Lecture 3: Policy Instruments II

Question 1

What is a subsidy?

Answer 1

A subsidy is assistance paid o a individual, business or economic sector

Question 2

Give examples for subsidies

Answer 2

• R&D subsidies: stimulate new sectors, businesses in start-up phase (positive externalities, spill-over effects), incl.
financing of investments
• Pollution reduction subsidy: Paying producers to reduce emissions; reduce negative externalities
• Consumer subsidy: Stimulating alternative energy sources (e.g. solar panel subsidy);
increase positive externalities G
• Tax exemptions: special tax treatments for certain products sectors (international competition concerns) or individuals (low income households)

Question 3

Name advantages and disadvantages of subsidies for pollution reduction

Answer 3

• Advantages: limited transaction costs; incentive to comply (effective)
• Disadvantages: ‘Polluter is paid’; dynamic effects (profits 1: influx of new polluters);
difficult to end … (not efficient)

Question 4

Give examples for perverse subsidies

Answer 4

• Subsidies on polluting energy indirectly raise the relative cost o renewable energy - Create lock-in effects in L desirable technologies
• Producer subsidies lead to larger than optimal production and related pollution
• Subsidies on consumer goods lead to larger than optimal consumption and waste (increase DWL)
• Subsidies are costly AND financed with taxes that distort other markets

Question 5

What is the Coase Theorem?

Answer 5

• Ronald Coase (1960), “The Problem of
Social Cost” - Nobel prize 1991

The Coase Theorem
Under certain circumstances, voluntary negotiations will lead to efficiency

• So the initial allocation of rights doesn’t matter for efficiency
• However, it does matter for distribution

Question 6

What are the conditions for the coase theorem?

Answer 6

• Property rights have to be well-defined
(and enforceable)..
• We need to be clear on who has what rights, so we know the starting point for negotiations

..and tradable…
We need to be allowed to
sell/transfer/reallocate rights if we want

..and there can’t be (high) transaction costs
• It can’t be difficult or costly for us to buy/sell the right

Question 7

What is cap and trade?

Answer 7

• ‘Market creation’ by government/regulator with:
• Ceiling for total permits (sector, region, period)
• Free trade in permits
• Possibly high fines if output exceeds permits
• Heterogeneity of mitigation costs among agents (see inefficiency of
C&C), and assymetric information.

Question 8

What are disadvantages of emissions trading systems?

Answer 8

• Initial distribution rights: allocation through grandfathering or auction? -> distributional effects (what is fair?), cost recovery?
(only with an auction!)
• Market power and strategic behavior: buying up all permits could prevent entry of new firms (less competition)
• Setting the emission cap at an optimal level is difficult because of vested (political) interests (e.g. results in grandfathering of permits)