and Incentives for Safety Juergen Bracht University of Aberdeen, - - PowerPoint PPT Presentation

Incentives against Pollution and Incentives for Safety

Juergen Bracht University of Aberdeen, Scotland Department of Economics juergen.bracht@abdn.ac.uk

Incentives against Pollution -- Objectives

• What externalities are and why they can lead to inefficiency and

government intervention in a market.

• The difference between negative, positive and network externalities
• The importance of the Coase theorem, which explains how private

individuals can sometimes solve externalities

• Why some government policies to deal with externalities—such as

emissions taxes, tradable permits, or Pigouvian subsidies—are efficient, but others—like environmental standards—are inefficient

Economics of Pollution

• Pollution is a bad thing.
• Yet most pollution is a side effect of activities that provide us with good things.
• Our air is polluted by power plants that generate the electricity that lights our cities, and our

rivers are damaged by fertilizer runoff from farms that grow our food.

• Pollution is a side effect of useful activities, so the optimal quantity of pollution

isn’t zero.

• Then, how much pollution should a society have? What are the costs and benefits
• f pollution?

Cost and Benefits

• The marginal social cost of pollution is the additional cost imposed
• n society as a whole by an additional unit of pollution.
• The marginal social benefit of pollution is the additional gain to

society as a whole from an additional unit of pollution.

• The socially optimal quantity of pollution is the quantity of pollution

that society would choose if all the costs and benefits of pollution were fully accounted for.

The Socially Optimal Quantity of Pollution

Marginal social cost, marginal social benefit Quantity of pollution emissions (tons) Q OPT $200 Marginal social cost, MSC, of pollution O Socially

• ptimal point

Marginal social benefit, MSB, of pollution

Pollution: An External Cost

• An external cost is an uncompensated cost that an individual or firm imposes on
• thers.
• An external benefit is a benefit that an individual or firm confers on others

without receiving compensation.

• Pollution is an example of an external cost, or negative externality; in contrast,

some activities can give rise to external benefits, or positive externalities.

• External costs and benefits are known as externalities.
• Left to itself, a market economy will typically generate too much pollution

because polluters have no incentive to take into account the costs they impose on

• thers.

A Market Produces Too Much Pollution

Q M K T Q H Q OPT $400 300 200 100 O Marginal social benefit at QMKT Market-determined quantity of pollution MSC of pollution The market

• utcome is

inefficient: marginal social cost

• f pollution

exceeds marginal social benefit Marginal social cost, marginal social benefit Quantity of pollution emissions (tons) Socially optimal quantity of pollution Optimal Pigouvian tax

• n pollution

Marginal social cost at QMKT MSB of pollution

Private Solutions to Externalities

• In an influential 1960 article, the economist Ronald Coase pointed out that, in an ideal world, the private sector

could indeed deal with all externalities.

• According to the Coase theorem, even in the presence of externalities, an economy can always reach an efficient

solution provided that the transaction costs—the costs to individuals of making a deal—are sufficiently low.

• The costs of making a deal are known as transaction costs.
• The implication of Coase’s analysis is that externalities need not lead to inefficiency because individuals have an

incentive to find a way to make mutually beneficial deals that lead them to take externalities into account when making decisions.

• When individuals do take externalities into account, economists say that they internalize the externality.
• Why can’t individuals always internalize externalities?
• Transaction costs prevent individuals from making efficient deals.

Private Solutions to Externalities

• Examples of transaction costs include the following:
• The costs of communication among the interested parties—costs that may be

very high if many people are involved.

• The costs of making legally binding agreements that may be high if doing so

requires the employment of expensive legal services.

• Costly delays involved in bargaining—even if there is a potentially beneficial

deal, both sides may hold out in an effort to extract more favorable

Policies Toward Pollution

• Environmental standards are rules that protect the environment by

specifying actions by producers and consumers. Generally such standards are inefficient because they are inflexible.

• An emissions tax is a tax that depends on the amount of pollution a firm

produces.

• Tradable emissions permits are licenses to emit limited quantities of

pollutants that can be bought and sold by polluters.

• Taxes designed to reduce external costs are known as Pigouvian taxes.

Environmental Standards vs Emissions Taxes

(b) Emissions Taxes (a) Environmental Standard 600 400 200 $600 200 600 300 $600 150 300 MB B MB B MB A MB A T A S A S B T B Emissions tax Environmental standards forces both plants to cut emission by half Without government action, each plant emits 600 tons Marginal benefit to individual polluter Marginal benefit to individual polluter Quantity of pollution emissions (tons) Quantity of pollution emissions (tons) Plant A has a lower marginal benefit of pollution and reduces emissions by 400 tons Plant B has a higher marginal benefit of pollution and reduces emissions by only 200 tons

Policies Toward Pollution

• When the quantity of pollution emitted can be directly observed and controlled,

environmental goals can be achieved efficiently in two ways: emissions taxes and tradable emissions permits.

• These methods are efficient because they are flexible, allocating more pollution

reduction to those who can do it more cheaply.

• An emissions tax is a form of Pigouvian tax, a tax designed to reduce external costs.
• The optimal Pigouvian tax is equal to the marginal social cost of pollution at the socially
• ptimal quantity of pollution.

Production, Consumption, and Externalities

• When there are external costs, the marginal social cost of a good or

activity exceeds the industry’s marginal cost of producing the good.

• In the absence of government intervention, the industry typically

produces too much of the good.

• The socially optimal quantity can be achieved by an optimal Pigouvian

tax, equal to the marginal external cost, or by a system of tradable production permits.

Positive Externalities and Consumption

S D MSB of flu shots O (a) Positive Externality Price of flu shot S D O (b) Optimal Pigouvian Subsidy Price, marginal social benefit of flu shot Price to producers after subsidy Optimal Pigouvian subsidy Price to consumers after subsidy Marginal external benefit Quantity of flu shots

QMKT QOPT QMKT QOPT EMKT EMKT

Private versus Social Benefits

• The marginal social benefit of a good or activity is equal to the marginal

benefit that accrues to consumers, plus its marginal external benefit.

• A Pigouvian subsidy is a payment designed to encourage activities that yield external

benefits.

• A technology spillover is an external benefit that results when knowledge spreads

among individuals and firms.

• The socially optimal quantity can be achieved by an optimal Pigouvian subsidy equal to the

marginal external benefit.

• An industrial policy is a policy that supports industries believed to yield positive

externalities.

Private versus Social Costs

• The marginal social cost of a good or activity is equal to the marginal

cost of production, plus its marginal external cost.

Negative Externalities and Production

MSC of livestock S D S D (a) Negative Externality Price of livestock Quantity of livestock Price, marginal social cost

• f livestock

Quantity of livestock Marginal external cost Price to consumers after tax Optimal Pigouvian Tax Price to producers after tax

QMKT QOPT EMKT QMKT EMKT QOPT

(b) Optimal Pigouvian Tax

Network Externalities

• A good is subject to a network externality when the value of the good to an

individual is greater when a large number of other people also use the good.

• Examples include:
• communication systems: telephones, telegraphs, fax machines, etc.
• railway systems
• air travel: hub and spoke
• Any way in which other people’s consumption of a good increases your own

marginal benefit from consumption of that good can give rise to network effects.

• Example: computer operating systems like Windows

Network Externalities

• Windows is used widely so it attracts more attention from software developers.
• As a result, there are more programs that run on Windows than on any other
• perating system.
• A good is subject to positive feedback when success breeds greater success and

failure breeds failure.

Efficient Level of Safety in Oil & Gas

We argue for the arrangement of retrospective liability of a responsible

• party. A regime could have the components:
• 1. Single responsible party. Contracts with other participants to receive

compensation in case of an accident.

• 2. Tax on non-compensable risk.
• 3. Financial capacity: Resources + Contractual Compensation + Insurance <

BP Spill Magnitude for deep-water drilling.

• 4. Damages: No damage cap, no punitive damages, compensate only

direct losses.

• 5. Priority of restoration coupled with benefit-cost test -- remediation.

Incentives for Safety -- Context

Environmental catastrophe – risk of pollution. Dead-sea oil drilling – activity. Example: BP Deep Water Catastrophe 2010. Earthquake in Peru. Companies will rely on expert intuition to assess risk. Moral hazard in the face of expert intuition. F1 car crash.

Incentives for Safety – Objective, Efficiency

The government’s objective is to balance deterrence of environmental catastrophes and encouragement of exploration and exploitation. We – we economists -- believe that society has to take into account both the COST OF LOSSES and the COST OF AVOIDING LOSSES. We note that this is a question about HOW MUCH? This is a question for economists. How much safety does society want? What it the efficient level of safety.

Incentives for Safety – Human Judgement and Biases

• Catastrophe: Easy to observe even for an outsider. Hard to predict,

with low probability and high loss.

• Availability heuristic – distortion.
• Risk: weighting of known probabilities and outcome.
• Uncertainty: weighting of unknown probabilities and outcome.
• Ignorance.
• Risk-seeking in loss domain with underestimation of reduction of

probability.

• Society will take on too much risk.
• We want efficient risk allocation!

Compensation, Tax and Cap

• The important objective is remediation, restoration PLUS or MINUS.
• Compensation will deter risk through liability system.
• Compensation will providing efficient insurance.
• Tax has a prospective deterrence role. Objective is less risk taking. Tax

would be equal to the expected loss.

• Cap has advantages and disadvantages. How high, how low?

Natural Resource Damage

• When there is an oil spill, what are the loss components?
• 1. Stopping a spill
• 2. Cleanup the damages caused
• 3. Financial loss imposed on businesses and workers
• 4. Remediation of natural resource damages

1. Comparison of costs and benefits. Rule.

• 5. Benchmark legislation and rule in US. Exxon Valdez.

Exxon Valdez

• There is literature on Contingent Valuation and Lost Passive Use.
• There are calculations of restoration cost S$ 15 bn to 20 bn.
• Question asked is: What is the value of the damage that remain?
• Answer given by a reference point that establishes a baseline. How

would the situation have been if there would have been no wrongful

• conduct. Make-whole approach.
• In terms of Willingness-of-accept.

Incentives for Safety

Liability as a Two-Tier System.

• 1. Strict liability up to firm’s resources, including insurance coverage.
• 2. Annual tax equal to expected costs in the coming year beyond this damages

amount.

• 3. Single operator who contracts with other operators in order to be

reimbursed.

Remediation.

Incentives for Safety – Oil & Gas Industry Custom UK

This is a secret. Separate decisions.

• Cessation of Production.
• Decommissioning is the removal of the infrastructure. Legal obligation.

Oil&Gas Authority. Remit. Topic for discussion.

Incentives for Safety – Nuclear Power Industry Custom Germany

• Law to Decommissioning of Nuclear Power Industry.
• Federal Fund with 24.1 billion Euro start capital. 100 billion Euro until

2010.

• Operator of nuclear power station go free.
• Decommissioning financial responsibility for the Federal State.
• Removal actual infrastructure and waste is still the responsibility of
• perators.
• Low interest rate. This is very cheap, currently, for the federal state.

The expected interest rate for the Fund is 3.7%.