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1 - Environmental Economics and the Theory of Externalities
- from PART I - ECONOMICS AND THE ENVIRONMENT
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 3-16
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Summary
Our aim in this book is to provide a comprehensive treatment of graduate level environmental economics in a single volume, using a style of presentation that integrates the many sub-areas of inquiry that have come to define the field. To this end we begin in this chapter by introducing the field of environmental economics via its roots in neoclassical welfare theory and the theory of externalities. Environmental problems and policy challenges stem, of course, from human uses of the environment and natural resources. This statement alone does not provide the basis for our study, however. Rather, it is the way that humans use the environment and the impact this use has on the well-being of others that interests us and defines the field. Our starting point therefore is the notion that one person's interactions with the environment can have direct and unsolicited effects on another person, without compensation or other recognition of the impact. To use the classic example, a factory owner whose plant sits next to a laundry impacts the launderer by dirtying the air he needs to produce clean linen. The launderer suffers as a result of the actions of the factory owner, without recourse or compensation. A contemporary example involves the leaching of nitrogen fertilizer from agricultural fields into underground aquifers, from which surrounding communities draw drinking water. Users of groundwater for drinking suffer due to the actions of the farmer, again without recourse or compensation.
These two examples serve to illustrate the types of problems considered in environmental economics and hint at both the positive (describing what is) and normative (describing what ought to be) aspects of study. From a positive point of view, we might be interested in understanding how existing institutional structures lead the self-interested factory owner and farmer to undertake actions that have negative consequences for others. From a normative perspective, we might be interested in suggesting policy interventions that help mitigate these consequences. In either case we are dealing with a potential misallocation of resources that affects the level of well-being that members of society can obtain. It is in this sense that environmental economics falls under the rubric of welfare economics and the theory of externalities, dealing specifically with the failure of market economies to properly account for the environmental ramifications of economic activity.
5 - Competitive Output Markets
- from PART II - THE DESIGN OF ENVIRONMENTAL POLICY
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 94-123
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Summary
Thus far in Part II of the book we have not explicitly considered output markets in our analysis of environmental policy. This simplification has allowed us to derive several useful results based only on firms’ abatement cost functions and the social damage function. In general, however, firms have both production costs and abatement costs, and except for “end of the pipe” type abatement technologies, these costs cannot always be separated. Moreover, for some pollutants, such as carbon dioxide emissions from fossil fuels, the only abatement possibility may be to reduce output. To analyze these types of cases, we need a richer model that explicitly accounts for the output market. In this chapter we focus on competitive output markets, and examine whether the results derived so far hold only for the separable case, or if they are indeed general.
In addition to accounting for a larger range of technologies, there are several policy motivations for considering output markets. Political debates on environmental policy often focus on distributional considerations, such as how a policy will impact output prices. Will polluting firms simply pass on higher prices to consumers? To consider this explicitly, attention needs to be given to firms’ output cost structure and consumers’ demand. Debate also focuses on the impact that policies may have on firms’ survival, scale of operation, and employment levels. For these types of questions it is necessary to consider the long-run entry and exit behavior of firms in response to the various policy options. Since entry and exit decisions in competitive markets are driven by zero profit conditions, we need to explicitly consider profit maximization, and therefore output markets.
Furthermore, we have modeled environmental standards in a stylized way, as emission caps for firms. In reality, command and control policies often work quite differently. They may fix emissions per unit of output, or limit quantities of a particular pollutant relative to the total amount of effluent released. These kinds of relative or performance standards are historically used to regulate vehicle emissions and wastewater disposal. A contemporary example is the European Union's target of producing 20 percent of its energy from renewable sources. To model relative standards and to study their performance, we again need to explicitly account for output levels.
16 - Discrete Choice Models
- from PART III - VALUING THE ENVIRONMENT
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 457-484
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Summary
In Chapter 15 we emphasized that revealed preference analysis often involves estimating the demand function for a private activity, which in some way relates to a quasi-fixed environmental good. In particular, we discussed how specific assumptions about an individual's preference function U(x,z,q) allow us to infer the value of an environmental good q from an estimate of the ordinary demand function x(p,y,q), which was assumed to be continuous and strictly positive. In actual applications, however, data at the individual level often consist of yes/no outcomes, small integers, and consumption levels equal to zero. For example, in a recreation application it is not unusual to observe a person making only one trip during the study period, and so the relevant decision is which site he visited rather than how many trips he made. Similarly, understanding the demand for water filtration in a household production application might involve analyzing whether or not a household has installed the necessary equipment. In these two contexts the data do not support estimation of a continuous demand equation, nor is the behavior generating the data well described by a continuous model. Instead, we need to use discrete choice analysis to frame the behavioral problem and estimate the relevant demand parameters. Other types of behavior are more explicitly discrete. For example, a person votes yes or no on a referendum, does or does not donate money to environmental causes, and accepts or refuses an offer of compensation for damages suffered. As these contexts illustrate, discrete outcomes are ubiquitous in environmental economics, and a working knowledge of discrete choice econometrics is essential for many areas of applied research. In this chapter we provide an overview of discrete choice models as they are used in the field, focusing on both conceptual and econometric topics.
The departure point for discrete choice analysis is the recognition that for many household decisions, the “which one” component of choice is more relevant than the quantity purchased. For example, most households buy only one automobile at a time, yet they select from dozens of different models at the time of purchase. Durable appliances such as washing machines are one-unit purchases, but there are usually a large number of different types available. In cases like these, a model is needed that describes how attributes of the choice alternatives and characteristics of the purchaser influence which option is chosen.
PART IV - THE PRACTICE OF ENVIRONMENTAL ECONOMICS
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 647-648
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Summary
Parts I, II, and III thus far have presented the theory, methods, and policy examples that have historically defined the field of environmental economics. The order of topics has largely followed the intuitive division of the field into the subfields of environmental policy design and non-market valuation. While this organizational scheme was pedagogically useful, it left several important areas heretofore uncovered. Many of these topics fall roughly under the rubric of the “doing” of environmental economics, and so in Part IV we begin by discussing a handful of loosely related topics organized around the theme of cost-benefit analysis (CBA), and then close the book with a wide-ranging discussion of current practice in the field.
Cost-benefit analysis is in some sense the quintessential applied task for environmental and other economists. However, there are important theoretical aspects that need to be understood – particularly when the task involves comparing costs and benefits over long periods of time. We therefore begin in Chapter 21 with a detailed discussion of discounting. We note the common practice of using the market interest rate to compare costs and benefits across time, and present the conceptual basis for this choice, based on the classic result from Ramsey (1928). We then discuss different viewpoints on discounting the distant future, when there are market failures and/or uncertainty about future interest rates. We note how this is particularly relevant for CBA of climate change policies, where the choice of a discount rate is of first order importance.
Climate change CBA is also the primary motivation for our second topic in Chapter 21: integrated assessment models (IAMs). An IAM in general is any modeling system that combines compatible modules from multiple disciplines for the purposes of conducting policy simulations. IAMs are best known for their role in climate change policy, whereby a model of the world economy is paired to a climate system model, and connections between the climate and economic systems are calibrated. As an example of this type of research, we present the analytical aspects of William Nordhaus's DICE model, and show how his stylized representation allows experimentation with different policy scenarios. A general lesson from this is that IAMs are not truth machines, but they are useful for comparing how different policies interact with the economic and climate systems to produce different future outcomes.
A Course in Environmental Economics
- Theory, Policy, and Practice
- Daniel J. Phaneuf, Till Requate
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- 27 February 2023
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- 24 December 2016
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This unique graduate textbook offers a compelling narrative of the growing field of environmental economics that integrates theory, policy, and empirical topics. Daniel J. Phaneuf and Till Requate present both traditional and emerging perspectives, incorporating cutting-edge research in a way that allows students to easily identify connections and common themes. Their comprehensive approach gives instructors the flexibility to cover a range of topics, including important issues - such as tax interaction, environmental liability rules, modern treatments of incomplete information, technology adoption and innovation, and international environmental problems - that are not discussed in other graduate-levels texts. Numerous data-based examples and end-of-chapter exercises show students how theoretical and applied research findings are complementary, and will enable them to develop skills and interests in all areas of the field. Additional data sets and exercises can be accessed online, providing ample opportunity for practice. For more information, visit the book's website at http://phaneuf-requate.com/.
2 - Environmental Problems and Policy Issues
- from PART I - ECONOMICS AND THE ENVIRONMENT
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 17-34
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In Chapter 1 we illustrated how the field of environmental economics has its roots in neoclassical welfare theory. From a theoretical perspective most contemporary topics in the field continue to fit into the historic paradigm of the failure of the first welfare theorem, missing markets, externalities, and public goods. Describing environmental economics in such purely theoretical terms, however, ignores the importance that practical policy issues have played and continue to play in the development of the field. Indeed research in environmental economics, perhaps more so than other fields in economics, is driven by the needs of the policy-making community.
Because of this link it is useful from the outset to understand how environmental economics developed in parallel with the growth of the environmental movement and the coming of national-level environmental policy. In the first section of this chapter we therefore provide a brief review the social, policy, and research themes from the last four decades that together helped to define the field. We follow in section 2.2 with a review of contemporary environmental problems that motivate current research, focusing on the causes and consequences of water, air, and land pollution in a variety of contexts. The environmental science discussion from this section transitions in section 2.3 to explore the relationship between economics and ecology. In both sections our review is selective and heuristic, with a focus on qualitative description rather than summarizing actual (and soon to be outdated) environmental trends. In the final section we review several policy examples in order to illustrate how the environmental and behavioral elements connect, thereby creating the need for environmental economics in policy design. These examples also provide specific context for the more abstract discussions that are used later in the book.
EVOLUTION OF ENVIRONMENTAL POLICY AND ECONOMICS
Concerns about environmental externalities are not new. For example, during the thirteenth century coal became commonly used in England as a heating fuel, and the consequences for air quality were dire enough that in 1306 King Edward I banned its use in London, albeit to little effect. Nonetheless, modern environmental awareness arose in developed countries in the 1960s as a result of the pollution consequences of the postwar economic expansion.
14 - Theory of Applied Welfare Analysis
- from PART III - VALUING THE ENVIRONMENT
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 391-419
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In this chapter we present the conceptual basis for applied welfare analysis. We begin with a review of consumer welfare theory, and how economists have used the theory to develop standard empirical techniques for measuring the welfare effects of changes in private good prices. We present the well-established duality results linking estimable demand functions to preferences, and ultimately to monetary measures of economic value. Since most of non-market valuation involves examining the welfare impacts of changes in quasi-fixed goods (such as the level of an environmental indicator), we then discuss how the standard price-change techniques must be modified when we consider quantity changes. We show that while duality can still be used to link demand for the quasi-fixed good to the preference function, the absence of market exchange rules out the use of observed behavior to directly estimate a demand function. Instead, extra-market information is needed to infer individuals’ monetary values for these goods, the sources of which we consider in subsequent chapters. We close this chapter by discussing generalizations needed to define welfare measures that are appropriate for use under state of the world uncertainty, and then by examining the conceptual relationship between different types of welfare measures.
It is useful at the outset to carefully define what we mean by monetary value, since it plays such a large role in the discussion. As described at the book's outset, the concept of value that we rely on is individualistic and based on consumer sovereignty, so that a person's preferences determine how outcomes (e.g. consumption levels, states of the environment, or his own health) translate to value. Outcomes can, of course, change through any number of channels. Prices can adjust, indirectly shifting consumption levels, or policy might directly alter environmental quality, thereby impacting the level of well-being that a person obtains. Establishing a monetary value for any action that directly or indirectly changes outcomes involves (a) defining a baseline state and an ending state, and (b) computing the person's willingness to pay (WTP) to secure the ending state, or his willingness to accept (WTA) to forgo it. The key points here are twofold.
19 - Stated Preference Methods
- from PART III - VALUING THE ENVIRONMENT
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 572-616
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In Chapter 14 we established the conceptual basis for non-market valuation and defined what we referred to as the fundamental challenge of welfare measurement. In particular, we noted that the absence of observable demand behavior for most environmental and other public goods requires additional assumptions or extra-market information to measure their value. Up to this point in Part III of the book we have focused on additional assumptions as a solution to the fundamental challenge. We have seen that in many instances, assertions about the relationship between the environmental or public good and a related private commodity can be used to link behavioral functions, which are estimable from actual behavior, to values for environmental goods. Examples of this type of revealed preference approach were discussed in Chapter 17 for recreation and Chapter 18 for property markets.
In this chapter, we turn our attention to an alternative strategy that uses surveys to obtain the data needed for welfare measurement. Stated preference (SP) methods use information on how respondents say they would behave in carefully constructed hypothetical situations, and so in contrast to revealed preference (RP) methods, there is no need to observe actual behavior. Stated preference methods are in fact quite general and have been used for decades in a variety of social science fields. Carson and Louviere (2011, p.541) present a definition that is almost a tautology when they note that “a stated preference survey is a survey that asks agents questions that embody information about preferences”. Seen in this light, familiar classes of surveys used in marketing (which of these would you buy?) and political polling (who will you vote for?) are examples of stated preference applications. Our interest is specifically in stated preference valuation methods in which answers to questions lead directly or indirectly to measures of economic value for a commodity that is being studied.
Stated preference valuation surveys in environmental economics typically focus on a well-defined environmental commodity, and usually present questions using one of the following three stylized formats, where B denotes an amount of money:
• Would you be willing to pay $B to have this improvement in resource quality?
• Which from among the following three resource quality and cost combinations would you select?
• How would your use of the resource change if the quality was improved to this level?
Frontmatter
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp i-iv
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References
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 24 December 2016, pp 719-748
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13 - Accumulating Pollutants
- from PART II - THE DESIGN OF ENVIRONMENTAL POLICY
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 353-388
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Summary
In the previous chapters we studied pollution problems mainly in a static framework. With noise pollution, for example, the externality results directly from the instantaneous flow of noise. Many other pollutants, however, accumulate, and the externality results from the stock of the pollutant rather than from its flow. This is in particular the case for greenhouse gasses such as carbon dioxide. It is also relevant for air pollutants such as sulfur dioxide and nitrogen oxides, as well as for liquid pollutants that accumulate in groundwater reservoirs. This is not to say that our analysis so far is valid only for noise or other non-accumulating externalities, in that we can interpret our earlier findings as steady-state results. In this chapter, however, we focus directly on the dynamic consequences of accumulating pollutants. Although we do not deal in depth with resource economics in this book, pollution abatement for accumulating pollutants has parallels to the exploitation and management of renewable resources. In the case of climate change, for example, the atmosphere can be thought of as a sink for pollutants, and as such as a renewable resource.
To analyze accumulation dynamics, we need additional analytical tools from dynamic systems analysis. When conducting analysis in continuous time, we typically apply methods from dynamic optimization and optimal control. A full introduction to optimal control theory is beyond the scope of this book. Nonetheless, in appendix A to this chapter we briefly define the main concepts of optimal control theory, and lay out in a recipe-like fashion the corresponding optimality conditions.
This chapter is organized as follows. In section 13.1 we set up a dynamic version of our Chapter 3 model, with environmental damage resulting from accumulated pollution. We start by briefly presenting a discrete time version of the model to derive the optimality conditions via the familiar Lagrange method. In section 13.2 we then analyze the continuous time model in detail by first setting up the optimality conditions and looking at the optimal steady state, and then turning attention to the optimal path into the steady state. We do this analytically and using phase diagram analysis. In section 13.3 we link the problem of an exhaustible resource to the problem of an accumulating pollutant.
22 - Cost- Benefit Analysis: Empirical
- from PART IV - THE PRACTICE OF ENVIRONMENTAL ECONOMICS
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 676-704
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We saw in Chapter 21 that cost-benefit analysis (CBA) is a technique used to assess whether a project is “worth it” from an efficiency perspective. As the name implies, a critical step in cost-benefit analysis is the estimation of the economic costs and benefits of the proposed action. In this chapter, we continue our discussion of CBA for environmental policy by focusing on two estimation-related topics: benefits transfer, and the empirical characterization of abatement cost functions.
We have noted that the benefits of environmental policy outcomes are usually non-market, meaning the methods presented in Part III of this book are critical inputs for executing at least part of an environmental cost-benefit analysis. In the context of an original study, however, non-market valuation methods require a non-trivial commitment of resources and often the skills of a specialist. This observation often presents policy analysts with a two-fold dilemma. First, in some instances deadlines and institutional constraints make execution of an original valuation study in support of a specific policy analysis infeasible. Second, many decisions – particularly those taken at more localized levels – are too limited in scope to justify expenditure on original research. In these cases, practitioners of CBA need some method of assessing non-market benefits without resorting to an original study. That is, the benefits of the proposed policy need to be measured using previous studies and secondary sources of information. The art and science of doing this is known in environmental economics as “benefits transfer.”
In contrast to benefits, it is often thought that the costs of environmental policy are relatively straightforward to estimate. For example, observation of accounting records on what regulated entities spend to comply with a policy should provide the data needed to tally the cost side of cost-benefit analysis. While this may be a useful first step, our discussion in Chapter 5 demonstrated that abatement cost, when properly viewed as the opportunity cost of reducing emissions, is a broader concept than firms’ compliance costs. Thus far in the book, however, we have said little about how to translate the conceptual aspects of abatement cost functions into empirical strategies for measuring the costs of environmental policies.
PART III - VALUING THE ENVIRONMENT
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 389-390
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Summary
Throughout Parts I and II of this book we have referred to damage, abatement cost, profit, and other economic functions in our discussion of environmental policy. As we have seen, these functions arise from household preferences and firm production technologies, and are therefore usually not directly observable. Nonetheless, to this point we have assumed regulators and other agents possess knowledge of these functions or estimates thereof, and conditional on this, we have proceeded with our mostly theoretical discussion of policy design. In Part III, we turn our attention to methods that have been developed to estimate the damage and cost functions needed to implement policy. With this, our emphasis switches to examining models of individual and household behavior, since the measurement concepts of interest usually arise out of individuals’ interactions with the environment. Furthermore, Part III of the book has a greater emphasis on econometrics, since our discussion will also examine ways that these models can be brought to data to produce empirical results.
The themes we discuss in Part III are usually referred to collectively as the sub-field of non-market valuation. The general problem of non-market valuation is to compute a monetary value for environmental resources or services that, in the general setup of market economies, are not subject to exchange, and therefore do not have an observable market price. For example, we might be interested in knowing the monetary value of preserving a wooded area in an urban landscape, relative to its value in a residential use. Likewise, large-scale biodiversity preserves usually preclude extractive use, such as mining and timber harvest, within the boundaries of the preserve. What is the monetary value of the biodiversity protection relative to the market value of the forgone minerals and lumber? To answer this and similar questions, conceptual models that connect the environmental resource to people's preferences (or in some cases firm profits), and econometric approaches that connect data to the conceptual models, are needed.
For this our starting point is neoclassical welfare theory, as it was when we started the book. This helps us to stress that the valuation problem should not be viewed as separate from the policy design problem in Part II, since they are two sides of the same coin.
9 - Ambient Pollution Control
- from PART II - THE DESIGN OF ENVIRONMENTAL POLICY
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 212-233
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To this point in Part II of the book we have generally considered the regulation of point sources, and with the exception of the spatial problem in Chapter 8, have assumed there is a one-to-one relationship between emissions and the ambient pollution level. This allowed us to measure environmental damages as a function of total emissions. In addition, we have implicitly assumed that emissions from particular sources are perfectly observable, so that responsibility for a given emission level can be assigned to a specific source. In this chapter we turn our attention to ambient pollution problems, in which environmental damage is assessed based on the concentration of effluent in the environment rather than the count of emissions at the polluting source. The ambient pollution problem has two crucial characteristics. First, ambient pollution problems often arise from non-point sources of emissions. A prominent example is agriculture, where nutrient fertilizers, animal waste, sediments, and pesticides can run off fields or leak from waste management systems into surface and groundwater. Emissions of these substances from individual agricultural producers are usually not observable. Rather, the collective consequences of all farmers’ emissions in a watershed are reflected in ambient concentrations of effluent in lakes, streams, and wells. Second, in many cases there is not a deterministic relationship between total emissions and ambient pollution problems. Instead, the relationship is stochastic, with randomness coming from weather events and other exogenous shocks beyond the control of polluters and the regulator. Once again considering the agricultural example, nutrient concentrations are generally higher in streams when the water volume is low. Similarly, heavy rains can increase the amount of nutrient and sediment runoff, thereby causing acute spikes in ambient pollution levels.
In this chapter we discuss the challenges associated with regulating ambient pollution levels. We begin in the next section by focusing on the non-point source pollution problem in a deterministic environment, which illustrates how moral hazard – i.e. the inability of the regulator to observe individual polluters’ emissions – necessitates the use of an ambient pollution tax in lieu of an emission tax. In section 9.2 we introduce a stochastic relationship between emissions and ambient pollution. We show that, under constant marginal damage, a uniform ambient tax can induce the efficient abatement effort, while under increasing marginal damage a uniform tax is only second-best optimal.
Dedication
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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11 - Innovation and Adoption of New Technology
- from PART II - THE DESIGN OF ENVIRONMENTAL POLICY
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 267-312
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Human history has been defined by innovation and technological progress. Economists have for decades recognized that technological progress is critical for increasing general material wealth and the quality of human life. More recently, economists began focusing on the specific role that technological progress plays in the environmental context. In this chapter we synthesize the large conceptual literature related to innovation, technology adoption, and the environment.
The general topic of technology nests several related but distinct sub-areas of environmental economics, and so in this chapter we will look at multiple decision margins from a variety of actors. For example, when subject to environmental regulation, polluting firms can directly invest in R&D (research and development) efforts to reduce their abatement costs. In section 11.1 we study this type of behavior when investment has purely private benefits, and ask if additional efforts by the regulator are necessary to assure an efficient amount of investment in abatement cost reduction. In section 11.2 we generalize the model to allow for investment spillovers, whereby R&D effort by an individual firm creates knowledge that serves to reduce the abatement costs of all firms in the industry. We will show that, while purely private benefits from investment do not result in additional market imperfections, the spillover case produces a second market failure, based on the public good nature of R&D effort. Thus two policy instruments are needed to reach an efficient outcome.
In other contexts, polluting firms do not internally innovate, but instead must decide whether to bear the fixed cost of installing an available (abatement) cost-reducing new technology. We study this context in section 11.3, where we compare private and socially optimal adoption outcomes and discuss the performance of our suite of policy instruments in regulating emissions, and encouraging firms to deploy the new technology. The incentives for technology adoption that the various policy instruments provide have been loosely referred to in the literature as their “dynamic efficiency” properties. We discuss rankings of policies relative to a common environmental starting point, as well as their comparative usefulness for decentralizing the fully efficient outcome.
8 - Institutional Topics in Cap and Trade Programs
- from PART II - THE DESIGN OF ENVIRONMENTAL POLICY
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 175-211
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Our discussion of environmental policy to this point has generally abstracted from the many ways that institutional and design elements can affect the performance of the suite of policy instruments. For example, while we have distinguished between auctioned and freely distributed permits in cap and trade programs, we have not addressed the many ways that freely distributed permits can be assigned to participating firms. In this chapter we discuss a collection of institutional issues in cap and trade programs, analyzing how design elements that are common in practice may affect performance.
We focus specifically on cap and trade because its theoretical merits have long been stressed by economists, and these efforts have paid off in the sense that emission trading is now part of the common parlance in environmental policy discussions. Indeed we now have experience with two major programs – the US sulfur dioxide program, and the European Union Emissions Trading System for carbon dioxide – and several smaller, regional programs. It is telling, however, that few if any of the existing programs were designed according to the principles described in the theoretical papers. Instead, they combine political compromises, interest group demands, and economic ideas in ways that have on occasion contributed to disappointing performances for cap and trade programs.
In what follows we examine seven topics related to cap and trade programs, and which economists have examined. In section 8.1 we present an analysis that explicitly accounts for differences in the location of polluting firms and the spatial extent of the damages their emissions cause. We show that cap and trade programs can be designed to accommodate the spatial dimension, but that it involves a change in focus from emissions to ambient pollution outcomes. In section 8.2 we address the temporal dimension by considering the merits of allowing polluters to transfer emissions across time by permitting them to bank (or borrow) emissions rights. Both the US SO2 program and the European Union CO2 program allow some form of permit banking, and so understanding how this affects behavior in these programs is necessary for evaluating their success. We show that, under some circumstances related to abatement cost uncertainty, some limited forms of banking are welfare improving.
6 - Non- Competitive Output Markets
- from PART II - THE DESIGN OF ENVIRONMENTAL POLICY
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
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- 27 February 2023
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- 24 December 2016, pp 124-141
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Summary
In the last chapter we introduced the output market to our analysis and used it to extend several of the results we derived in Chapter 3. Throughout we maintained the assumption that all markets were competitive, which allowed us to show that the optimal level of pollution was still characterized by the marginal abatement cost equals marginal damage condition. In this chapter we consider how optimal policy might be different under non-competitive market structures. As we will see, our analysis is complicated by the presence of both market power and pollution-related distortions, and these will cause some of our familiar results to no longer hold. Indeed, the presence of multiple distortions means the regulator's objective is typically to locate a second-best optimal emission tax rate that reflects the relative strength of the two market distortions. The material we present in this chapter will therefore be more technical than what was used in Chapter 5.
What is our motivation for including a chapter on non-competitive markets? Although competitive markets provide a useful starting point for studying environmental policy, non-competitive industries are the primary sources of many regulated pollutants. For example, in both the United States and parts of Europe electric utilities and petroleum refineries tend(ed) to exercise monopoly power at the regional level, pulp and paper production has concentrated in recent decades, and automobile manufacturing is done by a relatively small number of firms in any given country. These examples suggest that non-competitive industries are more than a theoretical curiosity for environmental policy. In response, an enormous literature has arisen that considers the role of market power in all its guises. Researchers have examined output market structures such as monopoly, oligopoly, and monopolistic competition. Homogeneous versus differentiated products, quantity versus price competition, and market power in factor markets have also been considered. In this chapter we limit attention to monopoly and oligopoly output market structures, since these provide useful vehicles for demonstrating the main techniques and conclusions from this larger literature.
The early literature on environmental policy and market power provides additional motivation for studying non-competitive output markets. Papers by Buchanan and Stubblebine (1962) and Buchanan (1969) challenged the Pigouvian point of view outright, by noting that a monopolist distorts the market by producing too little output.
23 - Final Thoughts
- from PART IV - THE PRACTICE OF ENVIRONMENTAL ECONOMICS
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
- Published online:
- 27 February 2023
- Print publication:
- 24 December 2016, pp 705-718
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Summary
Via the 22 previous chapters in this book we have tried to tell the story of environmental economics, beginning with its roots in neoclassical welfare theory and the environmental movements of the 1960s, and through to the sophisticated theoretical and applied research that today defines the field. We have attempted to integrate in a single volume the conceptual, empirical, and policy aspects of the field, without compromising on the depth of coverage. This, more than anything, explains the length of the book and the amount of time it has taken to write. Even with this, there are many topics that deserve discussion which we have elected not to cover in the book. In this chapter we will briefly discuss some of the important omissions and offer some closing thoughts.
We begin in the next section by noting that environmental economics, like many other fields in microeconomics, has experienced a flowering of empirical research. This is due to several simultaneously occurring factors, including greater appreciation for careful applied work in the economics profession, advances in applied econometric methodology, and the increased availability of high-quality behavioral and environmental data. Many of the questions being pursued do not fit cleanly into the standard canon of the field, which has served as the organizing principle of the book. To highlight this increasingly important aspect of the field, in section 23.1 we summarize a handful of recent papers that illustrate the range of empirical research questions that have occupied environmental economists.
In addition to specifically empirical topics, there are several other areas that we have not covered or have discussed only briefly. Examples include the large economic literature on climate change, topics at the nexus of energy and environmental economics, and political economy/environment issues related to interest group activities, alternative regulator objective functions, and voting. We have also omitted traditional resource economics, and topics that combine elements of environmental policy and natural resource management. In section 23.2 we catalog these topics, discuss their omission in the context of the book's organization and intent, and provide references for further reading.
7 - Environmental Policy with Pre- existing Distortions
- from PART II - THE DESIGN OF ENVIRONMENTAL POLICY
- Daniel J. Phaneuf, University of Wisconsin, Madison, Till Requate, Christian-Albrechts Universität zu Kiel, Germany
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- Book:
- A Course in Environmental Economics
- Published online:
- 27 February 2023
- Print publication:
- 24 December 2016, pp 142-174
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Summary
Our emphasis thus far in Part II of the book has been partial equilibrium, in the sense that we have focused only on the polluting sector in our consideration of environmental policy. When studying competitive markets from this perspective, we have consistently found that the optimal pollution level occurs at the point where firms’ marginal abatement costs are equal to society's marginal damages. Furthermore, the short run performance of the full suite of incentive-based policies was equivalent. Importantly, the extent to which the different policies raise revenue for the government was important only for equity, and did not play a role in efficiency comparisons. Thus emissions could be taxed or abatement subsidized, and pollution permits auctioned or freely distributed, and the only difference was in who captured the environmental scarcity rents. Things were slightly different in the long run, in that abatement subsidies could cause excess entry and were therefore inferior to emissions taxes. Nonetheless, we found that permit schemes that do not raise revenue perform equally to their auctioned counterparts, so long as total emissions are capped when firms enter or leave the market. The ability to separate equity considerations from efficiency outcomes was touted as an important source of flexibility available to the environmental regulator.
A question we have not yet examined is the extent to which these partial equilibrium results continue to hold when we consider how environmental policy might spill over into other markets. We saw in Chapter 5, for example, that environmental policy raises the output price of the polluting good. This can affect the demand for other consumption goods, impact households’ labor supply decisions, and cause changes in real income. More importantly, pollution externalities are usually not the only sources of distortions in an economy. Government revenue is often raised via proportional labor taxes, thereby encouraging the overconsumption of leisure, and causing potentially substantial welfare losses. Other factor input markets are also distorted, as are many product markets through value added taxes or subsidies. It is natural to ask how these pre-existing distortions might interact with environmental policy, causing us to alter the conclusions obtained when such spillover effects are ignored.
Thinking on this topic emerged along two lines. The first focused on the potential for environmental policy to result in a “double dividend”.