Economics of the Global CommonsTerms to LearnOutlineBasic Assumptions of MarketsMarket ImperfectionsPublic vs. Private GoodsTragedy of the CommonsOutlineSupply and DemandExternalities in the MarketMarginal Abatement CostMarginal Costs/BenefitsMarginal Costs/BenefitsSetting the TargetOutlineInstruments to Correct ExternalitiesTaxes and MAC CurvesCap and Trade and MAC curvesMarginal Abatement Curves Tax vs. Cap+TradeMore on Cap and TradeOther TopicsQuestionsDiscount RateMIT OpenCourseWare http://ocw.mit.edu15.023J / 12.848J / ESD.128J Global Climate Change: Economics, Science, and PolicySpring 2008For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.Economics of the Global Commons15.023 LectureTravis Franck27 Feb 2008Terms to Learn• Externalities (positive and negative)– Uncompensated (non-market) interaction• Tragedy of the Commons (Harding)• Marginal Cost/BenefitOutline• Market Failure and Environmental Issues• Working on the Margin• Instruments to Correct Market FailuresBasic Assumptions of Markets• Market efficiency depends on:– Perfect information– Perfect or complete competition• No single entity can influence prices– Clear and complete property rights– No transaction costs– Rational behaviorMarket Imperfections• Externalities• Incomplete Property Rights– Non-exclusive/non-rival, eg. Public goods– Tragedy of the Commons• Imperfect Competition• Imperfect Information• Transaction CostsPublic vs. Private GoodsExcludable Non-excludableRival Private GoodsCommon-pool resources(jogging path)Non-rivalClub Goods(cable TV shows)Pure Public Good(clean air, national defense)Important: Free markets only optimize production of private goods w/ internalized costsTragedy of the Commons• Original Point: Population Growth.• Original comparison: A “Commons” (or pasture):– Private benefit (PB) of grazing– Social cost (SC) of grazing (degradation of resource)– Even if PB<SC, people keep bringing cows because PB>0! • Solutions:– “Mutual Coercion” (e.g., regulation)– Privatization• Other examples: – Free Christmas parking.–Fishing–?Outline• Market Failure and Environmental Issues• Working on the Margin• Instruments to Correct Market FailuresQMP• An ideal market maximizes societal surplusSupply and DemandSDPAn externality is an impact outside the transaction.Example: For every unit produced, particulates are emitted causing $5 of health damageWe can “internalize” the externality by using a tax or a quota system. This achieves optimal Q, but there are still distribution questions…Externalities in the MarketQMPC(S)MPB(D)MSCMPC/MPB: marginal private cost/benefitMSC: marginal social cost$5Market QOptimal QMarginal Abatement Cost• “MAC curve”• Include all options for emission reduction, ordered by price, with quantity available at that priceCFL LightbulbsDouble PaneWindowsSolarPanelsPriceCO2reductionMarginal Costs/BenefitsP• The marginal cost is the cost of the next unit produced (or next ton of emission reduced). It is equal to the slope of the total cost.TCMACQuantityReduced0204060801001201401601802000 5 10 15Quantity ReducedPriceTCMACMarginal Costs/Benefits• The advantage of using the marginal cost is that decisions are “made at the margin”:– So comparing marginal benefit with marginal cost will tell you what decision to make– Difference between “private” marginal cost/benefit and “social” marginal cost/benefitSetting the Target• Cost/Benefit Analysis (MAC = Marginal Damage)• Valuation– Non-material goods and Public Goods have no property rights: Therefore there exists a need to determine “WTP”: Willingness to Pay• “Contingent Valuation” Surveys• Surrogate Markets (travel costs to parks, noise impact on price)• Experimental economics•Replacement Costs– “Existence value”Outline• Market Failure and Environmental Issues• Working on the Margin• Instruments to Correct Market FailuresInstruments to Correct Externalities• Command and Control (Quantity and/or tech))– E.g., install scrubbers, catalytic converters, etc.– Either specific technology, emissions rate, or emissions level for each emitter.• Tax (price)– Price per quantity emitted• Cap and Trade (market)– Total quota: participants allowed to sell allowances back and forthTaxes and MAC CurvesPTaxQ reducedMAC AA tax (as opposed to “command and control”) ensures “efficient” abatement allocationMAC BCap and Trade and MAC curvesP100 (A)0 (B)0 (A)100 (B)Pollution Reduction100 Units of Reduction, 2 companies:MAC (A)MAC (B)Marginal Abatement CurvesTax vs. Cap+TradeCap and TradeTaxNew MACPOriginal PlanOld MACConstant Cost or Constant Quantity?QMore on Cap and Trade• Safety Valves• Intertemporal Trading– SO2 market, early reduction credits• Initial Allocations– Grandfathering– AuctionsOther Topics• How do you choose an instrument (monitoring, enforcement, etc.)?• Upstream vs. Downstream instruments• Social justice movement• Polluter Pays Principle• Discount Rate• Pareto Efficient Improvements• Free Rider• Coase TheoremQuestionsDiscount Rate• Composed of:– Rate of Time preference– Marginal productivity of capital * marginal utility of money• Discount Rate is not Inflation: we use “constant” dollars• Usual expression:• Net Present Value = sum of all time periods, appropriately discounted. • Value judgment? Revealed preference? Long time horizon?ttrB−+=