ENVS 36b, Climate Change Economics and Policy, Fall 2020

Module 4: Economics Primer

• Supply, demand, and equilibrium
• Efficiency and the equimarginal principle
• Benefits and costs for environmental services
• Benefit-cost Analysis

The King of Burgers

Robert Baratheon is a huge burger lover. One day he walks into a burger place, and finds the menu to be the following. Which burger should Robert choose?

Burgers	No. Sausages	Price	WTP
Veggie Burger	0	$4	$5
Cheeseburger	1	$6	$8.5
Double Cheeseburger	2	$8	$11
Triple Cheeseburger	3	$10	$12.5
The Ultimate Cheeseburger	4	$12	$13

Maximize net benefits

Burgers	Price	WTP	Net Benefit
Veggie Burger	$4	$5	$1
Cheeseburger	$6	$8.5	$2.5
Double Cheeseburger	$8	$11	$3
Triple Cheeseburger	$10	$12.5	$2.5
The Ultimate Cheeseburger	$12	$13	$1

Some Algebra

WTP: \(-0.5Q^2+4Q+5\)

The demand for beef sausage:

P = 4-Q

Price for beef sausage

P = 2

Net benefit is maximized when price equals marginal benefit

Q = 2

Consumer surplus

Consumer surplus is the value that consumers receive from an allocation minus what it costs them to obtain it. Consumer surplus is measured as the area under the demand curve minus the consumer’s cost.

Producer surplus

Producer surplus

• Producer surplus is the difference between the amount that a seller receives minus what the seller would be willing to accept for the good.
• Given price P*, the seller maximizes his or her own producer surplus by choosing to sell Qs units.
• The producer surplus is designated by area B, the area under the price line that lies over the marginal cost curve, bounded from the left by the vertical axis and the right by the quantity of the good.

Equilibrium

A market equilibrium is characterized by the equimarginal principle, i.e.,

• For the consumer, price equals marginal benefit
  
• For the producer, price equals marginal cost
  
• Thus a market equilibrium is characterized by:

Marginal Benefit = Marginal Cost

The First Welfare Theorem

a.k.a the Invisible Hand Theorem

A complete and competitive market leads to a Pareto efficient allocation of resources.
- Adam Smith

• Pareto efficiency: no other feasible allocation could benefit at least one person without any deleterious effects on some other person
• Equilibrium from a competitive market is (Pareto) efficient

Question

What if you have waited in line for three hours for this amazing burger. Will your choice be different?

What if the restaurant has given you a free five-dollar coupon for your each visit?

What if on the way to the restaurant, you lost that five-dollar coupon?

What if the place is offering you a $11 coupon for your each visit?

What if in addition to the price the restaurant charges, the city collects a burger tax of $4 for each burger?

So, what happens when the good in question is carbon emission?

Question:

1. What is the optimal level of GHGs in the atmosphere?
2. Should we restore the level of GHGs back to zero? To the pre-industrial level?

We need to find:

• A demand curve
  • How much will we benefit from reducing GHGs?
• A supply curve
  • How much will climate change cost to our society?
• An optimal level of GHGs that equates supply and demand

Marginal benefit of (reducing) the stock of GHGs

Social Cost of Carbon

The economic benefits from reducing GHGs (or, the economic damage caused by climate change) is known as the social cost of carbon. This is measured in $/metric tons of carbon emission.

• SCC takes into consideration ALL climate-related damages
  • Direct and indirect costs
  • Current and future costs
  • Domestic and International costs

Estimates of the SCC

• Obama admin: $50 per ton (2015)
• Nordhaus (DICE): ~$200
• Stern and Stiglitz (2021): ~$150

And there’s the Trump admin’s number:

• Domestic-only effect, ignores global spillovers of \(CO_2\) emissions
• Uses a 7% interest rate, while the economic community recommends 3% or less
• Found a $1 per ton of carbon(!)

• The Biden administration restores the social cost of carbon back to $51/ton of CO2
• This is an interim number: the new administration has set up an inter-agency group to re-quantify the social impact of carbon
• It is NOT a carbon tax (we will talk about carbon pricing in a few weeks)
• It will be used in federal benefit-cost analysis (which we will talk about in 30 minutes)

What about the costs

Ways to reduce carbon emissions:

• Planting trees
• Transform energy systems
• …

An extreme example

• From mid March to mid June 2020, \(CO_2\) emission decreases by ~18% in the United States (Greestone 2020)
  • By the end of the year, ~6-12% reduction for the year 2020
  • RCP 2.0: 8% reduction every year until 2050
• \(PM_{2.5}\) levels decrease by 36% globally (Venter et al. 2020)
• \(NO_{2}\) levels decrease by 60%, also globally (Venter et al. 2020)

The US lost ~30% of its GDP in the second quarter

• The best estimate for cost: $3,000-5,000 per tonne of CO_2

This is really using a missile to shot a cow - Michael Greenstone

Marginal analysis vs. Benefit-Cost Analysis

• So far we have focused on the marginals
  • Is it worthwhile to clean-up/conserve/protect the last unit
  • In theory, it maximizes the net social benefit
• Real-world policies are (usually) not made in this way
  • Information on MB and MC is difficult to get
  • Political processes and voter preferences

Enters Benefit-cost analysis

• Reagan: every federal regulation needs to pass BCA
• Aim to de-regulate and restore a small government
  • Too much regulatory burden dis-incentivizes small businesses and entrepreneurial innovation

At the same time:

• There is a need to evaluate the efficacy/efficiency of public investments
• Benefit-cost Analysis (BCA) provides an economic framework
  • In every policy arena, from infrastructure to tax rates to dam constructions
• Straightforward, clear-cut rules

The Decision Rule

Let B be the total benefits from a proposed policy, and C be the total costs. The decision rule is:

If B>C, do it. Otherwise, don’t do it.

Alternatively,

If the benefit-cost ratio B/C>1, do it.

Benefit-cost analysis

• Monetizes environmental benefits & costs
  • What’s the economic loss from the BP oil spill?
  • What’s the economic benefits from wetland protection?
  • What’s the “Social Cost of Carbon”?
• For most environmental policies, benefits are much larger than costs
  • The Clean Air Act
    
  • The Clean Water Act
  • Climate change mitigation

Benefit-cost Analysis

Benefit-cost analysis always considers the TOTAL benefits and TOTAL costs of the policy. For example, for benefits, we have:

• Direct benefits (Human health, flood risk reduction, replacement of destroyed capital)
• Co-benefits (CAFE standard decreases PM2.5)
• Future benefits (less climate risk for future generations)
• Option and existence Value (even if we’re never going to see polar bears, knowing it’s there has economic value)

Benefit-cost Analysis

Benefit-cost analysis provides a normative criteria to evaluate public policy decisions

• Normative: entails a value judgment
  • That the societal welfare is measured by the TOTAL economic benefits and costs
• Public: Benefit-cost analysis only applies to decisions that involve a public project
  • Private companies will automatically evaluate decisions based on revenue and cost
  • Public projects do not face the scrutiny of economic(accounting) calculus
• Decision
  • Whether to do the project or not
  • Need a decision rule that is clear-cut

Class Reflection Question

1. What do you think are the strength of benefit-cost analysis?
2. What (and who) do you think are missing out in benefit-cost analysis?

Of course, benefit-cost analysis is NOT the only decision rule:

• Impact analysis
  • What are the environmental impacts of a proposed action?
  • If there is harm, then could it be mitigated?
  • Environmental Impact Analysis, Wetland Permit, Endangered Species Act
• Cost-effectiveness
  • Wish to achieve some normative societal outcome (social justice, universal healthcare)
  • What is the way that involves the least cost to achieve the policy target?

And there is this

Executive Order 13771 (1/30/2017): “(c) …any new incremental costs associated with new regulations shall, to the extent permitted by law, be offset by the elimination of existing costs associated with at least two prior regulations.”

• The Milton Friedman tradition: too much existing regulation are hurting businesses
• Total costs of the regulation should remain the same (or lower)
• But what about benefits?

And benefit-cost analysis does not guarantee economic efficiency

• BCA essentially evaluates whether the total benefit is larger than the total costs
  • Or, whether the net benefit is larger than zero
• That does not guarantee that the proposed policy MAXIMIZES societal welfare

What does benefit-cost analysis look like?