Knowledge Problem

Lynne Kiesling

On Friday at Environmental Economics, Tim Haab wrote about the implications of New Source Review for innovation in a regulated industry, and how to represent it in the standard Pigouvian model (do go read the whole post, it’s very useful). The basic question is this: does the stifling of innovation that results from New Source Review regulations change the fundamental analysis of the question of pollution?

I have some quibbles with how Tim frames the “externality” question — in particular, I prefer the “markets don’t fail, they fail to exist” formulation of the fact that some uncompensated cost is present, rather than “market failure” — but his post makes a really important point with respect to New Source Review and the Pigouvian model:

The technological improvements resulting from removal of New Source Review may shift the private supply curve to the right, and may reduce the emissions per unit of output, but that doesn’t solve the fundamental externality problem.   So even though the technological improvements may reduce per unit emissions, emissions may actually increase from the decreased costs of producing electricity (decrease per unit emissions, but increased units). Regardless, with or without the NSR regulation, there will still be emissions and those emissions will remain unpriced (inefficiently) by the market. ‘

While I agree that existing regulations may have reduced the incentive for innovation, their existence doesn’t change the fundamental market failure–emissions are not rationed through prices.  For a market to work efficiently, ALL costs and benefits of production and consumption must be internalized.  In such cases, emissions will be efficiently rationed.

I take issue with a couple of these points. First, if the Pigouvian model is the correct way to model the pollution question, it is incorrect that “ALL costs and benefits of production and consumption must be internalized”. For an illustration of why this claim is not correct, ask yourself this question: how much do you pay your neighbors for the lovely flowers they plant in their front gardens, and if you did pay them, would that induce them to plant more flowers? Of course you don’t pay your neighbors for the external benefit you derive from their lovely gardens, and I think it’s a safe generalization that your neighbor-gardeners have more intense preferences over their gardening decisions than you do over their decisions. What does that imply? It implies that even if you did pay them as compensation to internalize your benefit, if your marginal benefit is small relative to theirs, your payment is unlikely to change their decision at the margin of how much gardening to do. In other words, the only uncompensated costs and benefits that are important for achieving the optimal level of abatement (of a cost) or increase (of a benefit) are the costs and benefits that are Pareto relevant, that would at the margin change the behavior of the relevant party.

This must be a pet issue for me because I’ve written about it before, with respect to inefficient energy efficiency consumer subsidies, with respect to externality accounting, and with respect to the fact that Alex Tabarrok got a flu shot because he wanted to get kissed.

As a coda: I do not think that the Pigouvian model is the correct model, because it ignores the reciprocal nature of costs; in other words, it ignores the fact that the pollution problem is a problem of conflicting uses of a scarce common-pool resources, and the people with those different uses are imposing costs on each other. The polluter is not the only one creating a cost.

Second, I think Tim’s right about his interpretation of NSR and the Pigouvian model, but I also think that the Pigou model of a per-unit tax on output from a polluting firm is not the best model to use to see the effects of NSR, unless the policy you are analyzing is a per-unit output tax. I think a fuller answer to his astute student also includes the following:

If the policy is an emissions tax (e.g., a per-ton tax on sulfur dioxide or greenhouse gases), then NSR regulation artificially keeps abatement costs higher than they would be in the presence of the technological innovation. Thus at the margin, the NSR regulation does affect the firm’s choice, and the amount of abatement/emissions, because if the tax rate is higher than the abatement cost, then the firm will choose to abate. Thus NSR means that less abatement takes place under an emissions tax, by keeping abatement costs higher.

If the policy is a tradeable permit system, then NSR regulation artificially keeps abatement costs higher than they would be in the presence of the technological innovation. A firm’s abatement costs determine its demand for permits in the permit market. Thus at the margin, the NSR regulation increases the firm’s willingness to pay for permits, and leads to higher costs of achieving the abatement/emissions target.