Economic Incentive Policies

An alternative to the regulatory, or CAC, approach is an economic incentive, or EI, policy. Unlike the more rigid CAC approach, EI instruments discourage pollution with monetary incentives (penalties and rewards) such as taxes, user fees, or subsidies. Firms and households are not told how much they can pollute or what technology they must use, but their choices will have financial consequences and this will influence the choices they make.

Let's begin with a simple example of a pollution charge or tax. From the perspective of the polluter, a pollution tax would raise the cost of pollution by the amount of the tax (e.g., $10/ton of emissions). Compared with a situation of "no policy" where pollution has zero cost to the firm, a pollution tax introduces a cost curve in figure 10.1. Normally, we think of this as a fixed price per ton that does not change with the pollution level, so it is a horizontal marginal cost (tax) curve.

Key Concept: Pigouvian tax

In figure 10.2 we have added a dashed line to represent the tax. Polluters will not want to pay the tax, but they will also not want to pay the costs of abatement. Given a choice between the two, polluters will likely do whichever is cheapest. At QNL abatement is cheaper than paying the tax (MAC < $10), so they will reduce pollution. At some point, however, after they have used up the low-cost abatement actions, abatement becomes more expensive. At the point where MAC is equal to the tax, they will become indifferent to paying the tax or abating. Where the MAC curve is higher than the tax, they will choose to pollute and pay the tax rather than abate. From figure 10.2, we expect that with a $10 tax, polluters will abate until the level of pollution is reduced to Q*. This, in fact, is the optimal level of pollution, the point where the marginal benefits from reducing pollution (MAB) is just equal to MAC. When a pollution tax is set equal to the value of marginal environmental damage at this optimal level, it is sometimes called a Pigouvian tax, after the economist Arthur C. Pigou who proved in The Economics of Welfare (1920) that a tax on an externality set equal to the marginal external cost will be optimal.

One important difference between these two approaches is that in addition to the abatement costs under CAC, there is a "transfer" under the pollution tax. Under the CAC policy, all polluters have to do is reduce pollution to Q*. With a pollution tax, polluters will lower pollution to Q* at a cost equal to area B but then will still have to pay pollution taxes on Q* equal to C + D or $10 x Q*. Does this make the pollution tax more costly to society? From society's perspective the answer is no, assuming those revenues are used efficiently and not wasted. The tax payments do not represent a social cost; we refer to this as a transfer from polluters to government (see key concept page 59). Funds change hands, but no "real cost" is incurred such as using up resources or buying capital equipment. Of course, firms can't be expected to view it that way. To them, paying taxes is as costly as abatement: they don't like either one. In fact, firms will tend to prefer the CAC approach because the only costs they face are the abatement costs (area B in figure 10.2). Firms can be expected to pass all of the cost on to their customers in the form of higher prices, which could reduce demand. Also, if their competitors (including

$10 tax

Economics Pollution Curves

Quantity of pollution-►

Quantity of abatement

$10 tax

Quantity of pollution-►

Quantity of abatement

■ FIGURE 10.2 Externality and a pollution tax foreign producers) do not face these same costs, this could affect their competitiveness.

The net social benefit of the pollution tax, at least as depicted in this figure, appears to be the same as under a CAC approach, A + B - B = A, the shaded area. If the net benefits are the same for both CAC and a pollution tax, as in figures 10.1 and 10.2, why are economists so smitten with EI policies? The problem is with the figure, not with the economics. The figure suggests that the MAC curve is the same for each polluter. If that were true, or even approximately true, then the differences between CAC and EI may be very small. But if abatement costs differ significantly across polluters, then an EI approach lets individual firms make individual decisions that reflect those differences in cost. Faced with a given pollution tax, each firm (knowing its own situation best) can make its own "decentralized" decisions about whether to pay the pollution tax or to find ways to reduce pollution, and this can reduce the overall cost of reducing pollution.

So how do differences among polluters affect the social costs of pollution control? Usually a pollution problem involves numerous polluters who face different costs or have different capacities to reduce pollution. When this is the case, the pollution tax or other EI policies such as tradable pollution permits, discussed later in this chapter, will have a lower overall cost.

We can prove this point graphically. Consider a situation in figure 10.3 involving two polluting firms, firm 1 and firm 2, with different marginal abatement costs (MAC1 and MAC2, respectively). Each firm currently produces 100 tons of pollution per day, so a total of 200. Policymakers want to reduce pollution to a total of 120 tons/day. A CAC approach would simply require each firm to reduce pollution from 100 to 60 tons/day. The cost of this policy would be the sum of the cost for each firm. For firm 1, the area under MAC1 is A + B + C + D + E. The cost for firm 2 is the area under MAC2, or A + C. If we used a pollution tax, T, instead of a CAC approach, would the firms respond differently? Yes! Each firm would reduce pollution up to where MAC = T. Firm 1 would reduce pollution to 70 given its relatively high (steep) MAC curve. Firm 2 would reduce pollution to 50 given its relatively flat MAC curve. The new level of total pollution would be the same, 120 tons/day, but the firm with the lowest cost will do more of the abatement, and this lowers the overall cost of achieving the policy goal.

We can see this precisely by adding up the costs under the tax and comparing them to the costs under CAC. The total cost for firm 1 (the area under its MAC curve) would be A + B, and for firm 2 the total cost would be A + C + F. Let's subtract the total abatement cost (TAC) for the tax from the TAC for CAC, or:

TACcac - TACtax = (A + B + C + D + E + A + C) - (A + B + A + C + F) = 2A + 2C + B + D + E - (2A + B + C + F) = C + D + E - F

We can see that C + D + E is the area of the trapezoid between 60 and 70, and F is the area of the trapezoid between 50 and 60. Given the added height of C + D + E, the geometry tells us that the cost of using a CAC is greater than for a tax. Why? Because the tax provides incentives that equalize the marginal abatement cost among polluters, and this ensures efficiency. By contrast,

Equal Marginal Abatement Costs Taxes

■ FIGURE 10.3 Cost differences between CAC and El policies the CAC approach treats every polluter the same, regardless of any differences in their abatement costs.

The greater the differences in abatement costs among polluters, the greater will be the social cost advantages of a tax policy compared with pollution standards. These differences can be huge (or in some cases they may be small). Estimates of these differences have been made for a number of U.S. pollution policies, indicating that, compared with CAC approaches, the cost may be reduced by 30 to 95 percent if an efficient, EI approach is taken (see table 10.1).

One aspect of both policies that deserves some attention is how to choose the level of pollution and how to choose the pollution tax. Regulation requires setting the level of pollution. We can consider it to be somewhat arbitrary since we can never really know exactly what the MAC and MEC curves look like. We often estimate them, but there is always a high degree of uncertainty (and probably disagreement) about their actual position and slope. If we set the standard at a very low pollution level, firms may be forced to incur unnecessary costs and reduce pollution below the level that is really justified. Pollution taxes, however,



Cost savings compared with CAC


St. Louis




Lower Delaware Valley


Sulfur dioxide

Lower Delaware Valley


Four Corners


(AZ, NM, CO, UT)

Nitrogen dioxide






Dissolved oxygen Delaware River 30-60% Fox River, WI 28-56%

SOURCE: Tietenberg, Environmental and Natural Resource Economics, 4th ed. (New York: HarperCollins College Publishers, 1996).

■ TABLE 10.1. Estimated cost savings for EI policies compared with CAC policies are also arbitrary—policymakers must set the price. If they set it too low, then excess pollution may occur. If they set it too high, then excess abatement may occur. So although some critics may point to the difficulty of choosing a pollution level, or a pollution tax rate, this arbitrariness is similar for both: in the absence of full information about MAC and MEC, there will always be some guesswork in addressing environmental problems. Depending on where the uncertainty lies, there is an argument for choosing one over the other. It goes like this: If the cost of being wrong about marginal damages is very high, then there is a strong argument for preferring to set the quantity. If the cost of being wrong about the marginal abatement cost is very high, then there is a strong argument for preferring a tax.1

One additional advantage of a pollution tax, though, is that the policy itself will generate useful information; setting a pollution standard does not do this. When we set a pollution tax, firms will respond by reducing pollution by an amount of their choosing. That response may confirm the MAC curve estimated by the policymakers, but it may reveal something quite different. It may suggest that abatement is more, or less, costly than previously believed. In any case, the response of the firms reveals a point on the MAC curve, and that can be very useful information for policymakers. This advantage is significant, but the general public may not be particularly impressed. The public generally tends to be more concerned about the certainty of the policy in terms of the level of pollution and less interested in certainty about the marginal cost. There is one policy, however, that both reveals information about costs and ensures a prescribed level of pollution: tradable pollution permits, discussed next.

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