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


Going to Fenway

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Your roommate is going to go early to buy tickets

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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

camry

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.


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Increasing marginal harm from pollution


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


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Decreasing marginal benefits from PM reductions


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


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Increasing marginal costs


What is the efficient level of PM pollution control?


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Efficient pollution control maximizes net benefits


Thinking on the margin


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


Climate change: Marginal damages

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Climate change: Marginal costs

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Net benefits maximized where MB = MC

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Putting it all together

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Takeways


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)


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

[Ignore inflation and uncertainty about payment]


What amount a year from now makes you indifferent with $10K today?

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:


Discount rates allow sensible inter-temporal 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%)

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

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What discount rate should we use for policy?


What about the government?

Will return to this when we discuss climate change


Main points

Next up: How do we calculate MB and MC?

Required Readings

KO CH 1-2