eenotes_unc - REGULATION: UNCERTAINTY AND OTHER ISSUES I...

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Unformatted text preview: REGULATION: UNCERTAINTY AND OTHER ISSUES I Taxes and permits with uncertainty We saw in the previous notes that taxes and tradeable permits are identical, except that the government may allocate the initial permits and therefore not collect any revenue. Of course, tax revenue can always be rebated to the same individuals who would have been designated to get the permits. We will see that when the regulator is uncertain about firm marginal costs, price (tax) and quantity (permit) regulation give different allocations. Typically, the polluter will claim reducing emissions is very expensive, while the envi- ronmental lobby will claim emissions can be reduced without cost. For example, prior to creation of the SO 2 tradeable permit market, industry claimed emissions reduction would cost $300 per ton, while the environmental lobby claimed the costs would be zero. How is the regulator to set the tax or quantity of permits under such uncertainty? A Taxes and uncertainty Suppose a firm may have either high ( MC H ) or low ( MC L ) marginal costs of reducing emissions, with the average being ¯ MC . Suppose the regulator sets the tax so that marginal damages equal average marginal costs: t = MD ( E ∗ ) = ¯ MC ( E ∗ ) (52) t MD E t E ∗ MC H MC L ¯ MC E , L ¯ E E , H Figure 36: Tax regulation when marginal costs are uncertain. 56 Now the actual marginal costs will be either higher or lower than the average. The firm reduces emissions until the price (the tax) equals marginal costs: t = MC H ( E H ) , (53) if marginal costs are high and t = MC L ( E L ) , (54) if marginal costs are low. Thus the tax will be either too high or too low, creating welfare losses: E t MD t E ∗ H MD H MD L Welfare loss: MC H MC L E ∗ E H E ¯ MC MC H E ∗ L Welfare loss: MC L E L Figure 37: Welfare losses from tax regulation when marginal costs are uncertain. If marginal costs are low, the firm will reduce emissions a lot as it is cheaper than paying the tax. So we see too much emissions reduction, and marginal costs are above marginal damages. Conversely if marginal costs are high, the firm does too little emissions reduction as it pays the low tax rather than reducing emissions. Marginal damages are above marginal costs. The average welfare loss is average of the area of the two triangles. 57 B Permits and uncertainty Suppose we now impose a tradeable permit system in which we set the number of permits E ∗ so that marginal damages equal average marginal costs: ¯ MC ( E ∗ ) = MD ( E ∗ ) (55) Now if marginal costs turn out to be high, demand for permits will increase, raising the price of permits to p H in Figure 38. Marginal costs will be above marginal damages, creating welfare loss. Conversely, if the marginal costs are low, little demand for permits results, pushing the price down. Marginal costs are below marginal damages....
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This note was uploaded on 01/08/2012 for the course ECO 345 taught by Professor Kelly during the Fall '11 term at University of Miami.

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eenotes_unc - REGULATION: UNCERTAINTY AND OTHER ISSUES I...

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