Economic Efficiency and Environmental Protection
Outline
 Gross vs net policy benefits
 Maximizing net benefits from pollution control
 Discounting the future
Going to Fenway
Your roommate is going to go early to buy tickets
Which tickets should he buy?
Start with your “reservation price”
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
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.
Climate change: Marginal damages
Climate change: Marginal costs
Net benefits maximized where MB = MC
Putting it all together
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 intertemporal comparisons
The future value of money invested presently at the rate, $r$, for $t$ years:
To get the present value of some future payment $t$ years from now:
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
What about the government?
 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
Will return to this when we discuss climate change
Main points
 For welfare, we care about net benefits (not gross)
 Optimal level of quality follows the equimarginal principle
 When flows span time, essential to convert to net present value
Next up: How do we calculate MB and MC?