Economic Efficiency and Environmental Protection

Econ 2277

Prof. Richard L. Sweeney

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Outline

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

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

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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?

  • 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?

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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)

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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

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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

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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

  • 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 (FVFV)
  • divide by the present value (PV=10KPV=10K)
  • subtract 1 and call that number rr

That number (rr) is your consumption rate of interest, your “personal” discount rate

FVPV1=r\frac{FV}{PV}-1 = r

What are some reasons to discount?

Why is your rr > 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, rr, for tt years:
FV=(1+r)tPVFV=(1+r)^{t}PV

To get the present value of some future payment tt years from now:
PV=FV(1+r)tPV=\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.

NPV=t=0TBt(1+r)tt=0TCt(1+r)t=t=0TBtCt(1+r)tNPV=\sum_{t=0}^{T}\frac{B_{t}}{(1+r)^{t}}-\sum_{t=0}^{T}\frac{C_{t}}{(1+r)^{t}}=\sum_{t=0}^{T}\frac{B_{t}-C_{t}}{(1+r)^{t}}

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=$21,428200,000 / (28) * \$3 = \$21,428
Hybrid: 200,000/(41)$3=$14,634200,000 / (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 GG in each year =40K/MPG$3= 40K/MPG * \$3

Can calculate the present discounted value of this expenditure flow:

PDV(G)=G1+G2(1+r)1+G3(1+r)2+G4(1+r)3+G5(1+r)4PDV(G) = G1 + \frac{G2}{(1+r)^1} + \frac{G3}{(1+r)^2} + \frac{G4}{(1+r)^3} + \frac{G5}{(1+r)^4}

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 rr can have a big effect on net benefits

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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?