Lecture 25

Climate Change II: Carbon Pricing

Byeong-Hak Choe
bchoe@geneseo.edu

SUNY Geneseo

November 6, 2024

The Market for Pollution Reduction Under Uncertainty

The Market for Pollution Reduction

Price vs. Quantity

Imperfect Regulation in an Uncertain World

  • The theory in market-based policies we’ve discussed so far is based upon the assumption of perfect information
    • Regulators were assumed to know everything about both the benefits and costs of pollution control
    • In the real world practice of regulation, this assumption is far from the truth
  • Permits have the advantage of providing a more certain level of pollution control than do emission taxes.
    • This is because taxes have to be adjusted if regulators find pollutant levels resulting from a given tax are lower or higher than expected.

Price vs. Quantity

  • With cap-and-trade, directly control the quantity of pollution emitted.
    • Cap-and-trade is a quantity instrument
  • With pollution taxes, regulators only indirectly control the quantity of pollution, by guessing at industry response to a tax of a certain level.
    • Pollution tax is a price instrument

Price vs. Quantity

Martin Weitzman’s seminal contribution

  • 1960s economic research focus: Economic systems.

    • Key debate: Planned vs. market-based economies and their impact on prosperity.

  • Marty’s 1974 seminal work: “Prices versus Quantities”.

    • Central question: Are prices or quantities better for resource allocation?

  • Investigation of the above question in the context of uncertainty.

  • With uncertainty in costs of reducing pollution, two policies are no longer equivalent.

Price vs. Quantity

Case 1: Steep MB curve

\(MC_{1}\): Estimated \(MC\)

\(MC_{2}\): True \(MC\)

\(DWL_{1}\): DWL from Cap-and-Trade

\(DWL_{2}\): DWL from Pollution Taxes

  • When the \(MB\) curve is relatively steeper than the \(MC\) curve, a marketable permit system is preferred to a pollution tax because of the costs of being wrong.

Price vs. Quantity

Case 2: Flat MB curve

\(MC_{1}\): Estimated \(MC\)

\(MC_{2}\): True \(MC\)

\(DWL_{1}\): DWL from Cap-and-Trade

\(DWL_{2}\): DWL from Pollution Taxes

  • When the \(MB\) curve is relatively flatter than the \(MC\) curve, a pollution tax is preferred to a marketable permit system because of the costs of being wrong.

Carbon Tax vs. Cap-and-Trade

  • Q. Which case does correspond to climate change?

Price vs. Quantity

  • In Practice:
    • The instrument choice depends on whether the government wants to get the amount of pollution reduction right or whether it wants to minimize costs to firms.
    • Quantity regulations ensure environmental protection, but at a variable cost to firms, while price regulations ensure the cost to the firms, but at a variable level of environmental protection