Consider the problem of carbon dioxide emissions. We will abstract from the comp

Question

Consider the problem of carbon dioxide emissions. We will abstract from the complexity of the problem slightly, assuming there are polluters and consumers in two regions, the OECD (O) and the rest of the world (R). Suppose the marginal cost of controlling CO2 emissions is $13 per ton. Let the marginal willingness to pay for pollution reduction be 14 – Q for region O and 8 – 2Q for region R, where Q is the amount of pollution reduction.

The United Nations is considering two proposed methods for controlling CO2 emissions, both involving polluters paying for the damage they cause:

Proposal A involves the polluters paying damages to each region for the pollution generated.

Proposal B involves the polluters in each region independently negotiating pollution reductions with the consumers of their respective region, assuming the other region is not undertaking pollution reduction.

What is the socially efficient level of emissions reduction Q*? A graph of the marginal abatement cost and the total marginal willingness-to-pay curves would be helpful. (Hint: CO2 emission reduction is a global public good)

How much total pollution reduction will occur under Proposal A and what will be the total compensation received by regions O and R? If those payments were instead placed in the general coffers of the UN, would the outcome be any different from an efficient point of view? Why or why not?

How much pollution would be generated under Proposal B? Explain any differences between this answer and the answer to parts (a) and (b).

Explanation / Answer

Assume that we can treat all global polluters as a single agent and treat each region’s polluters as a single agent. There is a kink at Q = 4. Because emission reduction is a global public good, we must aggregate the MWTP vertically.

The socially efficient level of pollution reduction is derived where the marginal cost is equal to the global marginal willingness to pay

14 – Q + 8 – 2Q = 13

22 – 3Q = 13

Q* = 3

Hence, socially efficient level of pollution reduction is Q = 3

The marginal benefits from pollution reduction are equal to the marginal cost of pollution. This implies that the global damages are equal to the area under the total marginal benefits curve, which is just the vertical sum of the two regional marginal willingness to pay curves.

Now polluters are paying full compensation, they will set Q = 3 to maximize net profits. (The total compensation paid out is just the area under the Total MB curve. This is equal to the total damage in region (14- 3) x (14 - 3)/2 = $60.5 for region O.

The compensation received by region R is 1 (area below their marginal willingness to pay curve between Q = 3 and Q = 4).From an efficiency point of view, it does not matter who receives the payments.

Again setting the marginal cost equal to marginal willingness to pay separately for each region, region R polluters would not reduce pollution MWTPR > MAC. In region O, the emission reduction is such that Q0 = 1

The total reduction of 1 is less than in parts (a) and (b) because each region’s negotiations do not take into account the benefit to the other region. When polluters negotiate only with the consumers of their own region, the outcome is not efficient. In equilibrium, there would be even less pollution reduction as region R free-rides on region O’s pollution reduction.

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