Question

You work for a regulator that is deciding on what policy to choose in order control carbon dioxide. One of your colleagues suggests that `price regulation is preferred over quantity regulation if there exists uncertainty over the marginal cost function.’ Is this statement true, false, or uncertain? What policy should be used and why?

ps：Could you provide some economical theory behind this topic? thank you so much

Answer 1

Carbon Dioxide Emission is a kind of negative externality in which the environment gets affected. The cost of this externality is not borne by the producer as there is no system or technique to measure the loss it does to the Environment. The costs in such cases are externalized and are borne by the people living in that environment and not just the people who are responsible for increased carbon dioxide emissions. In these cases, there is a divergence between the Marginal Social Cost of production (MSP) and the Marginal Private cost of production (MPC), where MSP is always greater than MPC. The difference between both signifies the Marginal External Cost that the carbon dioxide production emission costs to the environment.

One approach by the regulator could be by increasing the Taxes paid by the producers who create this externality which automatically increases the Marginal Private Cost of Consumption and reduces the production of such commodities which increase Carbon Dioxide Emissions. Another strategy is to regulate the number of commodities produced by these producers. Every regulation has its pros and cons which will be examined here.

By regulating the price of commodities produced that increase negative externality.

When the government increases the taxes paid by the producer for each commodity it produces, it tries to limit the qty. produced by the producer as producer’s cost of production increases which encourages the firms to produce less output. The tax which is imposed to reduce negative externality which is a cost to others is termed as Pigouvian Tax. In, the case of a negative externality, the outcome of the market is not efficient and may lead to the overproduction of the goods. The tax is set equal to the Marginal External costs such that the incentives for the producer to produce more output decreases. As the private costs of the producer increase, his incentives to produce less increase which will automatically reduce the carbon dioxide emission in the environment. However, there are drawbacks of imposing this type of tax too. To impose the right amount of tax, govt. needs statistics about the correct social cost that the producer is imposing on the environment. It becomes difficult for the govt. to decide the optimal level of tax to reduce production. Another shortcoming associated with this is, it might decrease the consumer surplus of the consumers if the producer passes the increased cost as increased prices to them. In that case, consumers require to pay a higher price which is equal to the tax imposed by the govt. on them.

Graphically, producer maximizes its production equating Marginal Revenue and Marginal Cost and produces Q0 which is greater than Q1 which is produced when Marginal Social Cost is equated with Marginal Revenue. With the appropriate amount of imposed tax T, Marginal Pvt. Cost is increased for the producer and it starts producing Q1 which is the socially optimal amount of Output.

              

By regulating the quantity produced that increases negative externality.

The regulator might cap the maximum output the Producer can produce given the externality. This will restrict the amount of carbon dioxide by the producer. Govt. can permit a quantity quota in such a way that the negative externality associated with the production reduces. It permits the producer to produce a specific amount of output and hence the pollution. The main objective behind quotas is to limit the qty. produced to the efficient level. Imposing of quota lets the govt. to minimize the cost of these regulations on revenues. The downside of imposing a quota is to identify which producers deserve quota. Quotas decrease the incentive of using better technology as there is a limit to the output production. This doesn’t incentivize Producers to invest in better technology and also harm the new entrants as they are left with fewer incentives to get.

Accordingly, the most relevant way to address this situation is to use Tradable permits. Tradable permits are the quantity based environmental policy instrument. Producers, in this case, require them to produce a given amount of pollution. More is the pollution, higher is the price of Tradable Permit. The price of them is the tax and the amount of pollution that could be emitted with the permit is the quota. It is the combination of tax and quantity quota put together and is better and more efficient. A major advantage of Trade permit is that it provides the producers with the opportunity to trade according to their requirements and creates an efficient exchange. A polluter can buy the permit from the other polluter leaving the amount of Carbon Dioxide pollution in the environment balanced. Tradable permits are like the taxation scheme but with no need for the govt. to measure the social costs of pollution. Low permit prices signify the quantity of pollution is too large in the environment and needs to be reduced.

Any regulator can use the hybrid of Taxes and Quantity Quotas to tackle this situation. Using a hybrid reduces the drawbacks associated with it.