Chapter 6

Pollution control-
Part 2
Policy instrument selection:
Emission charge or
Standard?
 A comparison of emissions charges
and standard when abatement costs
are uncertain

f*

MAC MAC
 • Establishing a ‘baseline’ against
Target setting under perfect which the efficiency losses from
information errors due to uncertainty can be
measured.

• The efficient target, E*: emissions

level, equates to the MAC and
MDC MDC.

• The shaded area: the total net social

benefit that would be generated at
t*
that level of emissions (the
maximum net benefit available).

• Efficiency losses from uncertainty

MAC are those in which emissions are at
any level other than E*, so attained
net benefits fall short of their
maximum level.
E* Emissions, W
Figure 6.1 Uncertainty about abatement costs –
Δ TEC (W* &LH) =
costs overestimated Δ TDC ＋Δ TAC =
( 3 + 4 ) + (- 3) = 4
MDC

Loss when
standard used
4
fH
f* 2
Loss when MAC
Emission charge used (assumed)
3
MAC
1 (true)

Δ TEC (W* & Wf) =

Wf W* LH Emissions, W
Δ TDC ＋Δ TAC =
( -1 ) + (1+2) = 2
Figure 6.2 Uncertainty about abatement costs –
costs underestimated
Δ TEC (W* & Wf) =
Δ TDC ＋Δ TAC =
MDC
( 3+4 ) + (-3) = 4
Loss when
standard used
Loss when
Emission charge used
2
4
f*
fL
3 MAC
1 (true)

Δ TEC (W* &WL) = MAC

Δ TDC ＋Δ TAC =. (assumed)
( -1 ) + (1+2) = 2
WL W* Wf Emissions,
W
Figure 6.3 Uncertainty about abatement costs –
costs overestimated
Loss when Loss when
Emission charge used standard used

MDC
fH
f*
MAC
(assumed)

MAC
(true)

Wt W* LH Emissions, W
Figure 6.4 Uncertainty about abatement costs –
costs underestimated

Loss when
Loss when Emission charge used
standard used

MDC

f*
fL

MAC
(true)
MAC
(assumed)
LL W* Wt Emissions, M
 General results for
abatement cost uncertainty
• The relative slopes of the MAC and MDC functions
differentiate these two pairs of case s. We obtain the
following general results:
1. When the (absolute value of the) slope of the MAC
curve is less than that of the MDC curve, standard s are
preferred to emission charge (as they lead to smaller
efficiency losses).
2. When the (absolute value of the) slope of the MAC
curve is greater than the slope of the MDC curve,
emission charges are preferred to standard (as they
lead to smaller efficiency losses).
Figure 6.5 Uncertainty about damage costs –
damages underestimated
MDC
(true)

MDC
(estimated)

f 2

MAC
1 (true)

W* L Emissions, M
 2.3 Subsidies
Subsidy instruments are selected if MSB is greater
than MPB or the government want s to provide
incentives for improving environmental quality and
investing in abatement technology.
 Subsidy
In case of Positive Externality:
ÞSubsidy (s) = MSBQ* –MPBQ* = MEBQ*
• Total subsidies (S) = s x Q*
 Limitations

+ Subsidies result in financial pressure on the government

+Although emission subsidies would have the same incentive

for each individual source, total emissions may actually
increase due to the increasing number of emission sources.

=> Subsidies are not seen as viable environmental policies

except in special circumstances.
 2.4 Transferable Discharge Permit
(TDP)/Quota
• A transferable discharge permit creates a transferable
property right to emit a specified amount of pollution.
Feature:
• To create a market for pollution rights.
• A permit to emit a unit of a specific pollutant (Ton, kg)
• Each permit entitles its holder to emit one unit of the
waste material specified in the right.
• Permits are transferable: can be bought and sold
Functions of Gov. authorities:
• Determine the total allowable permits
• Decide the mechanism to distribute the initial pollution permits
 How permits work
o The government sets the desired level of emissions
(potentially considering MAC and MDC).
• Thus, like command and control policies, the
government controls the final amount of
pollution.
o Firms are issued permits to emit pollutants. Only
the desired number of permits is issued. Thus, the
quantity is assured. (e.g., if the goal is 1000 tons of
emissions, 100 firms may be permitted to produce
10 tons each).
o Firms can buy and sell permits.
 Firms can buy and sell permits
üFirms with higher MAC will be willing to buy permits from
firms with lower MAC.

üIf the price paid is less than the MAC of the high-cost
firm, it is better off.

üSimilarly, if the price is greater than the MAC of the low-

cost firm, it is better off. It can take the money it gets
from selling the permit, use it to reduce pollution, and still
have some left over.

üSuch trades are possible until MAC is equal across firms.

If P> MAC at the same level of emissions, the firm should sell permit

Initial emission permits: W0

• TACW0 : AW0Wm
P,C MAC1 • P>MAC0àFirm sell (W0-W1)
permits
B C • TAC after selling permit:
P
BW1Wm
A • Additional TAC : ABW0W1
MAC0
• Income from selling permits:
BCW0W1
• => Benefit after trade: ABC

O W1 W0 Wm W
If P<= MAC at the same level of emissions,
the firm should buy permit

Initial emission permits: W0

P,C MAC2
• TAC : AW0Wm
• P<MAC0 àFirm buy (W1-W0)
A
permits
MAC0 • TAC after buying permit: BW1Wm
C
P B • TAC saved: ABW0W1
• Permits buying fee: BCW0W1
=>Benefit after trade: ABC

O W0 W1 Wm W
 Transferable Discharge Permit Market

P,C P,C
MAC2

MAC1 A2
MAC2(W0)
P = MAC1(W1) B1 C1 P = MAC2(W2) C2 B2

MAC1(W0) A1

O W1 W0 W1 m O W0 W2 W2 m W
W

P = MAC1(W1) = MAC2(W2) (a)

W1+W2 = 2W0 (b)
Tradable permits Total 300 permits/year
One permit: allowed to emit a ton of
Cost SO2
Initial issued: 150 permits/firm =W0
Firm 1: Point R (MAC=500)
Firm 2: Point S (MAC= 2500)
MAC1
MAC2

P=?
2500 S W1=?
W2=?
How many permits will be
E
traded?
1000
R
500 Tons of SO2 emitted/ year Firm
1
0 100 150 300

300 200 150 0

Tons of SO2 emitted/ year Firm 2
Tradable permits
P=? W1+W2 = 300
Total 300 permits/year W1=?
One permit: allowed to emit a ton of SO2 W2=?
Initial issued: 150 permits/firm =W0
Firm 1: Point R (MAC=500)
How many permits MAC1 intersects MAC2 at P=1000
Firm 2: Point S (MAC= 2500) will be traded?

MAC1 (150) = 500 < P = 1000

MAC2(150) = 2500 > P= 1000
Cost

à Firm 1 sells permits

à Firm 2 buys permits
MAC1 MAC2
MAC1 (100) = MAC2 (200)

à W1= 100, W2= 200

2500 S
1000 à Firm 1 sells (150-100 = 50) permits
E à Firm 2 buys (200-150 = 50 ) permits
R Tons of SO2 emitted/ year
50
0 Firm 1
0 100 150 300

300 200 150 0

Tons of SO2 emitted/ year Firm 2
 Permit Market
• Buyers $ S
o New firms
o Existing firms looking to P*
expand
• Sellers D

o Firms leaving Q* Permits

area/industry
o Those who have
invested in efficient
technology
Permits flow from low MAC
polluters to high MAC polluters to
satisfy the equi-marginal principle
Advantages of Tradable discharge permits
• Least intervention
• Cost - effective, especially when many parties are
involved
• Provide observable market prices for environmental
services.
• Applied to a wide range of environmental problems

Disadvantages of Tradable discharge permits

• Appropriate mechanism to distribute permits
• Ineffective when there are few participants
• Can be accumulated by firms to deter entrants
 2.5 Deposit refund system
• Deposit-refund systems are a combination of a
product charge (deposit) and a subsidy for
recycling or proper disposal (the refund).
• Manufacturers or vendors of products that are
subject to deposits incur additional costs in handling
returned products, but these costs are often partially
offset by the interest earned on deposits, unclaimed
deposits, and sales of collected, used products.
 Objectives
• The objective of a deposit system is to
discourage illegal or improper disposal.
• Waste products discarded improperly have
higher social costs than those disposed of
properly since such discards can become an
eyesore, environmental, or health threat.
Improperly discarded waste is also quite
expensive to redirect to the legal waste
stream.
• E.g., Applied to beverage containers
Deposit Refund System
 Deposit refund model
vAssessing the model
• Encourages environmentally responsible
behavior without adding to monitoring and
compliance costs
• It can be used to encourage more efficient use
of raw material
 2.6 Environmental
Performance Bonds
² This instrument is the same as Deposit- Refund System but
resource extracting companies are subject to deposit a certain fund
or valuable assets.
² Objective: Companies need to take adequate measures to minimize
the environmental damages caused by their activities
² They effect the clean- up and restoration of residual damage in the
most cost effective manner
² Adequate fund are available for the clean up of waste and
restoration of damaged environments by anyone who fails to
comply
² Environmental bonds need not be a constrain on economic activity,
as they can be invested in interest bearing accounts or replaced by
bank guarantees.
Environmental Performance
Bonds
 Exercise 1
A paper company (MNPB = 4 - q) is operating next to a river,
dumping harmful chemicals into it. As a result, the soft drink
factory operating further down the river is suffering losses (MEC =
1/3 q) because of the incerased water purification costs.
• a)If the government now passes a law that everybody has the
right for a clean environment, how much would the paper
company have to pay (minimum and maximum) to the soft drink
company in order to be allowed to continue operation? What will
be the output of the paper company at the end of the bargaining
process? Please make a drawing showing the situation!

b) If the government would like to ensure the pollution reduction

using a norm or a tax, which instrument should it choose and why?
(Taking into account that the goverment does not know exactly
the MNPB curve of the paper company) (You do not need to
draw or make any calculations here!)
 Exercise 2
The profit curve of a steel plant is MNPB=9-q, the
associated environmental pollution causes social
costs in the order of MEC=1/2q. The authority tries to
estimate the company’s profit curve and arrives at
the following result: MNPB’=6-q.
• a) If the government decides to regulate using a
norm, where will it set the norm, and what will be
loss caused by the mistake?
• b) If the government decides to regulate using a
tax, where will it set the tax, and what will be loss
caused by the mistake?
•
 Exercise 3
• The marginal abatement cost curves of two
companies are the folowing: MAC1 = 5q1; MAC2 =
4q2 (where q means the amount of removed
emissions). The companies are regulated by a tax,
and the revenue of the authorities from the two
companies is 880 and 1200. The total cost of the
regulation for the two companies is 1040 and 1400.
• What were their original emissions?