Equilibrium Effects and Market Conditions THOMAS STERNER Policy Instruments for Environmental and Natural Resource Management Presented by Warawut Ruankham 2 May 2021, NIDA, Thailand

1. Chapter 14: Equilibrium Effects
and Market Conditions
THOMAS STERNER
Policy Instruments for Environmental and Natural Resource Management
Presented by Warawut Ruankham
2 May 2021, NIDA, Thailand

2. Content of Presentation
• Part I: direct and indirect effect of economic instrument (tax)
• Abatement and Output Reduction
• Output effect
• Part II: Revenue and other effects
• General Equilibrium, Environmental Taxation, and the double dividend
• Part III: Market Conditions
• Market Condition and Environmental Taxes

3. Goal Fulfillment, Abatement, and Output Substitution
Emission from economic activity depends on pollution intensity or
• Rate of emission (𝜉)
• Level of activity or size (q)
• Emission 𝑒 = 𝜉𝑞 where e can be reduced by (i) abatement technology and (ii) output
reduction from certain market based policy instrument
• Goals:
• (i) to have certain appropriate policy with essentially no impact on total use of the product (i.e. chorine
using for bleaching paper drafting tax in Sweden)
• (ii) Chosen instrument have the correct desirable “output effect”

4. Importance of Abatement cost and demand elasticity
Inelastic demand Elastic demand
Figure B:
• No clean technology
• Reduce demand to reduce
pollution
• Effectiveness of policy
depends on elasticity of
product (or slope of demand
curve)

5. Importance of Abatement cost and demand elasticity
Figure C:
• Both abatement and output are important
• Increasing in price due to tax can lower output
Effect of policy:
• 𝑞𝑚 -> 𝑞𝑎 : resulted from abatement effect
• 𝑞𝑎 -> 𝑞𝑜 : resulted from tax effect

6. Output and Abatement Effect (Algebraically)
• Tax or permit (T)
• Output q(T)
• Emission is a function of
𝒆 𝑻 = 𝒒(𝑻)𝝃(𝑻)
• Total differentiate
𝑑𝑒
𝑑𝑇
= 𝑞
𝑑𝜉
𝑑𝑇
+ 𝜉
𝑑𝑞
𝑑𝑇
𝑑𝑒
𝑑𝑇
𝑇
𝑒
= 𝑞
𝑑𝜉
𝑑𝑇
𝑇
𝑒
+ 𝜉
𝑑𝑞
𝑑𝑇
𝑇
𝑒
• Substitute 𝑒 = 𝑞𝜉
• Then,
𝑑𝑒
𝑑𝑇
𝑇
𝑞𝜉
=
𝑑𝜉
𝑑𝑇
𝑇
𝑞𝜉
+
𝑑𝑞
𝑑𝑇
𝑇
𝑞
• Express as elasticity
𝜀𝑒𝑇 = 𝜀𝜉𝑇 + 𝜀𝑞𝑇 -----------*
• total elasticity of demand = elasticity of
abatement + elasticity of output
• The output effect is the interaction b/w
slope of demand q=q(P) and shift in supply
P=P(T)
• Or combined q=q[P(T)]

7. Output and Abatement Effect (Algebraically)
• Then,
𝜺𝒒𝑻= 𝜀𝑞𝑃𝜀𝑃𝑇
• So, 𝜀𝑒𝑇 = 𝜀𝜉𝑇 + 𝜺𝒒𝑻 becomes
𝜺𝒆𝑻= 𝜺𝝃𝑻 + 𝜺𝒒𝑷𝜺𝑷𝑻 ----------------**
• Total response in emission =possibility of
reducing rate of emission + product of price
and tax elasticity of marginal of supply
(abatement elasticity)

8. Output and Abatement Effect
(case of tax elasticity of supply : linear and separable abatement cost)
• Firms maximize profit
𝝅 = 𝑷𝒒 − 𝒄 𝒒 − 𝒄(𝝃𝟎𝒒-e)−𝑻𝒆
• FOC:
𝜕𝜋
𝜕𝑞
= 𝑃 − 𝑐′ 𝑞 − 𝑐𝜉𝑜 = 0 ; 𝑜𝑟 𝑃 = 𝑐′ 𝑞 + 𝑐𝜉0
𝜕𝜋
𝜕𝑒
= 𝑐 − 𝑇 ; 𝑜𝑟 𝑐 = 𝑇
• Then, 𝑃 = 𝑐′ 𝑞 + 𝑇𝜉0
• Tax effect
𝑑𝑃
𝑑𝑇
= 𝜉0
• Express as elasticity
𝜀𝑃𝑇 =
𝑑𝑃
𝑑𝑇
𝑇
𝑃
𝜀𝑃𝑇 = 𝜉0
𝑇
𝑃
; 𝑃 = 𝑐′ 𝑞 + 𝑇𝜉0
𝜀𝑃𝑇 =
𝑇𝜉0
𝑐′ 𝑞 +𝑇𝜉0
• Tax elasticity of supply is the relative share of marginal
environment tax and marginal production cost

9. Output and Abatement Effect
(case of tax elasticity of supply : linear and separable abatement cost)
• Exact size of abatement and output effect is
• 𝜀𝑒𝑇 = 𝜀𝜉𝑇 + 𝜀𝑞𝑃𝜀𝑃𝑇
• 𝜺𝒆𝑻 = 𝜺𝝃𝑻 + 𝜺𝒒𝑷
𝑻𝝃𝟎
𝒄′ 𝒒 +𝑻𝝃𝟎
-----------***
• Total response in emission =possibility of reducing rate of
emission + product of price and tax elasticity of marginal of
supply (abatement elasticity)

10. Output Effect of Subsidies
• Rebound effect refers to the decline in emission due to higher product price
• Abatement subsidy (Baumol and Oates, 1988) suggested that (i) payment for emission reductions could exceed the
abatement cost , (ii) when marginal abatement cost are constant, subsidy is a repayment of abatement cost

11. Output Effect of Subsidies
From the figure:
• Tax (T) causes largest increase in MC and AC,
higher tax and abatement cost increase market price
which leads to exit
• A regulation (R) of emission would not have full
output effect
• Subsidy (S) instead will lead to a price reduction and
could delay exit (possibly encourages entry)

12. General Equilibrium, Environmental Taxation, and the
double dividend
• Although taxes are optimal policy instrument in terms of allocative efficiency and intensive
structure, they are often resisted by those who have to pay
• Then, “green tax reforms” were proposed, whereby the revenues from environmental taxation
were to be used to reduce other taxes.
• This idea give double or even triple dividend of environmental as well as economic improvement
( increased in employment and growth)

13. Taxation
• Generally, increasing in taxes makes higher price and lowers demand (loss in consumer surplus
and excess burden of taxes)
• Inverse elasticity rules:
• Elastic good (i.e., luxuries good)- taxes seem to be effective tools as it might not distort demand
• Inelastic good (i.e., foods) – taxes seem to be ineffective tools as it might distort demand, affect to the
poor and income inequality
Other rules
• Tax on labor (i.e., income tax) might distort allocation of working time (labor supply) and leisure
• Tax on factor input (i.e., land and forestry tax) which is undesirable to tax a intermediate goods (certain
input will be taxed twice)

14. Environmental Taxation
• An optimal environmental tax operates through five effects (Goulder et al. 1999):
1. Abatement effect
2. Input substitution effect which refers to substitution of cleaner input
3. Output substitution effect
4. Revenue-recycling effect, a positive effect of the environmental tax that confirms a double
dividend
5. Tax interaction effect, loss of consumer surplus and real wages that are due to distortion of
the consumption (or input) basket and reduces labor supply and tax incomes, leading to
further loss

15. Environmental Taxation
A) Inelastic demand
-steep demand
-little reduction in E
-large tax base
B) elastic demand
-large reduction in E
-abatement is easy (E may go to zero)
-tax base would be gone
C) Non- linear demand
-large reduction in E
- Large tax base

16. Market Conditions
• Not all market are perfect competitive
• For some developing country, optimal tax for externality produced by monopoly less than
standard “Pigovian tax”
• Two imperfection on optimal tax
• Monopoly
• Oligopoly or cartel

17. Market Conditions
• Monopoly produces lower than social optimal at Qm
and set higher price at Pm
• Social optimal output is at Q0
• If tax set at “Pigovian rule” which equals to sum of
marginal damage, then monopoly would lower Q
lower than Qm ( to Qmt and set even higher price at
Pmt)
• To calculate tax charge
𝑇𝑚 = 𝐷′
𝑒∗
−
𝑃
𝜀
𝑞′
𝑒
• However, this second-best charge might not always
feasible or desirable

18. Market Conditions
• Then, the second-best would be “negative tax” or
“subsidies” for two main reasons
• Subsidize to increase supply (to overcome monopoly)
• Tax on emission (to overcome externality)
• However, it is not attractive to subsidize monopolist
• If monopoly is unavoidable, we should have free
trade or liberalize trading to increase domestic
supply
• Finally, policy packages should be with combined
instruments (i.e., combination of an emission tax
and subsidy per unit of production but not increase
market power of monopolist)