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Political Considerations & Incentive to Innovate

Richard Martin

University of Victoria

April 4, 2019

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 1 / 20

Political considerations

We have seen that:

Performance standards are the most common form of environmental policy. Emission taxes dominate performance standards in a couple dimensions:

1 Cost effective reduction in emissions if firms face the same (positive) price on emissions: emission taxes are efficient in the static sense.

2 The strongest incentives for firms to invest in technology that will reduce their marginal abatement costs: emission taxes create better dynamic incentives.

Why are performance standards more common when emission taxes look better on paper?

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 2 / 20

Political considerations Fairness

Fairness:

Recall that in a long run perfectly competitive equilibrium any additional costs imposed on firms get passed through to consumers. Prior to policy, firms earn zero economic profit. Post policy, firms earn zero economic profit. The more costly the enviro policy is for firms (in the short run), the more costly it is ultimately for consumers. Poor people consume a larger proportion of their income than rich people. The more costly enviro policy is to firms in the short run, the more regressive the policy is to consumers in the long run.

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 3 / 20

Political considerations Political considerations:

Thus we have two potentially powerful special interest groups where their incentives to oppose costly enviro policy are aligned: businesses and the political left.

We can rank policy alternatives that yield the same socially optimal level of emissions in terms of how costly they are to firms (in the short run). This informs us about how much political resistance to expect from various policies... and provides an answer to why performance standards are so common when their “performance” is lacking.

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 4 / 20

Political considerations Political considerations:

$

emissions

Figure 1: Most preferred: subsidy or firm has property right, negotiated deal.

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 5 / 20

Political considerations Political considerations:

$

emissions

Figure 2: Default outcome: firm has property right, no negotiation.

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 6 / 20

Political considerations Political considerations:

$

emissions

Figure 3: Next best: Performance standard or equivalent gift of TEPs

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 7 / 20

Political considerations Political considerations:

$

emissions

Figure 4: Next next best: Liability

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 8 / 20

Political considerations Political considerations:

$

emissions

Figure 5: Next next next best: Emission tax OR negotiated outcome where recipient has property right OR TEP that are auctioned off rather than given away.

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 9 / 20

Political considerations Political considerations:

$

emissions

Figure 6: Worst: recipient has property right, no negotiation.

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 10 / 20

Incentive to innovate.

incentive to innovate:

In what follows all policies considered are assumed to achieve the static optimal level of emissions, given the current level of technology. We start by looking at decentralized policies where, by definition, the government does not respond to the innovation: all the government does is define and defend property rights. Next we look at more centralized policies, but assume that the government does not respond to the innovation: this is plausible for small firms. Finally we consider the same centralized policies, but assume that the government does respond to the innovation: this is plausible for large firms. Assume MD = e, MAC0 = 10 − e, MACi = 203 −

2 3 e

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 11 / 20

Incentive to innovate.

0 2 4 6 8 10

0 2

4 6

8 1

0

liability

emissions

$

MDMAC0

MACi

+

0 2 4 6 8 10

0 2

4 6

8 1

0

source property right + negotiation

emissions

$

MDMAC0

MACi

+

−

0 2 4 6 8 10

0 2

4 6

8 1

0

recipient property right + negotiation

emissions

$

MDMAC0

MACi

+

0 2 4 6 8 10

0 2

4 6

8 1

0

non−responsive tax/subsidy/TEP

emissions

$

MDMAC0

MACi

+

0 2 4 6 8 10

0 2

4 6

8 1

0

non−responsive standard

emissions

$

MDMAC0

MACi

+

0 2 4 6 8 10

0 2

4 6

8 1

0

responsive subsidy

emissions

$

MDMAC0

MACi

+

−

0 2 4 6 8 10

0 2

4 6

8 1

0

responsive tax / auctioned TEP

emissions

$

MDMAC0

MACi

+

0 2 4 6 8 10

0 2

4 6

8 1

0

responsive standard / gifted TEP

emissions

$

MDMAC0

MACi

+

−

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 12 / 20

Incentive to innovate. Liability

Liability:

Recall with liability the firm faces total cost= TAC(e)+TD(e) Prior to innovation firm chooses e = 5, so total cost= 10×5

2 = 25

Post innovation the firm chooses e = 4, so total cost= 10×4 2

= 20 Firm has incentive to innovate proportional to the green shaded area=$5

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 13 / 20

Incentive to innovate. Source has property right

Source has property right:

Recipient must bribe source to reduce emissions. Prior to innovation recipient will pay source $5 per unit abatement. Firm makes profit=bribe-TAC=5 × 5 − 5×5

2 = 12.5

Post innovation recipient will pay source $4 per unit abatement. Firm makes profit=bribe-TAC=6 × 4 − 6×4

2 = 12

Difference is green area (cost savings) minus red area (diminished bribe)... which is actually negative: firm has no incentive to innovate.

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 14 / 20

Incentive to innovate. Recipient has property right

Recipient has property right

Source must bribe recipient to allow emissions. Prior to innovation source will pay recipient $5 per unit of emissions. Firm has total cost=TAC+bribe= 5×5

2 + 5 × 5 = 37.5

Post innovation source will pay recipient $4 per unit of emissions. Firm has total cost=TAC+bribe= 6×4

2 + 4 × 4 = 28

Firm has incentive to innovate proportional to the green shaded area=9.5

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 15 / 20

Incentive to innovate. Non-responsive tax/subsidy/TEP

Non-responsive tax/subsidy/TEP: Innovation in small firm might not trigger a response: tax/subsidy/permit price constant at $5.

1 If tax $5 per unit then total costs= TAC+tax bill= 5×5 2

+ 5 × 5 = 37.5. Post innovation total cost=TAC+tax bill= 7.5×5

2 + 2.5 ∗ 5 = 31.25

The difference in the total cost is equal to the green shaded area $6.25. 2 With abatement subsidy prior to innovation profit= 5×5

2 = 12.5

With abatement subsidy post innovation profit= 7.5×5 2

= 18.75 The difference in profit is equal to the green shaded area $6.25.

3 Suppose firm has 4 TEP and can buy or sell permits at pp = 5 Prior to innovation it is optimal for 5 units of emissions. Firm has total cost=TAC+permit purchase= 5×5

2 + 5 × 1 = 17.5

Post innovation it is optimal for 2.5 units of emissions. Firm has total cost=TAC-permit sale= 7.5×5

2 − 1.5 ∗ 5 = 11.25

The difference in the total cost is equal to the green shaded area $6.25.

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 16 / 20

Incentive to innovate. Non-responsive standard

Non-responsive standard:

Prior to innovation firm has costs= 5×5 2

= 12.5

Post innovation firm has costs= 5× 10

3

2 = 25

3 = 8.33

Difference in cost is green shaded area=4.16

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 17 / 20

Incentive to innovate. responsive subsidy

responsive subsidy:

Same as the source having the property right except rather than the recipient bribing the source to reduce emissions it is the government doing the bribing: i.e. the bribe is the subsidy. Firms do not care whether the bribe comes from the recipient or the government: a bribe is a bribe.

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 18 / 20

Incentive to innovate. responsive tax/ auctioned TEP

responsive tax/ auctioned TEP

Same as the recipient having the property right except rather than the source bribing the recipient to allow emissions the source “bribes” the government to allow emissions: i.e. the “bribe” is the emissions tax or the price they pay for the permits in auction. Firms do not care whether they have to bribe recipients or government: a bribe is a bribe.

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 19 / 20

Incentive to innovate. Responsive Standard / Gifted TEP

Responsive Standard

Prior to innovation firm’s TAC= 5×5 2

= 12.5 Post innovation firm’s TAC= 6×4

2 = 12

Incentive to innovate is proportional to the difference: $.5. Innovation reduces abatement costs (green area) but also results in a stricter standard (red area).

Gifted TEP

Suppose that the firm is gifted the socially optimal number of permits (5 prior to innovation, 4 post innovation). Prior to innovation firm’s TAC= 5×5

2 = 12.5

Post innovation firm’s TAC= 6×4 2

= 12 Incentive to innovate is proportional to the difference: $.5. Innovation reduces abatement costs (green area) but also results in a smaller allocation of permits (red area).

graphs of policies

Richard Martin (University of Victoria) Chapters 10-13 April 4, 2019 20 / 20