## Economic Efficiency and Environmental Protection

[Econ 2277](http://www.richard-sweeney.com/intro_env_econ)
[Prof. Richard L. Sweeney](http://www.richard-sweeney.com/)

[(print this presentation)](http://www.richard-sweeney.com/intro_env_econ/slides/Efficiency.html?print-pdf)

## Outline

• Gross vs net policy benefits
• Maximizing net benefits from pollution control
• Discounting the future

## Going to Fenway

### Which tickets should he buy?

This is the max you’d be willing to pay for each seat.

Location WTP Price Net Benefits
Bleachers 65
Grandstand 80
Loge 100
Dugout 125

### Next we need to know how much each ticket actually costs

Location WTP Price Net Benefits
Bleachers 65 50
Grandstand 80 60
Loge 100 100
Dugout 125 775

### The best ticket maximizes NET benefits

Location WTP Price Net Benefits
Bleachers 65 50 15
Grandstand 80 60 20
Loge 100 100 0
Dugout 125 775 -650

Takeway: The optimal ticket is not the “best” seat, or even the best ticked you can afford

### Energy Efficiency Example

The 2017 Toyota Camry available in two versions: Conventional: 26 MPG ; Hybrid: 41 MPG

Which car is more efficient?

### Which Camry is more economically efficient?

Conventional model costs $23,000 Hybrid costs$28,000

### The best choice depends on how much you drive

Cost to own = Up front cost + Cost to drive

Cost to drive = Price of gas * Miles / MPG

If gas is $3, hybrid saves money if: Miles *3 * (1/26 - 1/41) >$5000

Or you plan to drive more than 147,000 miles!

### Let’s apply that logic to pollution

![title_img_2row](../inputs/efficiency/pm_graphic.jpg)

### According to the WHO, PM has the greatest effect on human health of any air pollutant.

Estimated to cause ~ 25% of lung cancer deaths, 8% of COPD deaths, and about 15% of ischaemic heart disease and stroke.
Given this, how much PM pollution should we allow?

### What does the “damage” function for PM look like?

Plot the social cost of PM against the level of PM pollution.

Increasing marginal harm from pollution

### What does the “benefit” function for PM pollution reductions look like?

• Imagine a starting point of no PM regulation

• Consider a continuum of measures that would reduce PM pollution

• What does the graph of total benefits from each policy level look like?

Decreasing marginal benefits from PM reductions

### What does the graph of total costs from PM policy look like?

• Reducing pollution involves real economic costs.
• What are some of these?
• Plot these policy costs against increasing policy stringency (cleaner air)

Increasing marginal costs

### What is the efficient level of PM pollution control?

• Policy which reduces PM entails both benefits and costs.

• What level of air quality (PM reductions) maximizes welfare?

• Plot total benefits and total costs against policy stringency

Efficient pollution control maximizes net benefits

### Thinking on the margin

• We know we want to maximized the difference between total benefits and total costs

• How do we actually find this point in practice?

### In economics, we typically work with marginal benefits and costs.

• A demand curve is a schedule of the marginal consumer’s reservation price
• these slope downward
• A supply curve is a schedule of the cost of producing the marginal unit
• these slope upward
• The same concepts apply to the benefits (demand) and costs (supply)of pollution control.

### Takeways

• Environmental protection characterized by increasing marginal costs and declining marginal benefits
• just as in Micro Principles
• Efficient level sets MB = MC
• “equimarginal principle”
• This implies that the optimal amount of pollution is probably not zero (or unlimited)
• can you explain why?

### Taking time into account

Costs may be incurred this year, benefits in the future (typical investment) or benefits this year, costs in the future (loan)

• How does the equimarginal principle apply in this situation?

• Can we compare benefits today to costs in the future (or vice versa)?

Question: Would you prefer to receive $10K today or$10K one year from now?

[Ignore inflation and uncertainty about payment]

• How about $10K today or$20K next year?

• How about $10K today or$15K next year, etc…..?

### What amount a year from now makes you indifferent with $10K today? • take that future value ($FV$) • divide by the present value ($PV=10K$) • subtract 1 and call that number$r$That number ($r$) is your consumption rate of interest, your “personal” discount rate ### What are some reasons to discount? Why is your$r$> 0? Some reasons: • immediate gratification • evolutionary explanation? • expect to be wealthier in the future • could invest it, or pay off debt (time value of money) ### Discount rates allow sensible inter-temporal comparisons The future value of money invested presently at the rate,$r$, for$t$years: $FV=(1+r)^{t}PV$ To get the present value of some future payment$t$years from now: $PV=\frac{FV}{(1+r)^{t}}$ ### When setting policy, we care about the present value of net benefits Net Present Value is the present value of benefits minus the present value of costs. ### Dynamic equimarginal principle Efficient environmental policy equates the present value of marginal costs with the present value of marginal benefits. ### The Camry revisited Let’s say you plan to drive your car 200,000 miles. Total gas expenditure: Conventional:$ 200,000 / (28) * $3 =$21,428$Hybrid:$ 200,000 / (41) * $3 =$14,634$Hybrid saves$6,794 which is more than the $5,000 up front cost difference. ### You’re not going to drive 200,000 miles overnight Assume you plan to drive 40K miles per year for 5 years. Gas bill$G$in each year$= 40K/MPG * $3$

Can calculate the present discounted value of this expenditure flow:

### Question: What discount rate should you use?

Assume prices already in real dollars (net of inflation)

### Imagine you carry a monthly credit card balance (APR is 20%)

Small differences in $r$ can have a big effect on net benefits

### What discount rate should we use for policy?

• For personal investments?
• if borrowing: typically borrowing rate
• if investing: typically rate of return

• One option is to consider the rate of alternative investments – Resources are limited.
• What are returns to investments in health or education?
• Another is to take a normative stance – Impose equity or value across time / generations