Pollution Taxes and Permits

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Common Test 1 Case Study Marking Scheme (I have provided the broad ideas. Please elaborate on each idea.) 1. Explain the economic case for implementing measures like the “pollution tax” and the “permits to pollute” to tackle the issue of emissions of greenhouse gases. [8]

Explain the economic rationale of implementing “pollution tax” and “permits to pollute”: Both policies are implemented to tackle the problem of greenhouse gases, which causes negative externality (third party spillover effect) in the form of global warming and climate changes that lead to lower health and decreasing economic development. Firms in the pursuit of self-interest (to maximize profits) cause pollution that imposes costs on other members of the society that are not fully reflected in market prices. Thus, the free market equilibrium emission of greenhouse gases will be more than the socially optimal level. Explain what is meant by allocative efficiency. Highlight any similarity and/or difference between the two policies: Both are policies that seek to reduce the level of emissions to the socially optimal level of pollution. Pollution taxes is a market based approach to limiting pollution emissions but permits to pollute is a combination of command and control and marketbased approaches to the task of limiting pollution emissions. While pollution taxes seek to reduce pollution by distorting prices, pollution permits seek to reduce it through quantity limits. Governments or governing body sets standards on the maximum amount of pollution/permits to be given out free of charge). After which firms are allowed to trade these permits on the market for tradable permits. Explain how the pollution tax works to achieve allocative efficiency/evaluation/advantages: Taxation policy allows the government to charge an amount of tax preferably similar to the value of MEC at the socially optimal level of production (the Pigovian tax). Pigovian tax is levied on producers who pollute the environment to encourage them to reduce pollution. In this case, the tax causes the producers to internalize the external cost of production such that the socially optimal level of production and hence, emission is achieved. In addition, the tax revenue collected by the government may be used to counteract the negative effects of the pollution. In the long run, firms have the incentive to adopt cleaner methods of production so that they can pay less pollution taxes. Possible evaluation/limitations of the pollution tax system & application to the context: A key problem with Pigovian tax is that of imperfect information, in other words, calculating what level of tax will counterbalance the negative externality. Another problem lies in the use of the tax revenue – whether it is used to clean up the environment or pocketed by corrupted officials. In addition, political factors such as lobbying of government by polluters may also tend to reduce the level of the tax levied, which will tend to reduce the effectiveness of the tax. Explain how the “permits to pollute” system works to achieve allocative efficiency/evaluation/advantages: The “permits to pollute” system is an application of Coase Theorem. This system of permits allows the government to set the overall level of pollution (emission of greenhouse gases) that it finds desirable. The government then decides on who has the right to pollute the air and in what quantity. Firms are, however, free to trade permits with each other. Firms that are already producing cleanly and do not need the permits can sell the permits to those firms who find it more difficult to meet the standards. In this way, market forces are allowed to determine the distribution of pollution without the need for the authorities to micro-manage. Firms whose emissions exceed the amount of credits they possess will be heavily penalised. Over time, the government can gradually reduce the number (volume) of pollution permits available so that total pollution emissions...
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