Market Failure and Policy Instruments: Climate Change

This paper aims at discussing CO₂ emissions as the result of market failure and some alternatives to deal with it. In details, I firstly demonstrate why climate change is caused by market failure through greenhouse gasses emissions (GHG) and CO₂ emissions. Secondly I outline and briefly mention several policy instruments available to deal with such problems. Thirdly and lastly, I discussed each instrument’s advantages and disadvantages.

The market usually does not function very well when it comes to public good as the public good has no price in it. Price can be assigned when there is property rights attached to the goods. That is exactly what is happening with public good, it lacks of property rights or is having ill-defined property rights. Imposing property rights means that we give the right to utilize the goods to some one/entities/clubs. Meanwhile, the characteristics of public good are non-excludability and non-rivalry. Non excludability means that it is impossible to exclude some one from utilizing the good. Non-rivalry means that the consumption of the good by an individual does not reduce the available amount for others to consume.

Carbon dioxide (CO₂) and other GHG are emitted to the earth atmosphere. Meanwhile, the atmosphere itself is a public good. It is non-excludable as everyone in the earth can emit anything to it or breathe the air from the atmosphere. It is non-rivalry since my emission does not reduce others’ rights to emit. It does not have price and thus no available market mechanism. In the end, when everyone emits GHG and CO₂ to the atmosphere, then there will be excessive stock pollutions in the atmosphere. Moreover, it is subsequently causing climate change.

However, as the awareness of the danger of climate change arise, countries started to seek out solutions to this problem. The climate change is a complex problem since it is a transboundary problem –i.e. climate change happens in everywhere and is caused in every place- and the existence of spill over –i.e the abatement of one country is enjoyed by other countries, so does the pollution of one country is affecting other countries too-.

There are several policy instruments available that can be used to mitigate the climate change problem. The policy instruments are grouped into three categories that are institutional approaches such as voluntary bargaining, command and control such as emission regulation, and economic incentive instruments such as taxes, subsidies, and tradable emission permits. The underline idea in economic incentive instrument is to give price to the emission so that profit-maximizing firm will also taking into account the opportunity cost of emission into their production plan.[1]

A profit-maximizing firm produces goods at optimal output level of maximal profit. Profit is maximal when marginal costs of firm equals to marginal benefits of firm (MC = MB). However when firm pollutes and the pollution is not priced, it creates social costs/damages to the society. The damages are called externality and are often not calculated in product price. By giving price to the damages –either through subsidies, taxes, or emission trades- the pollution then influences the cost function of the firm. Thus the firm internalizes the externalities.

Environmental taxes or known as Pigouvian Taxes is a practice of assigning taxes to pollution emitted by firms. Taxes are assigned to pollution as it will be less efficient if assigned to inputs or final products.[2] Pollutions are to some extent allowed as in an economic point of view, it is never about achieving zero pollution, and instead it is about balancing the benefits and costs. There are three steps to find the balance between benefits and costs –i.e. the optimal pollution level- that is identifying firm/industry profit function, the social damages function –that is the externality effects-, and the optimal pollution level.

The optimal pollution level is the point where the shadow price of social benefit is equal to the shadow price of cost. The shadow price of social benefit is the reduction in social damages due to a reduction in product produced, while the shadow price of cost is the loss of firm profits due to a reduction of a unit produced. In order to find the shadow price, we should calculate the marginal function –i.e. the first derivative- of firm’s profit function and social damages function. The next step is to equalize the marginal social benefit and marginal abatement costs. Environmental taxes then are applied to this level.

Subsidies work similarly to environmental taxes as at the optimal pollution level both mechanism –the environmental taxes and subsidies- are levied or paid at the same rate.[3] However, as Perman (2003) noted “the two instruments are different in their effects on income distribution”. Taxes caused firms to lose income while subsidies caused firms to gain income. In the short-run and at the optimal pollution level both mechanisms are similar; nevertheless, as subsidies are given in form of lump-sum payment, subsidies may give different long-term effects.[4]

Another mechanism of economic incentive mechanism is marketable emission permit. The idea is that government set an overall industry emission level and let the firms distribute the emission level independent of government intervention. In general, the mechanism works as follow: first, the government set a targeted industry emission level; second, an initial emission permit is distributed to each firm; third, firms sell/buy permit to another firms. This mechanism is also known as the cap-and-trade mechanism. Firms are able to sell or buy permit as they are different in their profit function. A firm may find it more profitable to emit more while other firms may find it more profitable to emit less and sell the excess allowances. Thus, an increase in one firm is compensated by decrease in other firm/s. Tradability is an important characteristic of marketable emission permit that grouped it into economic incentive instruments, otherwise it will be categorized as a command and control instruments.

There are several indicators to compare between above mentioned mechanism that is cost-efficiency and monitoring-administering-and-enforcing-compliance costs, long run effects, double dividend, and equity/distribution. It is obvious that command and control instruments are least cost-efficient compare to economic incentive instruments as compliance costs are usually high. European union emission trading for example estimates that the cost of emission trading is between 2.9 billion euros and 3.7 billion euros compare to 6.8 billion euros compliance costs annually.[5] Among economic incentive instruments, emission trading is the most cost-efficient compare to other instruments.[6] However, command and control may create greater long-run effects in term of technology advancement compare to other instruments as it provides incentive and guidance for technology research. I think that emission trading will give the biggest “double dividend” as it creates a lot of job opportunity. As of distribution issue, taxes may cause bigger effect for consumer –i.e. consumers bear the cost- regardless of polluter pays principle especially when market is of monopoly or oligopoly market.

Furthermore, in the presence of corruption, I think the emission trading will give best results compare to other instruments. The reason is that emission trading will minimize the involvement of civil servant in its operation and thus minimize the possibility of corruption.

Based on above comparisons, I think the best instrument is the emission trading.

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REFERENCES

European Commision. (2005) EU Action Against Climate Change: EU Emission Trading - an Open Scheme Promoting Global Innovation, Belgium.
Perman, R., Common, M., Mcqilvray, J., Ma, Yue. (2003) Natural Resources and Environmental Economics, 3^rd edition.

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[1] Perman, R., Common, M., Mcqilvray, J., Ma, Yue. (2003) Natural Resources and Environmental Economics, 3^rd edition.
[2] Ibid.
[3] Ibid.
[4] Ibid.
[5] European Commision. (2005) EU Action Against Climate Change: EU Emission Trading - an Open Scheme Promoting Global Innovation, Belgium.
[6] Perman, et. Al. Ibid.