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Economic Concepts
and Applications to Climate Change

Economic Concepts
• When markets work and when they don’t work

Policy Interventions to correct market failures

Recent research in climate change
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Part 1: Economic Concepts
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First Theorem of Welfare Economics
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Pareto efficiency
• No welfare enhancing trades can be made
• It is impossible to make somebody else better off without making
somebody else worse off
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First theorem of welfare economics: the equilibrium of a
competitive market economy is Pareto efficient if
• all goods are private
• no difference between private and social cost

Formalizes Adam Smith’s concept of an invisible hand
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Invisible Hand

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“Every individual … neither intends to promote the
public interest, nor knows how much he is promoting it.
He intends only his own security, his own gain. And he
is in this led by an invisible hand to promote an end
which was no part of his intention. By pursuing his own
interest he frequently promotes that of society more
effectively than when he really intends to promote it.”
“It is not from the benevolence of the butcher, the brewer, or
the baker that we expect our dinner, but from their regard to
their own interest.”
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Invisible Hand
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Idea behind invisible hand
• Societal perspective:

A good should be produced if the “utility” to the user exceeds the
cost of producing it
• Firm perspective

Can make a profit if the “utility” to the user (the maximum he/she
is willing to pay) exceeds the cost of producing it
• Ina well-functioning market, note how the incentive
of a firm align with that of society
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Key Concepts I: Private / Public Good

Public versus private goods
• Private good
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Rival: if I eat an apple, somebody else can’t eat the same
apple
Excludable: I can keep other people from eating my apple
• Public good

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Non-rival: if I walk in a park, my neighbor can do so at the
same time
Non-excludable: I can’t keep my neighbor from walking in the
park
Problem of free-riding: Incentive to let other people “provide” a
good without paying for it.
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Key Concepts II: Private / Social Cost

Private costs (benefits) of an action
• accruing to the actor only
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Social costs (benefits)
• total costs of activity including those that accrue to
people other than the actor
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Example: driving a car
• Private costs: fuel, maintenance
• Social costs include pollution, road wear
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External Effects

Any difference between private and social costs
is referred to as an “externality” or “external
effect”

Recall how markets work
• in seeking profits firm produce a good

If “utility” to consumer (maximum willingness to pay) exceeds
the cost of producing it
• Problem: if private cost are different from social cost,
firm doesn’t act in societies best interest
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Left - social cost 15, private 10
Right - private & social cost of 12
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Costs
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Private-Social difference
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Private
6
4
2
0
A
B
Choices
Corporation will choose A as private cost is lower
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Examples of Private v. Social

Conserving tropical forests
• Private benefits: may be small for landowner
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some sales of non-timber forest products
Eco-tourism
• Social benefits:
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carbon sequestration
biodiversity conservation
Avoided soil erosion
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Market Failure
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Social benefits > private benefits
• Good is underprovided
• Provider has too little financial incentive, i.e., doesn’t
capture all benefits
• Example: rainforest
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Social costs > private cost
• good is over-provided
• Provider does not account for all costs it imposes on
society
• Example: pollution, fossil fuel.
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Summary

Markets work very well when
• Assumption of first welfare theorem are met
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goods are private
private & social costs are equal
Less satisfactory otherwise
• “market failure” & rationale for intervention
• How best to intervene?
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Part 2: Policy Responses
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Policy Responses

What to do if there is a difference between
private and social costs
• Impose a tax (or subsidy)
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equal to difference between private and social costs
Incentive to firm realigned with societal interest
• Introduce property rights
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Based on the view that an excess of social over private costs
arises from the inability to own certain key resources, such
as the atmosphere.
Afterwards market outcome will be Paretoefficient again
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Side note: Equity & Efficiency
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First welfare theorem maximizes “the size of the
pie”, but says nothing about its distribution
Pareto efficiency is separate from any concept of
equity.
• It states that all opportunities for mutual gain are
exploited. But not that the outcome is in any way fair.
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Greenhouse Gases
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Two views on CO2 emissions
• social costs of burning fuels > private costs
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Solution: impose a carbon tax.
• use of the atmosphere for waste disposal without any
payment
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atmosphere should be someone’s property
if we want to pollute it we have to obtain their permission and
compensate them for damage to it
Leads to tradable SO2/CO2 permits
• Requires well-defined property rights!
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Cap & Trade Systems
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Set a limit on allowable emissions
• Every party that wants to emit a unit has to buy a
permit to do so
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If firms compete for a permit, they will bid up the price
If price gets too high, it becomes cheaper to abate
• Demand for permits starts to decline
• Permits establishes property rights in environmental
assets
• Key difference in implementation
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Auction off permits
Grandfather permits, i.e., allocated based on historic
emissions. (cheaper for firms)
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Examples of Cap -&-Trade:
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Title IV of Clean Air Act Amendments
• SO2 permit market
• Number of permits: 50% of historic emissions
• Permits are grandfathered (allocated based on
historic emissions)
• Advantage of permit market:
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Firms with lowest abatement cost will abate
gives firm incentive to innovate
• Initial cost estimates by industry > 1000 per ton SO2
• EPA: 250-350 per ton SO2 (Phase 1)
500-700 per ton SO2 (Phase 2)
• Permit price ~150 per ton SO2
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Examples of Cap -&-Trade:
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Fox River in Wisconsin
• Allowable firms to trade pollution rights
• Problem: each trade had to be approved
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Only 1 trade in many years
Lessons: Permit market works best
•
•
•
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Clearly defined property rights
Many potential buyers and sellers
Low transaction cost
Uniformly mixing pollutant
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Examples of Cap -&-Trade:
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Wetlands banking
• www.wildlandsinc.com
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Kyoto
• Chicago Climate Exchange
• www.chicagoclimatex.com
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Kyoto Protocol
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Cap-and-trade on emissions by industrial countries
and transitioning countries
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No significant restrictions on emissions by
developing countries
• “Clean development mechanism”
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Develop countries can get “credits” for reduction in developing
countries
Discussion to include “avoided” deforestation
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Kyoto Protocol – Annex B Countries
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Kyoto - targets
European Union (15 members)
-8%
US
-7%
Canada, Hungary, Japan, Poland
-6%
Croatia
-5%
New Zealand, Russian Federation, Ukraine
0%
Norway
+1%
Australia
+8%
Iceland
+10%
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Historic
Emissions
(2004)
-
World
27,245,758 100.0 %
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United States [5]
6,049,435
22.2 %
2
China
5,010,170
18.4 %
-
European Union
3,115,125
11.4 %
3
Russia
1,524,993
5.6 %
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India
1,342,962
4.9 %
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Japan
1,257,963
4.6 %
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Germany
808,767
3.0 %
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Canada
639,403
2.3 %
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United Kingdom
587,261
2.2 %
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South Korea
465,643
1.7 %
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Italy [6]
449,948
1.7 %
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Mexico
438,022
1.6 %
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South Africa
437,032
1.6 %
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Iran
433,571
1.6 %
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Indonesia
378,250
1.4 %
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France [7]
373,693
1.4 %
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Brazil
331,795
1.2 %
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Example: Burden-sharing agreement
(Europe)
Austria
-13%
Italy
-6.5%
Belgium
-7.5%
Luxembourg
-28%
Denmark
-21%
Netherlands
-6%
Finland
0%
Portugal
+27%
France
0%
Spain
+15%
Germany
-21%
Sweden
+4%
Greece
+25%
United Kingdom -12.5%
Ireland
+13%
European
Community
-8%
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Kyoto Protocol
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Doesn’t tackle India-China problem:
• Large fraction of world population
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Historically low per-capita emissions
Very few “grandfathered” permits
Problems is not theirs but of developed world
Could not stabilize emissions without radically new
technologies
India / China has no incentive to join
• Without participation by China / India

Kyoto Protocol will not come close to solving the problem so
other countries have little incentive to join.
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An Agreement on GHGs
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Developed world
• lead in development of new technologies
• might be sufficient to bring developing countries on board

Clean coal technologies
• China could use all of its coal, as could India
• This would be of immense value to them.
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An Agreement on GHGs
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China’s dilemma:
• burning coal generates terrible pollution

domestic political issue.
• Switch away from coal will increase energy costs

Development of clean coal technologies
• valuable to China (reduces other pollution)
• should encourage China and India to participate in an
agreement to reduce GHGs
• understanding that tight standards would only apply
once a new technology were in place.
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Part 3: Economic Research
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3a) Forecasting China’s Emissions
Auffhammer and Carson
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Province-level approach
• Gives better fit than national model
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Model CO2 emission using
• Population predictions
• Predictions on income growth
• Lagged emissions growth
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3a) Forecasting China’s Emissions
Auffhammer and Carson
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3b) Discount Rate
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Stern Report
•
http://www.hm-treasury.gov.uk/independent_reviews/stern_review_economics_climate_change/sternreview_index.cfm
• Advocates strong reductions in greenhouse gases
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Benefit outweigh cost
Nordhaus
• Cost are much larger than benefits
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Key difference
• Interest rates
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Stern uses 0.1%
Nordhaus argues for much larger number
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3c) Impact on Agriculture
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Nonlinear Effect of Temperature on Agriculture
• Warmer temperatures are better up to a point (corn)
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3c) Impact on Agriculture
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Looking at one crop (holding crop constant)
• Omits crop switching as a response to climate change
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Idea:
• Look at farmland values instead
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Capture value of land when it is put to best (most profitable)
use
Link them to climatic characteristics
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3d) Future Regulation - US
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Goulder (Stanford)
• Recommendations for California’s climate change
regulation
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Use market-based approach: tax or permits
Big discussion:
• Auction off permits or grandfather them
• Auctioning off is better for a societal perspective
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Generate government revenue
Other distortionary taxes (income tax) can be lowered
• Grandfathering is cheaper for industry
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Less political resistance
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3e) Future Regulation - US
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Stavins (Harvard)
• Kyoto was “too little too fast”
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“Small” emission reductions in short time frame
• Better approach
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“Stricter” goals but longer time frame to achieve
Give industry time to innovate
• New production processes
• carbon capture and storage
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