Regulation of Externalities

Environmental Protection

Risk & The Environment -- Links• Efficient Environmental Protection

– Marginal cost of harm– Marginal cost of abatement

• Key Questions: What is the value of –– A (statistical) life saved? – A (statistical) tree saved? – A (statistical) dolphin saved?

• Key Issues– Consumer heterogeneity (Costs & Benefits)

• Income, Geography, Workers– Distribution of costs & benefits

• Upstream/downstream– “Real” market solutions vs. “Real” regulatory solutions

Regulatory Approaches• Prescriptive Limits (Command & Control)

– Best Available Technology• Cheap enforcement, inflexible, static

– Effluent Limits (PPM)• Somewhat expensive enforcement, somewhat flexible

– Effluent Limits (Total)• Expensive enforcement, most flexible (& tradable), dynamic

• Incentive Systems (Market Mechanisms)– Internalize marginal cost– Firms choose least costly means of abatement– Costs reflected in prices

Tradable Permits• Examples

– Existing: Sulfur Dioxide (Acid Rain)– Proposed: Greenhouse Gas (Global Warming)

• System– Allocate emission rights (grants, auctions)– Firms & interest groups make buy/sell decisions– Consumer prices reflect emission prices (shift in supply curve)

• Example– Market price is t per unit of product for a particular firm– Firm can buy permit or install filters at cost of c with increasing

marginal cost (10% cut costs c, 20% costs 4c, 30% costs 9c)– Choice: Reduce emissions until MC=t, then purchase permit

• Permits vs. Taxes– Known abatement levels, preference heterogeneity, dynamic

efficiency

Firm Abatement Decisions

% Abatement

Cost Firm A MC Firm B MC

Firm AEfficientAbatement

Firm BEfficientAbatement

Global WarmingThe Ultimate Externality

• EDF System– Tradable permits for greenhouse gasses– Goal – reduce emissions to 1990 levels– International trades permitted– Trading system reduces cost from $582 to $19.9

billion

• Issue– Initial allocation– Short-term incentives– Compensated damages & moral hazard– Monitoring