I.    Pigouvian Taxation

• Pigouvian tax – A tax levied on each unit of a polluter’s output in an amount equal to the marginal damage that it inflicts at the efficient level of production.
• The goal is to set the tax so that the polluter incorporates the social cost.
• Note that Pigouvian taxation is a second-best solution, as we’ve taxed the output.  It would be better to tax the pollution directly.  Modern economic solutions to pollution, which we will discuss later, take this into account.
• It is a second-best solution because, although the level of output is correct for the technology being used, the firm doesn’t have the correct incentives to use the appropriate technology (e.g. pollution control, more efficient machines, etc.) because there is no price placed on pollution.
• However, there may be times when this is the best we can do.
• For example, we cannot measure the actual emissions from cars, so we instead tax gasoline consumption, since pollution is a by-product of gasoline consumption.
• The Pigouvian tax works by internalizing the cost of the externality.  We can do the same thing with a subsidy.
• In this case, the opportunity cost of polluting is losing the subsidy.
• Types of subsidies:
• An abatement equipment subsidy would pay a firm for adopting a specific abatement technology.
• A per unit subsidy pays a firm for each unit of pollution reduced below some predetermined level.
• Problems with subsidies
• Very different distributional effects
• The polluter receives money from the government, rather than paying
• Firms may enter market, so that total pollution increases
• Need to raise taxes to pay for subsidies
• Ethics?
• Should we have to pay to avoid pollution?
• Subsidies are often politically motivated, and can be difficult to remove when no longer needed.

II. Emission Fees

• Recall that the problem with externalities is that they are not reflected in prices.
• The government can rectify the problem by setting a price for pollution.
• The goal is to set the fee so that the polluter incorporates the social cost.
• If MAC is known, simply set the fee equal to MAC at the optimal level of pollution.
• The firm will find it beneficial to abate up to this point, since abating is cheaper than paying the fee.
• After this point, paying the tax is cheaper than abatement, so no further abatement occurs.
•  Note that since MAC = MD at the optimal level, the firm is taking into account the value of the damage it is doing.
• If MAC is unknown, the fee should be based on the expected value (the “best guess” of MAC).
• The main advantage of emissions fees is that, when there is more than one polluter, they achieve a given level of pollution control at the lowest possible cost.
• Thus, economists say that emissions fees are an efficient environmental policy.
• An efficient solution is found when the marginal abatement costs are equal across all firms.
• At this point, there is no way to shift abatement responsibilities among the firms and achieve a lower total cost.
• However, the cost to each individual firm is greater, since the firms pay both abatement costs and the fees.
• Thus, emissions fees are politically unpopular.
• You may download a spreadsheet with the numbers I used in class by clicking here.
• Another potential advantage of fees over CAC is that fees encourage innovation.
• Once you’ve met a CAC regulation, you have little incentive to do better.
• However, if you lower your MAC, you can abate more, and pay less in fees.
• See, for example, figure 12-7 in Field.