Climate Change
Climate change is arguably a gigantic market failure:
- CO2 emissions are causing global warming with severe economic and human consequences
- Our combined willingness to pay to reduce global warming must exceed cost.
Climate Change Policy
Taxes on CO2 emissions aim to achieve an efficient emission level across many sectors at the same time.
The tax on a tonne of CO2 should equal its external cost in terms of its contribution to global warming.
Cap-and-trade quota systems are similar:
- Cap total quotas at the efficient emission level
- Trade in quotas ensures efficient allocation
- Equilibrium quota price reflects level of external cost
Map of Carbon Taxes and ETSs
There are 73 carbon taxes and ETSs in operation. Despite the global energy crisis, new ETSs and carbon taxes launched
Externalities
Externalities represent the action of one directly affects the welfare of others.
Examples:
- Negative: pollution, smoking, CO2-emissions
- Positive: research, charity, vaccination
In the presence of externalities, free markets generally fail to produce efficient outcomes.
Market Equilibrium Efficiency with Externalities
The Efficient quantity (Q*) is smaller than equilibrium quantity (Q), and it causes social losses.
Corrective Tax
Taxation can restore efficiency in the presence of a negative externality. Idea: Introduce tax on cement production that equals the external cost:
- forces producers to “internalize” the external cost
- aligns the private and the social cost
- ensures that the efficient quantity prevails
Known as corrective tax or Pigouvian tax (after the economist Pigou who first suggested it)
The corrective tax brings the quantity down to Q*.