Model Based Policy Analysis (Subject) / 3. Theory and instruments in environmental policy (Lesson)

efficiency and markets, Externalities, Property rights, climate policy instruments

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• What is efficiency? An allocation is efficient or Pareto optimal if it lies on the Pareto frontier How to produce: The criterion does not give any information on how to produce the Pareto optimal amount Decision: MRTSLKX= MRTSLKY , with MRTS= marginal rate of technical substitution Who gets it (distribution): decision: MRSXYA= MRSXYB , with MRs= marginal rate of substitution What to produce: decision: MRSXYA= MRSXYB =MRTXY à marginal rate of transformation in production needs to equal the marginale rate of substitution in consumption Requirements for efficiency 1. Marginal rate of substitution in consumption = marginal rate of transformation (MRT) in production 2. Market generates prices such that MRS is the same for all consumers and equal to price ratio of goods 3. MRT must be equal for all producers. With a market, MRT is equal to price ratio
• What could be problems when applying the concept of the welfare theorems on environmental goods? Recap: Theorems of welfare: 1. In a competitive economy a market equilibrium is Pareto optimal 2. In a competitive economy, any Pareto optimum can be achieved by market forces, provided the resource allocations of the economy are appropriately distributed before the market is allowed to operate. Problem: Many environmental goods are not transacted at markets. Many resources are public goods or open access. Other resources traded (land, minerals, energy). Markets are often far from perfect and there are extrernalities. All that leads to market failure. Inequity/Inequality: need to redistribute endowments (has traditionally received little attention in economics, but this is changing). The climate issue is linked closely to many distribution issues. There is burden sharing (international or national). The arising question is, who has to mitigate how much? Polluters of the past or polluters of the present? Consumers or producers? Keep in mind: climate policies hurt poorer households more Inefficiency: the conditions of the welfare theorems are not met, there is market failure due to: a) imperfect competition b) incomplete markets: public goods, externalities, non-existence of market, transaction costs c) incomplete information (policy instrument) d) missing property rights (compensation)
• What are externalities? 1. Situation when the effect of production or consumption of goods and services imposes costs or benefits on others which are not reflected in the prices charged for the goods or services being provided. 2. Positive or negative externalities 3. Arise when property rights cannot be clearly assigned 4. Marginal WTP for a product causing a positive externality needs to be higher (--> higher price --> more production): Problem: Private mWTP lower than social mWTP negative externality: marginal social costs higher than marginal private costs, optimal amount produced is lower than private amount produced, price is higher
• Give examples for negative externalities as well as for positive externalities. negative: waste, water pollution, air pollution, noise positive: bee-keeping, vaccination
• Why are property rights important? Institutions are essential for function ability of markets à ensured property rights provide excludability Property rights allow a market to allocate goods and bads in an efficient way Initial allocation of property rights is important
• Give ashort explanation of the Coase-Theorem. 1. Robert Coase examined whether rights should be assigned to the polluter or the damaged 2. Property rights is considered a good/resource with a price 3. There are no transaction costs 4. Pollution permits are freely tradable , the initial allocation of permits is irrelevant 5.  Under certain circumstances it does not matter who holds the property right, but their allocation is important 6. Any precise definition of ownership rights leads to a pareto efficient internalization of external effects (via negotiations and without transaction costs) 7. A pareto-efficient internalization is independent of who owns the property rights – the polluter or the damaged party 8. Whether negotiations lead to a pareto-efficient internalization of external effects depends on the transaction costs as well as on the information levels of the parties involved and the nature of the negotiations Laissez faire: The polluter holds the property rights. He realizes a profit maximizing emission level without considering harmful effects to others. Polluter pays principle: The property rights are held by the damaged party (e.g. fishery).
• Polluter pays or laissez-faire? From the efficiency view it might be better, when the polluter is not made responsible for cleaning up, because they do not have a high willingness to pay. So, letting them clean up produces negative utility.
• Define "public good". Characteristics of public goods 1. non-excludability:A good is excludable if it is feasible to selectively allow consumers to consume the good. A bad is excludable if it is feasible to selectively allow consumers to avoid consuming the bad. Excludability needs to be practical (cost of excluding must not exceed utility). 2. non-rivalry: A bad (good) is rival if one person’s consumption of a unit of the bad (good) diminishes the amount available for others to consume. There is a negative (positive) social opportunity cost to others associated with consumption. A bad (good) is non-rivalrous otherwise. There might be no rivalry up to a certain degree of usage. Public goods are indivisible and, according to some, non-excludable in consumption
• What kinds of goods are there? 1. Pure private good: excludable and rivalrous 2. Congestible resource: excludable, non-rivalrous 3. Open-access resource: non-excludable, rivalrous 4. Pure public good: non-excludable, non-rivalrous
• How are governments able to correct market failure? 1. Create and enforce property rights 2. Provide information 3. Command-and-control: set of organizational and technical attributes and processes ... [that] employs human, physical, and information resources to solve problems and accomplish missions" to achieve the goals of an organization or enterprise (military) 4. Fiscal instruments
• Name marekt-based and non-market-based policy instruments. 1. market based a) taxes b) subsidies c) transferable permits 2. non-market-based (command-and-control-instruments) a) emission standards b) specification c) limits on e.g. discharges d) reporting requirements (soft measure, mainly provides more information) e) liability (promises by the companies) If an instrument is appropriate to increase efficiency depends on the lack of information and if there is more than one source of market failure
• How can we evaluate policy instruments? 1. Economic efficiency: a given objective is achieved at lowest costs, e.g. reduce GHG 2. Ecological effectiveness: ability to achieve a given target, e.g. increasing the share of renewable energies 3. Dynamic incentive effect: a policy has such an effect if it induces progress in environmental technologies.
• Explain and evaluate the pigouvian tax as an instrument of climate policy. Emmision charges Pigouvian taxes are levied on emissions. They cause the firms to lower their emission level e0 through abatement to apoint, where MAC=t. Emitters with lower abatement costs will reduce their emissions more, MACs equalize. A tax shifts the MPC curve up by the amount of the externality (difference MCpr and MCsoc). So that the producer has an incentive to reduce output or to change to cleaner processes or technologies. Evaluation 1. Economic efficiency: under perfect information taxes would be efficient. But normally there is asymmetric information. The government does not know the amount of externalities. Social costs are unknown. 2. Ecological effectiveness: Because the social costs are normally unknown, ecological effectiveness is only partially given. 3. Dynamic incentive effect: Tax gives the incentive to invest in new technologies and progress in environmental technologies.
• Evaluate subsidies as climate policy instruments. 1. Economic efficiency: Same problem as for taxes: social costs are unknown 2. Ecological effectiveness: because the social costs are unknown, no ecological effectiveness. Additionally, the subsidy might attract more and more inefficient producers 3. Dynamic incentive effect: Does not give any incentive to improve technology.
• Explain and evaluate emission trading as climate policy instrument. The regulator (e.g. government) sets the maximum level of emissions. Emission permits are handed out to the firms, either by grandfathering or via auctioning. Firms buy and sell permits according to permit prices compared to abatement costs. Firms with lower abatement costs can easier reduce emissions and therefore sell their permits to firms with higher abatement costs. There is no specification of who has to abate how much, so there is high flexibility. In the end, there will be an equilibrium price for emission units. Evaluation 1. Economic efficiency: Here, we still don’t know the social costs, but emission trading is more about quantity control, not about price control. 2. Ecological effectiveness: specific formulation possible and therefore high ecological effectiveness. 3. Dynamic incentive effect: high incentive effect for both: emission permits selling and buying firms. In theory, emission trading is the most effective measure, but the implementation is not easy and for optimal effectiveness a global system is necessary.
• First best vs. second best First best allocation: no distortions, fully efficient First best in context of climate change: Marginal Damage = Marginal Costs -> emission reductions are endogenous Distortion exists if society’s marginal cost of producing a good does not equal society’s marginal benefit form consuming the good à taxes create distortions Second-best is the most efficient outcome that can be achieved conditional on being unable to remove some distortions. (Classical example: existence of distorting taxes) theory of second best: What happens if one or more optimality conditions cannot be fulfilled? Second-best: in the case of climate policy: reach given target at minimal costs  Closely related to policy analysis: 1.       Analyze how2°C-target can be achieved at minimal cost 2.       Analyze how different policies reduce costs of reaching certain targets 3.       Analyze inefficiencies e.g. uniform carbon prices

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