Question

In a newly published article in the scientific journal “International Economic Review”, some authors study how carbon taxation could help reducing the climate change problem. They find that:

Carbon taxation is mostly studied in social planner or infinitely‐lived‐agent models, which obscure carbon taxation's potential to produce a generational win win. This paper's large‐scale, dynamic 55‐period, overlapping generations model calculates the carbon‐tax policy delivering the highest uniform welfare gain to all current and future generations. Our model features coal, oil, and gas, increasing extraction costs, clean energy, technical and demographic change, and Nordhaus' (2017) carbon/temperature/damage functions. Assuming high‐end carbon damages, the optimal carbon tax is $70, rising annually at 1.5 percent. This policy raises all generations' welfare by almost 5 percent. However, doing so requires major intergenerational redistribution.

a.What market failure is a carbon taxation to solve? Why is there a market failure here?

b.How is an economic model (à la Nordhaus) with “carbon/temperature/damage functions” set up?

c.It is said that the model leads to “highest welfare gains”. How is welfare measured according to economists?

d.How is the welfare measurement related to the concept of Pareto efficiency?

e.The Swedish carbon tax is about $90, i.e. more than $70. Is this aproblem, or is it even better to have a higher tax? Explain using the concepts discussed in c.

f.An alternative solution to the carbon tax is a cap-and-trade system. Explain how such a system works and the outcome of it compared to a tax.

g.Why do economists prefer taxes or cap-and-trade before quotas measured in carbon dioxide for each country?

h.Increasing extraction costs are here assumed for coal, oil and gas. How does that affect Hotelling’s model explaining how much that will mined now and in the future, and the prices of coal, oil and gas over time?

Answer 1

A. Market failure is a condition wherein the below given conidtions are prevalent:

1. Public Goods - Goods that are publicly or collectively consumed, which are non-divisible are known as public goods. Since these goods are collectively consumed, who will pay for such goods? What should be the price? These questions result in market failure.

2. Merit Goods - Merit goods such a good habit, health, education, ethics, environment etc. cannot be produced in a market situation. Production and distribution is not possible and the price is unknown. Customers are also absent. In this case market failure occurs.  

3. Uncertainties in market conditions - Natural or man-made calamities result in market uncertainties. The result is, the market is unable to deliver Price or Quantity out of an equilibrium condition.

4. Externality - Impact of one's actions on the by-stander. The third party, who is not even involved in the transaction gets impacted. A positive impact on the by-stander needs to be encouraed. A negative impact needs to be discouraged

5. Tragedy of Commons - Complete disregard to collective needs. People decide based on their own needs and never consider overall impact of a particular action from their side.

Carbon emission is a case of Externality, Tragedy of Commons, Merit Goods and is a common concern / public good. This is why, the question of Carbon Taxation is not a private economy question but needs to be solved through governmental intervention.

B. carbon/temperature/damage functions as per Nordhaus explains net GDP as the total output of the economy minus damages and costs of mitigation. In this context, Carbon emissions enhance the temperature levels. As temperatures rise, the total output (GDP) gets impacted negatively. From sector to sector this damage changes. This is why every time carbon levels increase, there is an economic concern as it is a cost as well as a damage.

C. Welfare is measured in totality as Social Welfare. All of us are part of the society. But we act in socioety as per our abilities. In short, at any given time, either we are Buyers or Sellers.

Social Welfare = Consumer's Surplus + Producer's Surplus

Consumer's Surplus is possible when there is a difference between what a Consumer is Willing to Pay and What he / she actually pays (Market Price). when Prices go up, Consumer's Surplus (CS) is low. Since Consumer's are part of society, the total Social Welfare goes down.

Producer's Surplus is the difference between the Minimum Supply Price and Selling Price (or, market price) received by sellers. Producer's Surplus increases with high prices and decreases with low price. This is why, too much low prices are against Social Surplus.

In the context of Carbon Taxation, any extreme action on prices / taxation will hurt Social Surplus / welfare.

D Pareto Efficiency is a condition where "Any reorganization leads to a condition where someone is better off and someone is worse off". This means, a Win-Win situation is not possible beyond a point. In Pareto efficiency conditions, people move on a contract curve under constraints. Constraints are a a reality of life where resorces are limited in quantity. Thus, people need to make adjustments in order to ensure that there are no "Losers" who are a reality because of some "Winners". In a market situation, Buyers and Sellers both have to be winners. Bias towards Buyers or Sellers is not a good stance from an economic point of view.

E Any proposition of a Tax to resiolve Carbon Emission is not a good situation as it creates an imbalance either between the buyers or the sellers. In other words, Consumer Surplus or Producers Surplus will be affected; resultng in net loss of Social Welfare.

F Compared to Taxation, Quota System of Cap on Trade is better.  Taxation reduces Social Welfare. Quota System is better as it allows market clearing with least impact on Buyers / Sellers.

H Economists prefer Cap on Trade rather than taxation because the latter option is welfare reducing and is against the Pareto Conditions.

I The model advises to look of damages or costs. In terms of conventional energy resources, both damages and costs are high. Therefore, total withdrawal from such resources has been advised in the model.