Business in a Modern World

1. Introduction2. Markets, Firms

&the Role of Government

3. The case of environmental policy

4. Global Economy I

5. Global Economy II

6. Global Economy III

Business in a Modern World Fabian Girod

Business in a Modern World

Markets, Firms, and the Role of GovernmentsLegal systems; externalities and public goods; social security and distribution; imperfect competition.

Firms and Governments: The Case of Environmental PolicyPollution; emission standards, taxes and permits; EU emissions trading scheme.

The Global Economy I: Trade and LocationInternational trade; comparative versus competitive advantage; location and MNEs.

The Global Economy II: Capital and CurrenciesCapital mobility and market integration, exchange rates.

The Global Economy III: Policy and OrganisationsTrade policy and capital restrictions; the future of nations and organisations

Concluding Remarks on Business in a Modern World

4. Global Economy I

• Part 1: Policy Approaches to Controlling Pollution

• 1. Introduction• 2. Main Objectives• 3. Efficient Policy• 4. Cost-Effective Policies• 5. ‘Dynamic’ Incentives• 6. Other Criteria• 7. Conclusions

Firms and Governments:Environmental Policy

4. Global Economy I

1. Introduction

• Today’s topic: Policy approaches to control pollution

• Main issues:– government objectives– efficient & cost-effective policies– incentives to use/invent eco-friendly technologies– policy instruments and information requirement

4. Global Economy I

2. Main Objectives

Now: Focus on pollution, i.e., flow of waste products from the economy back to the environment.

Pollution causes damage (externality) and benefits.

Damage includes loss of – use value– option value– existence value.

Take 15 minutes and give me examples! Is it possible to quantify that? Research it!

4. Global Economy I

2. Main Objectives

• Cuts in pollution can be achieved by means of– less output/consumption

check on EUROSTAT GDP in 2008 and 2009 and CO2 emissions!http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/themes– abatement

• Main objectives of environmental policy:– efficiency– cost-effectiveness– incentives to use/invent eco-friendly technologies

Can you think of other objectives?

4. Global Economy I

3. Efficient Policy

Efficient policy : cuts in polluting output

• Determining efficient pollution levels means balancing the trade-off between costs of & benefits from pollution.

• Efficiency condition:Marginal WTP for a product equals marginal social costs (marginal private plus external costs).

4. Global Economy I

Output

Efficient allocation Q*

Supply = Private marginal costs

Demand = Marginal WTP

Social marginal costs

Net benefit

3. Efficient Policy

4. Global Economy I

3. Efficient Policy

But: Environmental costs are ‘external’ costs.

No prices for pollution reflecting environmental scarcity.

Agents do not take environmental damage into account.

Inefficient high pollution levels in market equilibrium.

4. Global Economy I

Output

Efficient allocation Q* versus market allocation QM

3. Efficient Policy

4. Global Economy I

3. Efficient Policy

Possible efficient policy 1:

“Creating” a substitute for a market price by implementing an emission tax (or charge):

resulting tax payment per output unit = marginal damage at Q*

– Agents internalise environmental damage.

– “Modified” market outcome is efficient.

4. Global Economy I

Output

Efficient policy

Supply = Private marginal production costs + Tax

Q*= QP

Net benefit

3. Efficient Policy

4. Global Economy I

3. Efficient Policy

Efficient policy 2: increase in ‘abatement’

• Efficient pollution level (which we don’t know!) minimises the sum of – damage costs of pollution &– abatement (or control) costs of pollution.

• Marginal damage costs increase with the quantity of emissions.

• Marginal abatement costs increase with the quantity of emissions reduced (i.e., decrease with the quantity of emissions).

4. Global Economy I

3. Efficient Policy

Quantity of emissions

Marginal costs

Marginal abatement costs

Marginal damage costs

Remember a damage has a certain benefit (cause)

Q*Emission Cuts

4. Global Economy I

3 Assignments

1) Damage includes lossGive examples! Is it possible to quantify that? Research it!

2) Cuts in pollution can be achieved by means ofless output/consumption check on EUROSTAT GDP in 2008 and 2009 and CO2 emissions!

3) Summarize different positions regarding pollution (proof!) from different stakeholders e.g.specific industries, parties,interest groups, NGOs etc.

4. Global Economy I

emission cuts in emission

marg. costs

total costs

marg. damage

total damage

costs + damage

0 6 12 42 0 0 42

1 5 10 30 2 2 32

2 4 8 20 4 6 26

3 3 6 12 6 12 24

4 2 4 6 8 20 26

5 1 2 2 10 30 32

Q = 6 0 0 0 12 42 42

Example: Socially optimal outcome

4. Global Economy I

emission cuts in emissio

marg. costs

total costs

marg. damage

total damage

costs + damage

0 6 12 42 0 0 42

1 5 10 30 2 2 32

2 4 8 20 4 6 26

3 3 6 12 6 12 24

4 2 4 6 8 20 26

5 1 2 2 10 30 32

Q = 6 0 0 0 12 42 42

Cost to reduce the 6th unit of emissionsReduction costs of 5 emissions unitsAdditional damage caused by the 3rd emission unit

Cumulated damage

4. Global Economy I

emission cuts in emission

marg. costs

total costs

marg. damage

total damage

costs + damage

0 6 12 42 0 0 42

1 5 10 30 2 2 32

2 4 8 20 4 6 26

3 3 6 12 6 12 24

4 2 4 6 8 20 26

5 1 2 2 10 30 32

Q = 6 0 0 0 12 42 42

4. Global Economy I

3. Efficient Policy

Efficiency condition:If pollution is efficiently allocated, then the marginal damage costs of pollution equal the marginal abatement costs.

Market allocation:

• Damage costs are externalities, firms’ abatement costs are private.

Firms do not abate REALITY if no policy applied

4. Global Economy I

3. Efficient Policy

Possible efficient policy Pigouvian Tax:

Implementing an emissions tax which is equal to the marginal damage at the point where the marginal damage and abatement costs are identical.

Firms cut emissions as long as the marginal abatement costs are below the emissions tax.

Damage costs are internalised.

••

4. Global Economy I

3. Efficient Policy

Quantity of emissions

Marginal costs

Marginal abatement costs

Marginal damage costs(socialized without any measure)

Emission CutsQ

4. Global Economy I

3. Efficient Policy

Major Problem:– lack of information about marginal damage costs

(despite of a wide range of valuation methods)– lack of information about abatement costs &

differences in abatement costs between emission sources

– Difficulties in evaluating the efficient intertemporal use of resources

• Less ambitious policy assessment criterion:– cost-effectiveness

But what could be there reason for implementing it?

4. Global Economy I

4. Cost-Effective Policies

“Exogenous” environmental targets determined in the political process.

Cost-effectiveness:An allocation is cost-effective if it meets a given environmental target in a manner that minimises total abatement costs.

Simple case (Example):– 2 emission sources– abatement costs differ between emission sources– given pollution target

4. Global Economy I

emission

cuts in

emission

marg. costs

total costs

marg. costs

total costs

0 6 12 42 6 21

1 5 10 30 5 15

2 4 8 20 4 10

3 3 6 12 3 6

4 2 4 6 2 3

5 1 2 2 1 1

Q = 6 0 0 0 0 0

Question: Cost-effective outcome if total cuts = 6?

The case with 2 firms

To cut the sixth unit of emission costs 12 Units of money

To cut 6 emission units is necessary to minimize sum of total costs (1+2)

Cut in emission of firm 2

Cut in emission of firm 1

4. Global Economy I

Emission cuts

Marginal costs

Emission cuts firm 2

Firm 1

Firm 2

6Cuts firm 1

Initial situation without cuts

4. Global Economy I

Optimality condition:If an allocation is cost-effective (i.e., if it minimises total costs of pollution cuts), then the marginal abatement costs will be identical for all emission sources (here: polluting companies).

This principle can be applied to a case with countless companies e.g. the European trading scheme

4. Global Economy I

4. Overview of instruments

Instruments to cut pollution

Market based

Tax (Pigouvian

tax)permits

Non-marketed

Emission standards

4. Global Economy I

Command-and-control policy: Emission standards

• Emission standard:– legal limit on the quantity of emissions– allocation between different emission sources/firms?

• Any arbitrary allocation between sources/firms does– usually not equalise marginal abatement costs– not lead to cost-effective outcomes.

• For example: “equal” obligations to cut emissions

4. Global Economy I

For example: “equal” obligations to cut emissions

- Read article (!)

4. Global Economy I

Marginal costs

Firm 1

Firm 2

Emission cuts

Cuts firm 2

Cuts firm 1 3 66

4. Global Economy I

See the difference

4. Global Economy I

Non-market based instrument:See example above (Emission standards):An “equal" cut of three emission units is not cost-effective.

• Problem:– Cost-effective standards require knowledge of

abatement costs that governments do not have. And even if they had, these costs are, due to dynamics, constantly changing !

4. Global Economy I

Market-Based Instruments I: Emission Tax (Pigou)• A tax on each unit of pollutant emitted, imposed by the

government.

• Emission tax serves as a substitute for the missing market price of the environment.

Response of firms:• Firms cut emissions as long as marginal the abatement

costs are below the emissions tax.

4. Global Economy I

Result:

• If firms face an identical emission tax, they face identical incentives to cut emissions.

Marginal abatement costs are equalised across firms.

Abatement costs are “automatically” minimised;

• emission taxes are cost-effective.

• Note: Knowledge of abatement costs is not needed!

4. Global Economy I

Marginal costs

Firm 1

Firm 2

Total cuts

Emission cuts firm 2Cuts firm 1

Emission cuts

4. Global Economy I

4. Cost-Effective Policies: Tax

Problems:– Iterative trial-&-error process is necessary to achieve

environmental targets (Was the tax imposement successful).

– Costs of legislative adjustments can be substantial.

Discussion: • What about using subsidies to install new technology

instead of taxes?

4. Global Economy I

Market-Based Instruments II: Emission Permits

• Transferable emission permits:• Permits that allow a firm to emit a specific amount of

pollutant over a specific time period; freely tradable.

Basic idea:• Generate a market for the environment by setting

aggregate “supply” of pollution

setting indirectly the price of the environment. What does the “price” depend on ?

4. Global Economy I

Response of firms:– Firms cut emissions & sell permits not needed as long

as the marginal abatement costs are below the permit price.

– Firms buy permits and emit more as long as the marginal abatement costs exceed the permit price.

Result:– Trade takes place until all firms’ marginal abatement

costs are equalised, and are equal to the permit price.– All firms face identical incentives to cut emissions.

4. Global Economy I

4. Cost-Effective Policies: Permits

Marginal costs

Firm 1Firm 2

Total cuts

Emission cuts

Initial distribution of permits: Incentives to trade emission permits when marginal abatement costs differ

4. Global Economy I

4. Cost-Effective Policies: Permits

Marginal costs

Firm 1Firm 2

Total cuts

Equilibrium cuts firm 2Equilibrium Cuts firm 1

Emission cuts

Market equilibrium after trade in permit market

4. Global Economy I

Abatement costs are ‘automatically’ minimised; emission permits are cost-effective.

Note:– Knowledge of abatement costs is not needed!– Cost-effectiveness is independent of initial permit

allocation.– No (costly) iterative trial-&-error process to meet

environmental targets.

4. Global Economy I

Permits put into practice: How does this work?• initial allocation of permits:

– auctions– free allocation (grandfathering)

• Problems:– imperfect competition for permits– new market entries– transaction costs of trade

We will discuss this further !

4. Global Economy I

Conclusion:Both market-based approaches, emission taxes & permits, are suitable to achieve cost-effectiveness.Permits enable the government to achieve directly pollution targets; taxes require a (costly) trial-&-error process.

4. Global Economy I

5. ‘Dynamic’ Incentives

• ‘Dynamic’ incentives to use (and invent) eco-friendlier technologies in the case of emission taxes:– lower (marginal) abatement costs– lower tax payment– But: costs of switching to ‘new’ technology

• Example:– two technologies – ‘old’ and ‘new’ – available to a firm– new technology: lower (marginal) abatement costs– switching to new technology: fixed costs F

Example: Carbon Capture & Storage

4. Global Economy I

Quantity of Emissions

Marginal Costs

Emission Cuts

New technology

Old technology

Abatement costs

Tax payment

Dynamic incentives :Example with tax

4. Global Economy I

Marginal Costs

Emission Cuts

New technology

Old technology

Cost reduction

4. Global Economy I

Result:• Firm chooses ‘new’ technology if cost reduction is greater

than costs of switching to ‘new’ technology F.

4. Global Economy I

Dynamic incentives to use (and invent) use eco-friendlier technologies in the case of emission permits:

– lower (marginal) abatement costs– revenues from selling permits (!)

Discussion:• Is there any difference between taxes and permits? • Why? Why not?• What about the dynamic incentives of emission standards?

4. Global Economy I

Marginal Costs

Emission Cuts

New technology

Old technology

Abatement costs

Costs of Permits

4. Global Economy I

6. Other Criterias argument for market-based approaches

• Response to economic cycles & growth– E.g. see following example of CO2 prices during the

economic crisis

• Distributional issues

• Ancillary benefits (‘double dividend’)

4. Global Economy I

7. Conclusions

The message of economics:

• In principle, market-based instrument are cost-effective and provide dynamic incentives to use (and invent) eco-friendlier technologies;

• they are “superior” to traditional command-and-control approaches to controlling pollution.

• Let’s talk about political experiences in the next lesson!

4. Global Economy I

Basic Reading

• Tietenberg (2007), Environmental Economics and Policy, 5th Edition, Boston et al.: Pearson – Addison Wesley, chapter 13.

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