Economic Solutions to Environmental Problems: The Market Approach

Chapter 5

Economic Solutions to
Environmental Problems: The
Market Approach

© 2004 Thomson Learning/South-Western


Descriptive Overview
 Market approach – an incentive-based policy
that encourages conservative practices or
pollution reduction strategies
 Difference between market approach and commandand-control approach is how each approach attempts
to achieve its objectives

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Descriptive Overview
 Identifying Types of Market Instruments
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Pollution charge
Subsidies
Deposit/refund systems
Pollution permit trading systems

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Pollution Charges
 Pollution charge – a fee that varies with the
amount of pollutants released
 “Polluter-pays principle”
 Product charge – a fee added to the price of a
pollution-generating product based on its quantity or
some attribute responsible for pollution

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Pollution Charges
 Modeling a Product Charge as a Per Unit Tax
 Policy motivation of a product charge is to induce
firms to internalize the externality by taking account of
the MEC in their production decisions
 Pigouvian tax – a unit charge on a good whose
production generates a negative externality such that
the charge equals the MEC at Q
 Assessing the Model
 Difficult to identify the dollar value of MEC at Q
 Model implicitly allows only for an output reduction to
abate pollution
E

E

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Pollution Charges
Figure 5.1 Implementation of a Pigouvian Tax to Achieve
Efficiency

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Pollution Charges
 Modeling an Emission Charge: Single-Polluter
Case
 Emission or effluent charge – a fee imposed directly
on the actual discharge of pollution
 Assessing the Model
 Emission charge stimulates the natural economic
incentives of the polluter

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Pollution Charges
Figure 5.2 Modeling an Emission Charge for a Single Firm

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Pollution Charges
Figure 5.3 Effect of Technology Improvement on a Firm’s

Least-Cost Decision Making

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Pollution Charges
 Modeling an Emission Charge: Multi-Polluter Case
 Assessing the Model
 Emission charge exploits each polluter’s natural
incentive to pursue a least-cost strategy
 Low-cost abaters do most of the cleaning up and highcost abaters pay more in taxes to cover the greater
damages they cost
 Potential increase in monitoring costs
 Part of tax burden is shared with consumers in form of
higher prices

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Pollution Charges
Figure 5.4 Effect of an Emission Charge in a Two-Polluter
Model

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Pollution Charges
 Pollution Charges In Practice
 Internationally, pollution charge is most commonly used
market-based instrument

 Several countries use effluent charges to control the
noise pollution generated by aircraft
 Real-world application of the product charge is one
levied on lubricant oils by Finland, Hungary, and Italy

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Environmental Subsidies
 Two major types of subsidies:
 Abatement equipment subsidies
 Pollution reduction subsidies

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Environmental Subsidies
 Modeling an Abatement Equipment Subsidy
 Abatement equipment subsidy – a payment aimed at
lowering the cost of abatement technology
 Attempts to internalize the positive externality
associated with the consumption of abatement
activities
 Pigouvian subsidy – a per unit payment on a good
whose consumption generates a positive externality
such that the payment equals the MEB at Q
 Assessing the model
E

 Difficulty measuring the MEB

 May bias polluters’ decisions about how best to abate
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Environmental Subsidies
 Modeling a Per Unit Subsidy on Pollution
Reduction
 Per unit subsidy on pollution reduction – a payment
for every unit of pollution removed below some predetermined level
 Assessing the Model
 Might be less disruptive than an equipment subsidy
 Can have perverse effect of elevating pollution levels
in the aggregate

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Environmental Subsidies
 Environmental Subsidies in Practice
 Internationally, many countries offer environmental
subsidies in the form of grants or low-interest loans
 In the United States, the most common use is federal
funding for publicly owned treatment works

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Deposit/Refund Systems
 Deposit/refund system – a market instrument
that imposes an up-front charge to pay for

potential damages and refunds it for returning
a product for proper disposal or recycling
 Combines the incentive characteristic of a pollution
charge with a built-in mechanism for controlling
monitoring costs

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Deposit/Refund Systems
 Economics of Deposit/refund Systems
 Intended to force the potential polluter to account for
both the marginal private cost (MPC) and the marginal
external cost (MEC) of improper waste disposal
 Targets the potential polluter instead of penalizing the
actual polluter

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Deposit/Refund Systems
 Modeling a Deposit/Refund System
 Deposit serves the same function as a pollution
charge with the critical difference that the refund helps
to deter improper waste disposal
 Assessing the Model
 Encourages environmentally responsible behavior
without adding to monitoring and compliance costs
 Can be used to encourage more efficient use of raw
materials

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Deposit/Refund Systems
Figure 5.5 A Pigouvian Subsidy in the Market for Scrubbers

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Deposit/Refund Systems
 Deposit/Refund Systems in Practice
 Beverage container disposal
 Disposal of used tire, car hulks, and lead-acid
batteries

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Deposit/Refund Systems
Figure 5.6 Modeling a Deposit/Refund System in the Market for
Waste Disposal

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Pollution Permit Trading Systems
 Pollution permit trading system – a market
instrument that establishes a market for
rights to pollute by issuing tradeable

pollution credits or allowances
 Pollution credits – tradeable permits issued for
emitting below an established standard
 Pollution allowances – tradeable permits that
indicate the maximum level of pollution that may be
released

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Pollution Permit Trading Systems
 Structure of a Pollution Trading Systems
 Two components:
 The issuance of some fixed number of permits in a
region
 A provision for trading these permits among
polluting sources within that region
 Bargaining gives rise to a market for pollution rights

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Pollution Permit Trading Systems
 Modeling a Pollution Permit System for
Multiple Polluters
 Incentive to trade as long as two firms face different
MAC levels
 Trading will continue until the incentive to do so no
longer exists, at which point, the cost-effective
solution is obtained

 Assessing the Model
 Trading establishes the price of a right to pollute
without intervention
 No tax revenues are generated
 Trading system is more flexible
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