Economics of Environmental Policy Instrument Design – notes & summary
Final grade = 20% graded assignments + 30% case study + 50% written exam
Chapters from the book:
Week 1: 2 (from Welfare and Policy Reform t/m Public Goods and Club Goods), 4, 9
Week 2: 14 (The Economics of Controlling Stock Pollutants and Climate Change Policy & Equity
Discounting and Climate Change Policy), 11 (beginning t/m Output Effects of
Subsidies and Other Policy Instruments & General Equilibrium, Taxation, and the
Double Dividend), 5
Week 3: 6, 10 (Uncertainty in Abatement and Damage)
Week 4: 7, 6 (Green and White Certificates in Europe)
Week 5: 22 (A Simple Bioeconomic Model of a Fishery), 25, 8 (Provision of Information &
Corporate Social responsibility), 26
Week 1 - Chapter 2, 4, 9
CONDITION FOR WELFARE THEOREMS: a first-best economy which has a series of characteristic:
- Perfect competition;
- No problems such as externalities, public goods or increasing returns to scale;
- Perfect information on the part of buyers and sellers;
- Maximizing utility and production functions;
- Complete markets;
- No distortionary taxation.
Much of the economic analysis concerns the failure of one or more of these assumptions.
The fundamental theorems of welfare economics:
➢ First theorem (the ‘invisible hand’ theorem): in a first-best economy, the operation of perfect
competition will lead to a Pareto efficiency. Supports the case for non-intervention.
➢ Second theorem: in a first-best economy it is possible to reach any desired point on the
contract curve by establishing a suitable set of initial endowments.
The second theorem implies that any outcome can be “decentralized” which is achieved by market
agents themselves, if the state arranges appropriate conditions (e.g. lump-sum redistribution of the
initial endowment). It means reallocating money without affecting the mechanism. Such mechanism
do not always work in practice (partly because taxes and subsidies influence people’s behavior), but
in some cases, policy instruments can decentralize the outcome.
➢ Economies with an excessive degree of state intervention fail severely in attaining efficiency.
➢ Economies with an excessively free market may fail on both efficiency and social issues.
Some countries from the former Soviet Union rapidly moved from an excessive degree of state
intervention to an insufficient state institution. They learned the hard way that the market is a social
institution which requires at least the minimal state (property rights and contract laws) in order for
entrepreneurs feeling comfortable enough to invest in the economy.
No minimal state → economic stagnation → expensive abuse of originally productive recourses.
,The relative importance of institutions in countries may vary depending on:
- Cultural norms (less political enforcement may be needed in extremely structured cultures
with a tradition of a high work ethic).
- Characteristics of technology (institutions in countries where technological progress is slow
and labor-intensive will be different from countries where technological progress is rapid and
capital-intensive).
- Market structure
- The size and openness of the economy
- Issues related to risk
- Information asymmetry
One common problem for the analysis of the cost-effectiveness of environmental policies is that the
process of policy reform (e.g. redesigning taxes) changes the relative prices and incomes in a way
that makes comparisons with the original state difficult. A successful process of policy reform may
well entail taking temporary steps that are not efficient.
We focus on four kinds of market failure:
- Noncompetitive markets
- Externalities (central market failure in environmental economics)
- Public goods because consumption is not according to wtp
- Common pool resources (central market failure in environmental economics)
Definition of an externality issue: one agent’s utility or profit function contains a real variable the
value of which is unintentionally affected by the behavior of another actor, while there is no market
transaction between them on the size of the effect → market inefficiency.
o Real variable means not expressed in money terms.
o Source of the issue: typically ill-defined property rights.
o Possible response: Pigouvian taxation or assigning property rights.
Negative externality: agent A’s activity causes a damage or imposes a cost to agent B (air pollution)
Positive externality: agent A’s activity causes a benefit to agent B (education)
The difference between MPC and
MSC represents the externality per
unit.
E = market equilibrium (inefficient)
B = social equilibrium (efficient)
BDE = DWL due to non-optimal
outcome (E).
DWL due to negative externality
makes a case for government to
improve upon market outcome.
,History shows that property rights and market values appear only when the use is couples to scarcity
(when supply is not infinite such as oxygen). In fact, the absence of property rights or of markets is an
alternative way of defining externalities. Externalities are commonly distinguished as depletable or
nondepletable (the poo of a horse is a depletable externality because when someone takes it,
another person can’t - non rivalry - and the smell of the horse’s poo is a nondepletable externality
because one person’s exposure can’t reduce the exposure to others - nonexclusive -).
Public good = a good that is both non-excludable (individuals cannot be excluded from use) and non-
rival (consumption by one individual does not reduce availability to others).
- Market failure: Non-excludability invalidates the use of the price mechanism: free-riding
resulting in overuse or underproduction.
- Optimal provision: Look at social value (combined willingness to pay of all the consumers)
Vertical summation
Private good = a good that is both excludable and rival.
Horizontal summation
, Club good = a good that is non-rival but excludable (private parc or cable tv)
- Optimal provision: Samuelson rule still holds (supply quantity Q such that P = ∑ MWTP)
Common pool resource = a good that is rival but very costly to exclude users (fisheries)
- Market allocation is likely to be inefficient as individuals will over exploit the resource.
Excludable Non-excludable
Rival Private goods Common-pool resources
• Parking spaces • Ocean’s fish stock
• Horizontal summation
Non-rival Club goods Public goods
• Private parks • Defense
• Samuelson rule • Vertical aggregation & Samuelson rule
The basic purpose of policy instruments is to correct for market failures. An important function of
policy instruments is to encourage abatement.
Overview of policy instruments; four different types of policy instruments:
➢ Command & Control = policies focused on limiting environmental problems by specifying
how to manage a pollution-generating process, imposing detailed regulation.
o Emission standards (e.g. standard on air pollution of waste incinerators)
o Production/technology standards (e.g. require using best available technology)
o Product standards (e.g. light bulb)
o Bans (e.g. dirty vehicles) & quotas (e.g. fisheries)
Command & Control regulation can be economically inefficient because:
- Abatement costs may vary across firms → equal abatement for firms is inefficient → for
efficiency, firms that have lower abatement costs should abate more (see figure below).
- With mandatory technology, firms have little choice and are not encouraged to explore cost-
efficient ways of achieving pollution control. They cannot trade reductions between
resources, and they are not given any incentive to develop cleaner technology.
Final grade = 20% graded assignments + 30% case study + 50% written exam
Chapters from the book:
Week 1: 2 (from Welfare and Policy Reform t/m Public Goods and Club Goods), 4, 9
Week 2: 14 (The Economics of Controlling Stock Pollutants and Climate Change Policy & Equity
Discounting and Climate Change Policy), 11 (beginning t/m Output Effects of
Subsidies and Other Policy Instruments & General Equilibrium, Taxation, and the
Double Dividend), 5
Week 3: 6, 10 (Uncertainty in Abatement and Damage)
Week 4: 7, 6 (Green and White Certificates in Europe)
Week 5: 22 (A Simple Bioeconomic Model of a Fishery), 25, 8 (Provision of Information &
Corporate Social responsibility), 26
Week 1 - Chapter 2, 4, 9
CONDITION FOR WELFARE THEOREMS: a first-best economy which has a series of characteristic:
- Perfect competition;
- No problems such as externalities, public goods or increasing returns to scale;
- Perfect information on the part of buyers and sellers;
- Maximizing utility and production functions;
- Complete markets;
- No distortionary taxation.
Much of the economic analysis concerns the failure of one or more of these assumptions.
The fundamental theorems of welfare economics:
➢ First theorem (the ‘invisible hand’ theorem): in a first-best economy, the operation of perfect
competition will lead to a Pareto efficiency. Supports the case for non-intervention.
➢ Second theorem: in a first-best economy it is possible to reach any desired point on the
contract curve by establishing a suitable set of initial endowments.
The second theorem implies that any outcome can be “decentralized” which is achieved by market
agents themselves, if the state arranges appropriate conditions (e.g. lump-sum redistribution of the
initial endowment). It means reallocating money without affecting the mechanism. Such mechanism
do not always work in practice (partly because taxes and subsidies influence people’s behavior), but
in some cases, policy instruments can decentralize the outcome.
➢ Economies with an excessive degree of state intervention fail severely in attaining efficiency.
➢ Economies with an excessively free market may fail on both efficiency and social issues.
Some countries from the former Soviet Union rapidly moved from an excessive degree of state
intervention to an insufficient state institution. They learned the hard way that the market is a social
institution which requires at least the minimal state (property rights and contract laws) in order for
entrepreneurs feeling comfortable enough to invest in the economy.
No minimal state → economic stagnation → expensive abuse of originally productive recourses.
,The relative importance of institutions in countries may vary depending on:
- Cultural norms (less political enforcement may be needed in extremely structured cultures
with a tradition of a high work ethic).
- Characteristics of technology (institutions in countries where technological progress is slow
and labor-intensive will be different from countries where technological progress is rapid and
capital-intensive).
- Market structure
- The size and openness of the economy
- Issues related to risk
- Information asymmetry
One common problem for the analysis of the cost-effectiveness of environmental policies is that the
process of policy reform (e.g. redesigning taxes) changes the relative prices and incomes in a way
that makes comparisons with the original state difficult. A successful process of policy reform may
well entail taking temporary steps that are not efficient.
We focus on four kinds of market failure:
- Noncompetitive markets
- Externalities (central market failure in environmental economics)
- Public goods because consumption is not according to wtp
- Common pool resources (central market failure in environmental economics)
Definition of an externality issue: one agent’s utility or profit function contains a real variable the
value of which is unintentionally affected by the behavior of another actor, while there is no market
transaction between them on the size of the effect → market inefficiency.
o Real variable means not expressed in money terms.
o Source of the issue: typically ill-defined property rights.
o Possible response: Pigouvian taxation or assigning property rights.
Negative externality: agent A’s activity causes a damage or imposes a cost to agent B (air pollution)
Positive externality: agent A’s activity causes a benefit to agent B (education)
The difference between MPC and
MSC represents the externality per
unit.
E = market equilibrium (inefficient)
B = social equilibrium (efficient)
BDE = DWL due to non-optimal
outcome (E).
DWL due to negative externality
makes a case for government to
improve upon market outcome.
,History shows that property rights and market values appear only when the use is couples to scarcity
(when supply is not infinite such as oxygen). In fact, the absence of property rights or of markets is an
alternative way of defining externalities. Externalities are commonly distinguished as depletable or
nondepletable (the poo of a horse is a depletable externality because when someone takes it,
another person can’t - non rivalry - and the smell of the horse’s poo is a nondepletable externality
because one person’s exposure can’t reduce the exposure to others - nonexclusive -).
Public good = a good that is both non-excludable (individuals cannot be excluded from use) and non-
rival (consumption by one individual does not reduce availability to others).
- Market failure: Non-excludability invalidates the use of the price mechanism: free-riding
resulting in overuse or underproduction.
- Optimal provision: Look at social value (combined willingness to pay of all the consumers)
Vertical summation
Private good = a good that is both excludable and rival.
Horizontal summation
, Club good = a good that is non-rival but excludable (private parc or cable tv)
- Optimal provision: Samuelson rule still holds (supply quantity Q such that P = ∑ MWTP)
Common pool resource = a good that is rival but very costly to exclude users (fisheries)
- Market allocation is likely to be inefficient as individuals will over exploit the resource.
Excludable Non-excludable
Rival Private goods Common-pool resources
• Parking spaces • Ocean’s fish stock
• Horizontal summation
Non-rival Club goods Public goods
• Private parks • Defense
• Samuelson rule • Vertical aggregation & Samuelson rule
The basic purpose of policy instruments is to correct for market failures. An important function of
policy instruments is to encourage abatement.
Overview of policy instruments; four different types of policy instruments:
➢ Command & Control = policies focused on limiting environmental problems by specifying
how to manage a pollution-generating process, imposing detailed regulation.
o Emission standards (e.g. standard on air pollution of waste incinerators)
o Production/technology standards (e.g. require using best available technology)
o Product standards (e.g. light bulb)
o Bans (e.g. dirty vehicles) & quotas (e.g. fisheries)
Command & Control regulation can be economically inefficient because:
- Abatement costs may vary across firms → equal abatement for firms is inefficient → for
efficiency, firms that have lower abatement costs should abate more (see figure below).
- With mandatory technology, firms have little choice and are not encouraged to explore cost-
efficient ways of achieving pollution control. They cannot trade reductions between
resources, and they are not given any incentive to develop cleaner technology.
