The “equimarginal principle”Not an accident that the marginal abatement costs are equal at the most efficient point.Equimarginal Principle: Efficiency for a homogeneous pollutant requires equating the marginal costs of control across all sources.Control costsShould include all other costs of control monitoring & enforcementadministrativeEquipmentRegulatory uncertainty increases costs.If you are a polluter, what would be your response to uncertainty in what you have to do?Does this increase your costs? Would like to design regulations that provide an incentive to innovateCommon Instruments for regulationCommand and Control: Centralized determination of which firms reduce by how much.Taxes: charge $X per unit emitted. This increases the cost of production. Forces firms to internalize externality.Quotas/standards: uniform standard (all firms can emit Y) or non-uniform.Tradable permits: All firms get Y permits to pollute, can buy & sell on market. Other initial dist’n mechanisms.Weitzman on carbon taxes“One can only wish that US political leaders might have the insight to understand and the courage to act upon the breathtakingly-simple market-friendly idea that the right carbon tax could do way more to unleash the power of decentralized American inventive genius on the problem of developing economically-feasible non-carbon-intensive alternative technologies than all of the command-and-control schemes and patchwork subsidies making the rounds in Washington these days.”Example 1: Taxes in ChinaChina: extremely high air pollution – causes significant health damage.Instituted wide-ranging system of environmental taxation2 tiersWorld Bank report estimates that MC of abatement << MB of abatement.A creative quota: bubble policyMultiple emissions sources in different locations.Contained in an imaginary “bubble”.Regulation only governs amount that leaves the bubble.May apply to emissions points within same plant or emissions points in plants owned by other firms.Example 2: Bubble policy in RINarraganset Electric Company:2 generation facilities in Providence, RI.Required to use < 2.2% sulfur in oil.Under bubble policy:Used higher sulfur in one plant, burned natural gas at other plantSavings: $3 million/yearExample 3: SO2 Allowances1990 CAAA sought to reduce SO2 emissions from 20 million tons/yr to 10 million tons/yrSet up market in emission allowances97% of 10 million tons allocated to pollutersRest auctioned at CBOT – anyone can buy: see http://www.epa.gov/airmarkets/formsSO2 Allowance Prices, 1994--2004Source: http://www.epa.gov/airmarkets/trading/so2market/alprices.htmlHow big the tax or how many permits?We know:Optimal level of pollution is Q*Marginal Social Cost at the optimum is P*Marginal Private Cost at optimum is Pp.Optimal tax exactly internalizes externality:t* = P* - PpEffectively raises MC of production$/unitDirty