Unit 1: Economic Fundamentals

# Unit 1: Economic Fundamentals
## Econ 3535
### Kyle Butts
### University of Colorado: Boulder

---

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# Lecture 1

- Intro to Class

- Prisoner's Dilemma Review

---

## Reading for this class:

[Robert Frank's The Darwin Economy](../Articles/Excerpts from The Darwin Economy.pdf)

---

## Elk Antlers and the Prisoner's Dilemma

---
### Elk's Prisoner Dilemma

Elk in the wild battle for females with their horn. Having larger horns gives an advantage in battling horns.

Large horns hurt their ability to run away from predators though. If elks could agree, they would all prefer to cut the size of their horns in half.

<br>

**Payoff Table:**

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  <thead class="gt_col_headings">
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      <th class="gt_col_heading gt_columns_bottom_border gt_left" rowspan="1" colspan="1">Big Horns</th>
      <th class="gt_col_heading gt_columns_bottom_border gt_left" rowspan="1" colspan="1">Small Horns</th>
    </tr>
  </thead>
  <tbody class="gt_table_body">
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<td class="gt_row gt_left">(3,3)</td>
<td class="gt_row gt_left">(8,0)</td></tr>
    <tr><td class="gt_row gt_left">Small Horns</td>
<td class="gt_row gt_left">(0,8)</td>
<td class="gt_row gt_left">(5,5)</td></tr>
  </tbody>
  
  
</table>
</div>

---
### Elk's Incentives

If Elk 2 is going to have big horns, two options: 
  - Elk 1 has big Horns, the payoff would be 3.
  - Elk 1 has small Horns, the payoff would be 0.
  
Elk 1 will choose big horns (or, natural selection chooses). We call big horns  a *dominant strategy*

The same is true for Elk 2. The Nash Equilibrium is big horns.

<br>

**Payoff Table:**

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<table class="gt_table">
  
  <thead class="gt_col_headings">
    <tr>
      <th class="gt_col_heading gt_columns_bottom_border gt_left" rowspan="1" colspan="1">Elk 2 / Elk 1</th>
      <th class="gt_col_heading gt_columns_bottom_border gt_left" rowspan="1" colspan="1">Big Horns</th>
      <th class="gt_col_heading gt_columns_bottom_border gt_left" rowspan="1" colspan="1">Small Horns</th>
    </tr>
  </thead>
  <tbody class="gt_table_body">
    <tr><td class="gt_row gt_left">Big Horns</td>
<td class="gt_row gt_left">(3,3)</td>
<td class="gt_row gt_left">(8,0)</td></tr>
    <tr><td class="gt_row gt_left">Small Horns</td>
<td class="gt_row gt_left">(0,8)</td>
<td class="gt_row gt_left">(5,5)</td></tr>
  </tbody>
  
  
</table>
</div>

---
### Terminology

*Game Theory*: 
  - The study of strategic interaction between rational decision makers

*Nash Equilibrium*:
  - A common outcome in game theory models, where incentives overlap in a way that produces a “rational” solution
  
*Prisoner's Dilemma*:
  - A type of Nash equilibrium where cooperation leads to the best overall outcome, but individual incentives push away from this outcome

---
### Nash Equilibrum

We have assumed that you have no control over the other person's choice.

Do we believe this to be true in the following games:
  - Elk Horns?
  
  - Selling used car and being honest about it's condition? What about selling to your family?
  
  - Two restaurants choosing the price of their meals?

---
##Prisoner's Dilemma in Resource Economics

***Open Access Goods***:
  - *Non-excludable* resource that can be used by anyone. 
  - What happens to a park on a nice summer day?
  
***Natural Resources*** 
  - Different from most other goods because they do not originally belong to anyone
  
---
### Natural Resources Examples
.subheader.alice[Cooperation vs. Defection]

*Oil and gas extraction*:

---
### Natural Resources Examples
.subheader.alice[Cooperation vs. Defection]

*Oil and gas extraction*:

- Cooperation = responsible extraction methods
- Defection = damaging extraction

*Groundwater extraction*:

---
### Natural Resources Examples
.subheader.alice[Cooperation vs. Defection]

*Oil and gas extraction*:

- Cooperation = responsible extraction methods
- Defection = damaging extraction

*Groundwater extraction*:

- Cooperation = limited pumping to keep pumping costs down
- Defection = extracting as much as possible and raising the costs for everyone

*Climate change mitigation*:

---
### Natural Resources Examples
.subheader.alice[Cooperation vs. Defection]

*Oil and gas extraction*:

- Cooperation = responsible extraction methods
- Defection = damaging extraction

*Groundwater extraction*:

- Cooperation = limited pumping to keep pumping costs down
- Defection = extracting as much as possible and raising the costs for everyone

*Climate change mitigation*:

- Cooperation = adhering to international standards
- Defection = emitting as much as is privately profitable

*Fisheries and forestry*:

---
### Natural Resources Examples
.subheader.alice[Cooperation vs. Defection]

*Oil and gas extraction*:

- Cooperation = responsible extraction methods
- Defection = damaging extraction

*Groundwater extraction*:

- Cooperation = limited pumping to keep pumping costs down
- Defection = extracting as much as possible and raising the costs for everyone

*Climate change mitigation*:

- Cooperation = adhering to international standards
- Defection = emitting as much as is privately profitable

*Fisheries and forestry*:

- Cooperation = sustainable harvest levels
  - Defection = unsustainable harvest levels

---

### The point
<hr><br>

When resource users defect from the cooperative outcome, total economic value is diminished.

*Even though it may be rational for all users to defect*

---
### Case Study: commonly owned pastures in England

In the early 1800s, ranchers were allowed to openly graze on commonly owned pastures.

> “Why are the cattle on a common so puny and stunted? Why is the common itself so bare-worn, and cropped so differently from the adjoining inclosures?”

> William Forster Lloyd, Oxford University, 1832

<br>

Ashton (1997) credits enclosing these pastures to private allotments to helping start the industrial revolution by increasing agriculture productivity to the point where farm workers could move to industry jobs.

---
#### *Breakout Rooms:*

Using game theory, why would enclosement increase productivity?

---
##Tragedy of the Commons

*The Commons*:

- Any system where finite resources can be accessed and affected
by multiple economic agents with divergent interests

- Original term comes from shared grazing land in the middle of a
town

*Tragedy of the Commons*:

- Open access goods are mismanaged as a result of misaligned
private incentives

Contrast this with traditional economic markets

- Selfish behavior and the profit motive often lead to a socially
optimal outcome

---
#### Solutions

- Folk Theorem: expanded understanding of rationality in repeated games

- Elinor Ostrom: mechanisms for commons enforcement

- Research focused on all of the ways that communities overcome the bad incentives- lots of field work

- Example: Pasture rotations and irrigation schedules monitored and enforced by the users of the commons without any government regulation

- Privitzation of common goods as in the England example.

---
## Reading for Next Time

- "Static Efficiency", page 20
  
  - "Relating Optimality to Efficiency", page 50
  
  - "Comparing Benefits and Costs Across Time", page 52
  
  - "Choosing the Discount Rate", page 62

---
class: clear, middle
# Lecture 2

- Economic tools for analyzing natural resource problems

- Discounting and Present Value

---
### Recap

- Private benefits but publicly shared costs → suboptimal economic welfare
  - In natural resource economics, this is outcome is called “tragedy of the commons”
  
- Solutions to Tragedy of Commons
  
  - Folk Theorem (improvement from repeated interactions)
  
  - Horizontal enforcement (Ostrom’s research)
  
  - Expansion of property rights
  
  - Contracts
  
  - Laws and penalties

---
### Differences Between Traditional Economics and Natural Resources

*Traditional Economics*

- Static outcomes

- “Static Efficiency” page 20

- `$MC = MB$` is usually optimal

- Rational self interest leads to optimality

*Natural Resource economics*

- Dynamic outcomes; we use discounting and present value

- `$MC$` and `$MB$` aren’t fair comparisons, some costs are left out

- Especially external and future costs

- Rational self interest often leads to tragedy of the commons

---
## Discounting

**Discount Rate** captures the *time value of money*.

- Opportunity cost associated with time (can make investments that yield returns instead).
- Discounting rate also has a subjective component as well.

<br>Why is a dollar today worth more than a dollar tomorrow?

- riskless cost of capital

- risk premium

- pure rate of time preference

---
### Why use Discounting?

People actually think this way, if not precisely

- Banks use discounting to decide interest rates

- Government agencies use it to decide on spending

- People use it when making large purchases

Economists don’t really have a choice to use discounting - it is present in real life

- Useful concept for being explicit about *intertemporal tradeoffs* (intertemporal: across time periods)

---
## Present Value

In words:

- To calculate present value, discount future values back to today.

- Capture what some future outcome (benefit or cost) is equal to in present dollars

In math:

$$ 
PV(B_t) = B_t / (1+r)^t
$$

- `$t$`: time-index (e.g. years). Today is `$t = 0$`, next year is `$t = 1$`, and so on.

- `$B_t$`: amount of benefit or cost in period `$t$`

- `$r$`: discount rate. Many different options for `$r$` and require a choice (e.g. `$r = 0.03$`).

---
### Example

How much would you be willing to pay now for something worth $1000 in 5 years time.

$$ 
PV(1000) = 1000 / (1+r)^5
$$

<br>
- `$r = 0$`:

- `$PV(1000) = 1000/(1)^5 =$`  $1000, i.e. the same because you don't discount the future. 
  
- `$r = 0.02$`:

- `$PV(1000) = 1000/(1.02)^5 =$` $905.73
  
- `$r = 0.10$`:

- `$PV(1000) = 1000/(1.04)^5 =$` $620.92

---
### Which Discount Rate to Use?

*Private decisions:* market interest rates = revealed time preference

*Policy decisions:* much debate! (Example 3.4)

- Stern Review used 0.1-1.4% (panic, prescriptive)

- Nordhaus prefers 3-6%, as does IPCC (apathy, descriptive)

- US government uses 2.5%-3.5% (in between)

<br>
Lower discount rates `$\implies$` more value placed on future

---
### Lower Discount = Better for Environment?

Example where it does not: [Natural Habitat Restoration](https://darrp.noaa.gov/economics/habitat-equivalency-analysis)

Polluters are often required to pay fees for damages done to natural habitats

- They have to compensate the cost they caused by destroying the habitat. How much?

- They get judged based on the net present benefits of all fixes they pay for.

Does lower interest rate yield more or less investments?

---
### Climate Change Example

Let's say climate change will cost $2 trillion dollars 100 years from now (per year).

How much would we invest today to avoid this this cost:

`$r = 0.03$`:

`$$2,000,000,000,000/(1.03)^{100} = 104 \text{ billion}$$`

`$r = 0.07$`:

`$$2,000,000,000,000/(1.07)^{100} = 2.3 \text{ billion}$$`

---
### Net Present Value Stream

Of course, climate change will create costs for each year, so we will add up all the present value of costs per year:

`$$C_1/(1 + r)^1 + C_2/(1+r)^2 + \dots + C_{100}/(1+r)^{100} + \dots$$`
This value is the willingness to pay for climate change today.

<br>
<hr>
Two important considerations:

1. What is the appropriate value of `$r$`?

2. Since 2010, the investment cost of stopping climate change has dropped precipitously

---
## Economic Models

> “All models are wrong, but some are useful”
> 
> George Box

In our case, “useful” means whether or not the models give a deeper understanding of natural resources

<br>

Components of an Economic Model:

- Motivation

- Assumptions

- Agents

- Equilibrium

---
## Reading for Next Time

- "Resource Taxonomy", page 119
  
  - "A Two-Period Model", page 103-107
  
  - [Michael Greenstone's Managing Climate Risk](../Articles/What Financial Markets Can Teach Us About Managing Climate Risks.pdf) ([online version](https://www.nytimes.com/2017/04/04/upshot/what-financial-markets-can-teach-us-about-managing-climate-risks.html)).

---
class: clear, middle
# Lecture 3

- Resource taxonomy

- Recyclable resources

- Two-period model with constant MC and fixed supply

---
## Recap

Benefits and costs that happen in the future need to be compared to those that happen now

- How much should we be willing to invest to avoid 1 million dollars worth of climate change?

<br>

**Present Value**:

$$ 
PV(B_t) = B_t / (1+r)^t
$$

- Which discount rate to use is a tough choice and requires thought.

---
## Discounting Summary

We value things in the present more than in the future

- How much more is debatable

Value increases over time

- Investments, technology, total wealth in society

But so do costs that society incurs

>"An ounce of prevention is worth a pound of cure"

- Capital is scarce, and opportunities to solve problem cheaply tend to go away as the problem gets worse over time

---
## Depletable Resources

**Current Reserves** (economic)

- Can be profitably extracted at current prices

**Potential Reserves** (economic)

- Function of prices and costs

**Resource Endowment** (geographic)

- Total amount of resources in the ground

---
.center[
### Example: Gold Mine

<br>

- Should this mine be in the Current Reserves or the Potential Reserves?

- If the price of gold dropped by 80%, should this mine be in the Current Reserves or the Potential Reserves?

---
### Recyclable Resources

Manufacturers either buy recycled materials from processing plants, or else source new materials from elsewhere
- Incentives to recycle change with the price of the raw material and the price of recycling material

A subset of potential reserves
- Recyclability of a material is also function of market prices

If all costs are accounted for, this determines “recyclability”
- e.g., Metals and paper are often more recyclable than glass

---
### Modeling Efficient Material Allocation

Motivation:

- Want to decide how much of the mineral is efficient to leave behind

Assumptions:

- Only two time periods, constant MC, simple demand function, etc.

Economic agents:

- Suppliers and demanders in both periods

Equilibrium:

- *Pareto Optimal*: nobody can be made better off without making someone else worse off

- *Dynamic efficiency*: total economic surplus (value created) is maximized across time (taking into account the discount rate)

---
#### Mineral Example

Two-Period Model: now and future

Inverse Demand Curve - `$P = 8 - 0.4Q$`

Marginal Cost -  `$MC = 2$`

Supply is connected to the resource endowment, which is the amount that is theoretically available.

- Supply matters! Is `$S = 20$`? `$S = 30$`?

---
class: center, middle

<div class="figure" style="text-align: center">
<img src="data:image/png;base64,#graphics/two_period_ex1_1.png" alt="Unlimited Supply Example" width="2472" />
<p class="caption">Unlimited Supply Example</p>
</div>

---
## Reading for Next Time

- "A Two-Period Model", page 103-107

---
class: clear, middle
# Lecture 4

- Mineral two-period model

- Marginal user cost

---
#### Mineral Example

Two-Period Model: now and future

Inverse Demand Curve - `$P = 8 - 0.4Q$`

Marginal Cost -  `$MC = 2$`

Supply is connected to the resource endowment, which is the amount that is theoretically available.

- Supply matters! Is `$S = 20$`? `$S = 30$`?

---
class: center, middle

<div class="figure" style="text-align: center">
<img src="data:image/png;base64,#graphics/two_period_ex1_2.png" alt="Scarce Supply Example" width="2472" />
<p class="caption">Scarce Supply Example</p>
</div>

---
### Solving the model
 
- Our goal is to maximize `$PV$` subject to the constraint that `$Q_1 + Q_2 = Endowment$`

<br>

When resources are scarce, greater current use diminishes future opportunities.

---
## Marginal User Cost

*Marginal User Cost*:

The present value of these forgone opportunities at the margin.

<br> 
- Without scarcity, producers will continue to produce until the marginal unit has net benefit of `$0$`.

- With scarcity, producers will produce until they run out of resources. There could be value to having another unit, this is the *Marginal User Cost*.

---
### Using MUC to solve model

When `$MUC_1 = MUC_2$`, we say the solution is *dynamically efficient*.

- Total `$PV(NB)$` is maximized

<br>

We then have to check if `$Q_1 + Q_2 = Endowment$`

---
## Reading for Next Time

- "Efficient Intertemporal Allocations", page 123-130

---
class: clear, middle
# Lecture 5

- Two-period model wrap up

- Markets

---
class: center, middle

---
### Questions

- Why do we put the period 2 quantities going in the opposite direction?

- Why are the intercepts (6 vs. 5.45) different?

- What would happen to the intercepts if the discount rate increased?

- What does equilibrium on the vertical axis represent?

---
### Complicating the Model

*Different demand curves across time*

- Kerosene vs coal vs natural gas

*Evolving marginal cost of extraction*

- Bioeconomic systems

- e.g. fish supply grows more slowly if you fish more in period 1

*Relationship with complements/substitutes*

- Coal vs natural gas

*Exploration and technology progress*

- Fracking

---
## Do Mineral Markets Work?

Since firms are rationally self-interested, markets work as long as:

1. they discount the future the same as society does

2. property rights are secure (no tragedy of the commons issues)

3. all costs are considered (private costs and costs to society)

---
## Reading for Next Time

- "Externalities as a Source of Market Failure", page 25-27
  
- Example 2.2 Shrimp Farming Externalities in Thailand, page 27

---
class: clear, middle
# Lecture 6

- Efficiency

- Welfare theorem

- Property rights

---
### Macro View of Efficiency

*Trade and the environment*

- Race to the bottom

- Porter Hypothesis

- Environmental Kuznets Curve

*Resources and development*

- Natural resource curse

- Institutional quality

---
### Micro View of Efficiency

*Efficient operation of markets*

- Welfare theorem

- Property rights

*Inefficient operation of markets*

- Pigou and externalities

- Coase and reciprocity

*Correcting inefficiencies with property rights*

---
## Efficency

Economic models usually try to find the solution that will provide the best possible outcome

- From among the set of possibilities

- According to the choice of outcome that is being modeled

*Examples*

- Efficient sustainable yield in a fisheries model

- Efficient harvest date for trees in a forestry model

- Efficient quantity in a supply and demand model

---
### Social Planner

Economists often describe efficiency in terms of what the **social planner** would choose

- Hypothetical, all-knowing, benevolent decision maker who decides everything on behalf of the economic agents
  
  - This outcome contrasts with the outcome resulting from the collective action of many self-interested individuals

<br>

*Example*

In the two-period model with scarcity, (10.3, 9.7) was efficient

However, we would expect (15, 5) is the likely outcome if self-interested users in Period 1 got to make all of the decisions

---
## First Fundamental Welfare Theorem

Provides the conditions needed to be satisfied for the market to reach the same solution as the social planner.

<br>

A market allocation will maximize total economic value without need for intervention ***IF*** the following conditions are met:
  1. Property rights are well-defined

2. Buyers and sellers behave competitively by maximizing benefits and minimizing costs

3. Buyers and sellers know all prices

4. Transaction costs are zero

---
### Property Rights

A set of legal entitlement over assets are well defined if they are:

1. Comprehensively assigned

2. Exclusive

3. Transferable

4. Secure

---
### Pigou and Externalities

**Externality**: a cost or benefit imposed on outsiders who had no choice

- Can be modeled as supply or demand (or some of both)
  
  - Named after Arthur C. Pigou (1920)

*Examples* 
- Oil production

- Negative supply externality: oil spills

- Negative demand externality: vehicle emissions

- Vaccines

- Positive demand externality: higher population resilience
  
  
---
#### Demand and Supply

- Private demand/supply curves consider only value to the decision makers

- Social demand/supply curves consider society’s value

- Also called Social MB/Social MC curves

- “Society” includes decision-makers

- Difference between demand curve and social MB curve is the per-unit amount of the externality

---
## Market Inefficiency

When an externality is present, the First Fundamental Welfare Theorem is violated

<Br>

Property rights are not well-defined

- Negative externality: you don’t have the right to protection from pollution

- Positive externality: you don’t have the right to capture benefits of vaccination

---
### Pigouvian Tax/Subsidy

Pigou proposed a corrective tax to deal with negative externalities

<br>

*Example*: If consumption of a gallon of gasoline causes an additional $1 of pollution, put a $1 per gallon tax on it

- Demand curve becomes identical to social MB curve

- Force market participants to internalize the externality

- Benefit: total welfare is maximized

- Drawback: some individuals may still lose

- In theory, can compensate those affected by the externality

---
## Reading for Next Time

- "Externalities as a Source of Market Failure", page 25-27
  
  - Example 2.2 Shrimp Farming Externalities in Thailand, page 27
  
  - "Coase Theorem", page 39-41

---
class: clear, middle
# Lecture 7

- Coase theorem

- Bargaining

---
### Recap

*Externality*
  - Additional cost or benefit to outsiders

*Pigou’s solution- taxes and subsidies*

- Internalize the externality

*First Fundamental Welfare Theorem*

- When private decision makers face the same incentives as a “social planner,” we get the right outcome
  
  
---
.center[
  ### Coase Theorem

---
## Coase Theorem

As long as property rights are secure and transaction costs are zero, both sides can work it out

- Social welfare is maximized, no matter who has the rights

- Ronald Coase (1960)

Maximizing social welfare

- In general, it is at the quantity where social MB = social MC

- When two activities are incompatible, the one with the higher surplus should be allowed

---
### Coase Theorem in Reality

More likely to hold true for bilateral externalities than any other kind

- Two-party negotiations are easier than 10 party negotiations

- Major point of Coase’s paper was that transaction costs are usually too high

If every human was guaranteed the right to low concentrations of GHGs…

- Fossil fuel companies would have to go door to door negotiating

- Probably would result in a good environment, but also no energy at all
  
  
---
### Comparison of Solutions

Suppose a rancher and a farmer operate on adjacent land. The rancher’s livestock causes some damage to the farm.

*Pigouvian tax*

- Assess damage caused per animal, tax the farmer that amount per animal

*Coase bargaining*

- Assign property rights, let the two sides negotiate
  
  
---
#### Example

Rancher benefits from additional cows

- `$MB = 10 – 0.5Q$`

Farmer incurs costs from additional cows

- `$MC = 0.5Q$`

How many cows are socially optimal?

- i.e. how many cows maximum net benefit?

Let’s graph it!

---

---
#### Scanario 1: High Transaction Costs

Whoever has the property rights will enforce them and refuse to negotiate
  - Farmer has the rights- zero cows

- Rancher has the rights- add cows until `$MB = 0$`

`$$10 – 0.5Q = 0 \implies Q = 20 \text{ cows}$$`

<br>
See the graph to understand why 10 is preferred to 0 or 20

---
#### Scenario 2: No Transaction Costs

Coase bargaining can be effective:

Farmer has the rights - negotiate a payment from the rancher for the right to graze

- First cow- rancher is willing to pay up to $9.50, farmer is willing to give up the right for $0.50 or more

- Second cow- rancher is willing to pay up to $9, farmer is willing to give up the right for $1 or more

- …

- 10th cow- rancher is willing to pay up to $5, farmer is willing to give up the right for $5 or more

<br>

*Welfare is maximized when Coase Bargaining occurs*

---
## Reading for Next Time

- [Ronald Coase and the Misuse of Economics](../Articles/Ronald Coase and the Misuse of Economics.pdf) ([online version](https://www.newyorker.com/news/john-cassidy/ronald-coase-and-the-misuse-of-economics)).

- "The Command-and-Control Policy Framework", page 397-404

---
class: clear, middle
# Lecture 8

- Policy tools

- Local pollutants

---
## The Big 3: Policy Tools

**Command and control**

- Standards, technology mandates, quotas, etc.

**Taxes (market-based)**

- Pricing externalities

**Cap and trade (market-based)**

- Issue permits, allow for trading

---
### Efficiency of Policy

Assuming we have a clear goal in mind, e.g. emissions
  - *efficiency* is hitting that goal as cheaply as possible

**Marginal abatement cost**

- The cost associated with eliminating the next amount of pollution

- Different sources have different MAC curves

<br>

Efficiency means that abatement comes from sources where it is easiest/cheapest to abate

---
### Marginal Abatement Cost

MAC is usually increasing in the level of abatement

- Unconstrained pollution costs nothing to the firm

- First unit of abatement is fairly easy

- For most firms, reducing emissions to zero requires shutting down completely

MAC generally comes from one of two abatement methods (whichever is cheaper)

- Opportunity cost of lowering output

- Direct cost of making the production process cleaner

---
### Local Air Pollutants

Important setting where all three major policy tools are used

Local air quality has some of the familiar open-access problems, but not others

- Not hard to measure responsibility for most of it

“Local” means that the emission source matters

- *e.g.* SO2, NOx, fine particulate matter, etc.

- Important non-local emissions include ozone-depleting chemicals and greenhouse gases

---
### National Ambient Air Quality Standar (NAAQS)

Established in the Clean Air Act of 1990, NAAQS sets standards for state and local regulators on six pollutants

- Carbon Monoxide, Lead, Nitrogen Oxides, Ozone, Particulate Matter, Sulfur Dioxide

States can choose which policy tools to use

---

<table style="font-size: 12px">
<thead>
  <tr><th colspan="2">Pollutant<br>
				[links to historical tables of NAAQS reviews]</th>
			<th>Primary/<br>
				Secondary</th>
			<th>Averaging Time</th>
			<th>Level</th>
			<th>Form</th>
		</tr>
</thead>
<tbody>
  <tr>
      <td colspan="2" rowspan="2"><a href="/co-pollution/table-historical-carbon-monoxide-co-national-ambient-air-quality-standards-naaqs">Carbon Monoxide (CO)</a></td>
			<td rowspan="2">primary</td>
			<td>8 hours</td>
			<td>9 ppm</td>
			<td rowspan="2">Not to be exceeded more than once per year</td>
		</tr>
	<tr>
	    <td>1 hour</td>
			<td>35 ppm</td>
	</tr>
	<tr>
	    <td class="blue" colspan="2"><a href="/lead-air-pollution/table-historical-lead-pb-national-ambient-air-quality-standards-naaqs">Lead (Pb)</a></td>
			<td class="blue">primary and<br>
				secondary</td>
			<td class="blue">Rolling 3 month average</td>
			<td class="blue">0.15&nbsp;μg/m<sup>3</sup>&nbsp;<sup><a href="#1">(1)</a></sup></td>
			<td class="blue">Not to be exceeded</td>
	</tr>
	<tr>
	    <td colspan="2" rowspan="2"><a href="/no2-pollution/table-historical-nitrogen-dioxide-national-ambient-air-quality-standards-naaqs">Nitrogen Dioxide (NO<sub>2</sub>)</a></td>
			<td>primary</td>
			<td>1 hour</td>
			<td>100 ppb</td>
			<td>98th percentile of 1-hour daily maximum concentrations, averaged over 3 years</td>
	</tr>
	<tr>
      <td>primary and<br> secondary</td>
			<td>1 year</td>
			<td>53 ppb <sup><a href="#2">(2)</a></sup></td>
			<td>Annual Mean</td>
	</tr>
	<tr>
	     <td class="blue" colspan="2"><a href="/ground-level-ozone-pollution/table-historical-ozone-national-ambient-air-quality-standards-naaqs">Ozone (O<sub>3</sub>)</a></td>
			<td class="blue">primary and<br>
				secondary</td>
			<td class="blue">8 hours</td>
			<td class="blue">0.070 ppm&nbsp;<sup><a href="#3">(3)</a></sup></td>
			<td class="blue">Annual fourth-highest daily maximum 8-hour concentration, averaged over 3 years</td>
	</tr>
	<tr>
	    <td rowspan="4"><a href="/pm-pollution/table-historical-particulate-matter-pm-national-ambient-air-quality-standards-naaqs">Particle Pollution (PM)</a></td>
			<td rowspan="3">PM<sub>2.5</sub></td>
			<td>primary</td>
			<td>1 year</td>
			<td>12.0 μg/m<sup>3</sup></td>
			<td>annual mean, averaged over 3 years</td>
	</tr>
	<tr>
	    <td>secondary</td>
			<td>1 year</td>
			<td>15.0 μg/m<sup>3</sup></td>
			<td>annual mean, averaged over 3 years</td>
	</tr>
	<tr>
	   <td>primary and<br> secondary</td>
			<td>24 hours</td>
			<td>35 μg/m<sup>3</sup></td>
			<td>98th percentile, averaged over 3 years</td>
	</tr>
	<tr>
	    <td>PM<sub>10</sub></td>
			<td>primary and<br>
				secondary</td>
			<td>24 hours</td>
			<td>150 μg/m<sup>3</sup></td>
			<td>Not to be exceeded more than once per year on average over 3 years</td>
	</tr>
  <tr>
      <td class="blue" colspan="2" rowspan="2"><a href="/so2-pollution/table-historical-sulfur-dioxide-national-ambient-air-quality-standards-naaqs">Sulfur Dioxide (SO<sub>2</sub>)</a></td>
			<td class="blue">primary</td>
			<td class="blue">1 hour</td>
			<td class="blue">75 ppb <sup><a href="#4">(4)</a></sup></td>
			<td class="blue">99th percentile of 1-hour daily maximum concentrations, averaged over 3 years</td>
	</tr>
	    <tr><td class="blue">secondary</td>
			<td class="blue">3 hours</td>
			<td class="blue">0.5 ppm</td>
			<td class="blue">Not to be exceeded more than once per year</td>
	</tr>
</tbody>
</table>
*Source: [epa.gov](https://www.epa.gov/criteria-air-pollutants/naaqs-table)*

---
#### Command and Control Policies

Emissions standards
  - Assign each polluting firm a level of pollution they are allowed to reach

- Penalize for infractions

Issues

- May prevent high-value production from Firm A (allowance too small)

- May allow low-value pollution from Firm B (allowance too large)

---
#### Command and Control Policies

Production/technology standards

- Force all polluting firms to adopt a particular technology or production practice

- Alternatively, ban particularly bad practices

Issues

- Firms may find it less costly to reduce emissions by some other means

- Policy will only be effective to the extent that it mandates the least-cost method of abatement

---
#### Corrective (Pigouvian) Taxes

Set a per-unit tax on firm-level emissions

- Increase the `$MC$` of production, results in lower equilibrium `$Q$`

- Firms still incentivized to maximize profits through optimal production and innovation

Issues

- Sometimes hard to accurately determine correct tax

- Does not act as an emergency backstop
  
  
---
#### Cap and Trade

Set a maximum level of pollution allowed within a region

- Issue permits that add up to that level, allow firms to buy/sell

- Firms that can cheaply reduce pollution can sell permits to those who cannot

Issues

- Sometimes hard to choose an optimal level of allowable pollution

- Initial permit allocations are often controversial

- But they don’t matter for efficiency- Coase Theorem applies!

---
## Reading for Next Time

- "Command and control vs market-based policies", page 397-411

---
class: clear, middle
# Lecture 9

- Policy comparisons

- Numerical example

---
### Recap

Marginal abatement cost

- Costs faced by a firm of reducing emissions by one more unit

Efficiency requires reducing emissions from the cheapest sources

Cap and Trade and Corrective Taxes both lead to the efficient outcome

- However, the information available to policy makers often means one is preferable to the other

---
#### Example

Suppose there are two firms and the government wants to reduce emissions by 15 units (from `$40 \to 25$`)

*Option 1: Command and Control*

- Choose an abatement amount for each of the two firms, adds up to 15

*Option 2: Tax*

- Choose a per-unit tax on emissions that incentivizes the two firms to reduce by 15
  - Requires knowledge of the full marginal abatement cost curve.

*Option 3: Cap and trade*

- Issue 25 permits, allow firms to trade as desired

---
class: center, middle

<div class="figure" style="text-align: center">
<img src="data:image/png;base64,#graphics/emission_tax_ex1.png" alt="Emission Tax Example" width="2411" />
<p class="caption">Emission Tax Example</p>
</div>
  
---
class: center, middle

<div class="figure" style="text-align: center">
<img src="data:image/png;base64,#graphics/credit_trading_ex1.png" alt="Emission Trading Example" width="2440" />
<p class="caption">Emission Trading Example</p>
</div>

---
#### Efficiency in the above example

Efficiency is achieved where the MAC curves cross

- Firm 1 reduces by 10, Firm 2 reduces by 5

- If regulation forced it to be (9,6) we would still have 15 units of abatement but at greater total cost to society

<br>

A command and control quota will only be efficient if it happens to be exactly (10,5)

---
#### Efficiency of Cap and Trade Policy

Suppose the initial allocation of permits cover all but 9 units of Firm 1’s pollution, and all but 6 units of Firm 2’s pollution

- Firm 2 is willing to pay up to the MAC of the 6th unit for another permit

- Firm 1 is willing to sell a permit for as little as the MAC of its 10th unit

<br>

Permit price will be very close to the MAC intersection (gets closer as number of firms increases because of declining market power)

---
#### Efficiency of Corrective Tax

Optimal corrective tax will be where the two MAC curves intersect

- Solution was: F1 abates 10, F2 abates 5

<br>

Logic behind F1’s decision to abate 10 units

- 1st unit’s MAC < tax `$\implies$` abate this unit

- 2nd unit’s MAC < tax `$\implies$` abate this unit too

- …

- 10th unit’s MAC = tax `$\implies$` indifferent either way

- 11th unit’s MAC > tax `$\implies$` pay the tax instead of abating

---
#### Equivalence of the Two Policies

Under the assumption of perfect information…

The optimal tax leading to X units of abatement is the equal to the trading price of permits that allow all but X units of pollution

- Cap and trade sets the quantity, taxes set the price

Under both systems, we expect the efficient outcome to occur

- However, perfect information is a very strong assumption, unlikely to hold in reality. 
  
  - How would the government know the marginal abatement cost curves of the firms? The firms have no incentive to tell the truth to the government.
  
  
---
#### Differences

**Government revenue**

Suppose that both firms start out polluting 20 units:

*Tax*

- Pay the tax rate on every unit they do not abate
  
  - Firm 1 pays tax on 20-10 = 10 units

- Firm 2 pays tax on 20-5 = 15 units

*Cap and Trade*

- Only pay for additional permits beyond the ones provided by government

- Firm who sells permits can actually make money from the policy

- Government can auction permits instead of giving them out for free; can generate some revenue but hard to compare directly with the tax revenue

---
class: clear, middle
# Lecture 10

- Policies Continued

- Numerical Exercise

---
### Recap

Marginal abatement cost

- Costs faced by a firm of reducing emissions by one more unit

Efficiency requires reducing emissions from the cheapest sources

Cap and Trade and Corrective Taxes both lead to the efficient outcome

- However, the information available to policy makers often means one can be preferable to the other

---
## Cap and Trade Model

Government wants to lower sulfur dioxide emissions from the electric power sector, and they have two options:

1. Uniform emissions standard

- All firms are forced to reduce emissions by a certain amount

2. Cap and trade system
  
  - Hand out permits, allow firms to trade

*Assumptions*

- Two firms with different MAC curves

- Firms abate emissions by spending money on pollution control equipment, not by cutting output (simplifying)

---
### Problem Set up

Price of electricity: $100/MWh and both companies supply 1 MWh.

Baseline Emissions: `$13$` lbs. `$SO_2$` per MWh.

Profit functions are:

`$$\pi_x = 100 - 1/2 a_x^2$$`

`$$\pi_y = 100 - a_y^2$$`

where `$a_x$` and `$a_y$` are the amount of emissions abated (lbs. `$SO_2$`).

Therefore the marginal cost of abatement are:

`$$MAC_x = a_x \text{ and } MAC_y = 2a_y$$`

<br>
Emission Goal: 
14 lbs. Remaining
12 lbs. Abated

---
#### Questions

For 1. a uniform standard, and 2. a tradable permit system, find:

- Abatement of each firm

- Total costs and profit for each firm

- Industry profit and total emissions

<br>

How does the efficiency of the two policies compare?

- Efficient policy will maximize profit while meeting the emissions target

---

---
#### Command and Control in Practice

Economists often argue against command and control policies, especially when affected firms have heterogeneous cost structures

- Fines tend to be too small relative to the cost of compliance

- Incentive to cheat

---
#### Benefits of Command and Control

Emergency backstop

- When we know for sure that benefits don’t justify a certain level of pollution, a pollution quota doesn’t risk inefficiency

- Additional quota mandating each firm to stay below 20 lbs of pollution will not hurt anything

Simple minimum standards

- Banning lead-based paint, for instance

- Phasing out incandescent bulbs?

Regional standards (as in NAAQS)

- Distributes regulatory burden to a lower level than federal
  
  
---
## Videos for Next Class

- [Taxes and Deadweight Loss](https://www.youtube.com/watch?v=NuLlNAdrom4)

- [Pigouvian Taxes](https://www.youtube.com/watch?v=UYShebe44Xs)

---
class: clear, middle
# Lecture 11

- Taxes and Deadweight Loss

- Corrective Taxes and Subsidies

---
## Taxes

We saw before how a tax relates to a two-firm cap and trade model

A different way to think about tax is with the supply and demand model

- Often, there are more than two firms producing an externality

- Also, sometimes the demand side produces externalities

Any number of firms can be combined into a supply curve

- The supply curve expresses the number of units the whole market is willing to supply at each price

- Same idea for consumers and the demand curve

---
### Corrective taxes

Tax a market if…

- Social marginal benefit < private marginal benefit, OR

- Social marginal cost > private marginal cost

A tax/subsidy on one side of the market shifts the corresponding curve to the left or right

- Key is to think about effect on incentives

<br>

Taxes reduce the quantity of the good bought/sold in the market

- The tax “corrects” incentives that led to too much of the good

Subsidies increase the quantity of the good bought/sold in the market

---
#### Example

Tax on supply `$\implies$` firms marginal cost increases (supply curve move up)

Tax on demand `$\implies$` consumers willing to pay (after the tax) decreases (demand curve shifts down)

---
### Deadweight Loss

Deadweight loss (DWL) is what we call lost potential economic surplus

*Always a comparison of two alternative scenarios*

- DWL = (old surplus) – (new surplus)

<br>
Example: DWL from a tax on movie tickets.

50% tax on movie tickets `$\implies$` I will go to the movies less

- Producer surplus: theater loses surplus in the form of profits

- Consumer surplus: I lose surplus because I am no longer buying something that was more valuable to me than the firm's cost

- Government revenue: government gains revenue from the tax

`$$DWL = PS + CS - GR$$`

---
### Deadeweight Loss Visualized

---
## Taxes and Externalities
Regular markets do not generate externalities

- Movie ticket sales don’t really affect non-participants

Taxes in regular markets cause DWL because Q is *inefficiently low* after 
  - There would be greater total surplus if the tax were removed

In markets with a negative externality (and without a corrective tax), there is DWL because Q is inefficiently high
  - There would be greater total surplus if the decision makers considered all costs to society, not just their own

---
### Supply-Side Externality and Deadweight Loss

---
### Pigovian Tax

Pigou’s idea: 
  - Negative externality can be fixed by an equally sized corrective tax

If the tax is chosen correctly, it will shift the demand curve so that it is the same as the social marginal benefit curve (or supply/ social marginal cost)

*The punchline*
  - We wish people made decisions like the social planner would
  
  - Taxes and subsidies can make up the difference

---
## Reading for Next Time

- "Trade and the Environment", page 545-549
  
  - Example 20.2 The Natural Resource Curse
  
  - [Carbon Taxes Won't Do Enough to Slow Global Warming](../Articles/Carbon Taxes Wont Do Enough to Slow Global Warming.pdf) ([online version](https://www.bloombergquint.com/business/2019/09/25/carbon-taxes-won-t-do-enough-to-slow-global-warming)).

---
class: clear, middle
# Lecture 12

- Growth and Development

- Trade

---
# Midterm
48% multiple choice (12 questions)
Based on everything

52% math/short answer
Based on the models covered in the math assignment
Be neat, show your work, partial credit is available

50 minutes long

You may bring a “cheat sheet” on a single note card

---
### Midterm test advice

I care about concepts more than situation-specific details

Good question: Is the two-period mineral extraction model an example of the prisoner’s dilemma? Why or why not?
Bad question: Which six pollutants are covered under the NAAQS?

Cheat sheet
In my experience, 90% of the value of a cheat sheet comes from making it
Personally, I would put theorems and math examples on it, along with concepts I might accidentally mix up with others

---
## International trade

Near-universal agreement from top economists that free trade creates economic value

“If that's not right, almost all of economics is wrong.”

\- Richard Schmalensee, in response to this question

]

<div class="figure" style="text-align: center">
<img src="data:image/png;base64,#graphics/free_trade_q.png" alt="Free Trade Question" width="2253" />
<p class="caption">Free Trade Question</p>
</div>

]

---
### Race to the Bottom - Pollution havens
  - Theory that countries will lower their environmental standards to stay competitive with countries that are willing to pollute
  - Prisoner’s dilemma again!

Little evidence this has been happening; still a concern for future policies
  - Environment is becoming more fragile

---
### Porter Hypothesis
Firms in countries with strict environmental standards may have a long-run advantage

- *Induced innovation* - technology improvements that result from regulations

If this hypothesis is true, trade may cause the opposite of the “race to the bottom”

- Some empirical support, but definitely controversial still

- Might explain lack of support for the race to the bottom theory

---
### Environmental Kuznets Curve

Observed relationship between national income levels and environmental quality measures
  
<div class="figure" style="text-align: center">
<img src="data:image/png;base64,#graphics/kuznets_curve.png" alt="Kuznets Curve" width="50%" />
<p class="caption">Kuznets Curve</p>
</div>

---
### Environmental Kuznets Curve

Implications for trade
  - If trade makes countries wealthier, maybe makes environment worse
  - *Example:* China ($7,000 GDP per capita) exports manufactured goods to the US ($53,000 GDP per capita), resulting in poor air quality in many Chinese cities
  - When does a nation start trading off economic growth for environmental quality?

---
### Resource Curse

Natural resources are a valuable component of a nation’s economy

However, countries with abundant resource endowments seem to do worse
  - Slower economic growth
  - More authoritarian governments
  - Currency problems

---
#### Resources and government
Natural resources are an easy source of revenue
  - Little pressure on governments to be accountable
  - Well-connected individuals preserve the status quo
  - Military regimes can support themselves through conquest

> “There are twenty-three countries in the world that derive at least 60 percent of their exports from oil and gas and not a single one is a real democracy"
> 
> - Larry Diamond

---
#### Evidence
> “Economies with a high ratio of natural resource exports to GDP… tended to have low growth rates during the subsequent period”
> 
> - Warner and Sachs (1995)

> “More natural resources push aggregate income down when institutions are grabber friendly”
> “More resources raise income when institutions are producer friendly”
> 
> -Mehlum et al. (2006)

---
#### Institutional quality

Mehlum et al. (2006) describe “institutional quality” as an average of five indices

1. Rule of law index 
2. Bureaucratic quality index 
3. Corruption in government index
4. Risk of expropriation index
5. Government repudiation of contracts index

When economists say that “institutions matter,” this is what they mean