Basic options for the internalization of externalities
dr. Gabor Harangozo
Corvinus University of Budapest
Main regulatory options to achieve the social optimum of externalities(internalizing externalities)
1. Setting a norm (or standard or pollution limit)
2. Levy taxes on polluting activity (PPP-the polluter pays principle)
3. Enabling market forces (bargain) to achieve the social optimum
1. Setting of a norm
Norm
MEC
Qs Qp0
MNPB
Costs,
benefits
Economic
activity
Minimum penalty
Environmental norms in practice
Most common approach of regulation: in international and EU level
Almost exclusive in case of hazardous materials
Example: almost all fields of environmental protection
Types: regulation on emissions vs. immissions
Emission norms: refer to emitted quantity etc.
Immission norms: refer to pollution concentration, exposition level etc.
Water protection norms in paper industry
Maximal load of organic elements (Biological Oxygen Demand – BOD):
BOD5 = 25 mg/l
Outflow of the (company) sewage works is measured
2. Taxes on the polluting activityThe Pigovian tax
Social cost should be internalised
through the introduction of a tax based on
the unit of production.
Arthur Pigou (1877-1959)
1920: Economics of Welfare
Assumptions
Perfect competition
Pollution is proportional to production
The MNPB and MEC curves are known
(by regulating authorities)
The optimum rate of the Pigovian
tax equals the amount of external
effects caused by the socially
optimum production level.
The optimum rate of the Pigovian tax
Amount of tax paid
The optimum size of the Pigovian tax
Costs,
benefits
Economic activity
MNPB
Marginal external cost, MEC
Qp0 Qs
Tax rate
Limitations of the theory of Pigou
• The identification of the MEC curve
• Asymmetric information
• Pollution is not proportionate with production
• Lack of perfect competition
• Does not motivate environmental innovation
• MEC can be several times higher than MC
Environmental taxes in practice
Regulators aim to decrease environmental loads by the taxation of polluting activities, products, raw materials etc.
PPP - „Polluter Pays Principle”
Types:‒ product fees (levied on producs)
‒ pollution/emission taxes (levied on production)
Major fields in practice:‒ Transportation taxes (on vehicles, fuel, congestion charges)
‒ Energy taxes
‒ Pollution taxes
Green taxes in the EU
Example: Environmental product fees
On products considered as environmentally harmful
Effects on competition (neutrality?):
‒ Internationally: yes
‒Among sectors: no
Examples:
‒Fuels and oil products
‒Packaging materials
‒Paper based ads
‒Tyres
‒Paints and other chemicals
‒Etc.
• Based on production relatedemissions
• Effects on competition(neutrality?):
‒ Internationally: yes
‒Among sectors: no
• Main types:
‒air pollution charges
‒water pollution charges
‒soil pollution charges
Example: Emission taxes
Exercise
A cement factory (MNPB=10-Q) is in a densely populated areaand polluting the air (MEC=1/4 Q).
How much will the slaughterhouse produce withoutregulation? How much profit will it have, and what will be the net effect for socuety in this case?
If the government wants to limit the production of theslaughterhouse to the socially desirable level using a norm, where will it set the norm and how much profit will theslaughterhouse have in this case?
If the government wants to achieve the social optimum using a tax, how high should the tax rate be? How much taxwill the slaughterhouse pay, and how much profit will it haveremaining? What is the net effect for society in this case?
Please also make a drawing showing the situation!
Homework for 12th November
The operation of a paper mill (MNPB=12-2Q) raises alsoexternal effects in the form of polluting the river nearby(MEC=Q).
How much will the paper mill produce without regulation? Howmuch profit will it have, and what will be the net effect forsociety in this case?
If the authorities want to limit the production of the paper millto the socially desirable level using a norm, where will theyset the norm and how much will it cost to the company?
If the government wants to achieve the social optimum usinga tax, how high should the tax rate be? How much does thetax-based regulation cost to the paper mill altogether?
Please also make a drawing showing the situation!
3. Enabling a bargain process The Coaseian bargain
As a result of a bargaining process the
system reaches the social optimum
independent of who ownes
the property rights.
Ronald Coase (1910-2013)
1960: The Problem of Social Cost
Assumptions
Perfect competition
Established property rights
Pollution is proportionate with production
MNPB, MEC are known
All interested parties have the necessary information
Zero transaction costs
ForestTimber processing
company
Transportation
of wood on the river
Mercury pollution
Guests leave
Hotel
The allocation of rights
1. Everyone has the right to use (pollute) the
environment
the party suffering from pollution will have to pay
the polluter so he will reduce his output
2. Everyone has the right to a clean environment
the polluter will have to pay the party suffering
from the pollution so he will allow production
The Coase-theory says that the social optimum
will be reached in both situations, if the
property rights are set.
Equilibrium the Coase-theorem
Qp
Costs,
benefits
Economic activity
MEC
0 Qs
MNPB
A
B CD
Scenario 1: everyone has the
right for a clean environment
• Starting point of bargain: 0
• End point of bargain: Qs
• Polluter pays to the sufferer
• Minimum: B
• Maximum: A+B
Scenario 2: everyone has the right
to use (pollute) the environment
• Starting point of bargain: Qp
• End point of bargain: Qs
• Sufferer pays to the polluter
• Minimum: C
• Maximum: C+D
1 2
The chance for reaching agreement
Theoretically equal in both situations
In practice, willingness to pay must be accompanied by the ability to pay
Therefore, chances for reaching agreement are smaller when the rights are with the polluter and the sufferer has to pay
Limitations of the theory of Coase
• assumes perfect competition
• the identification of the participants of the
bargaining process poses problems:
• high number of interested parties
• identification of those who cause the damage
and those who suffer from it
• interests of future generations
• transaction costs are often high
• only a few practical examples