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2.3. Stimulus to Innovation and Technical Change

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Savings from Economic Incentives

Market-based instruments should have significant advantages over command and control mechanisms in terms of stimulating technical change and innovation in pollution control. The reason is that each and every unit of pollution is costly to the firm. In contrast, under a command and control approach, once a source has satisfied the emission limits, all pollution within those limits is costless. Why spend valuable resources instituting further controls when there is no reward? In fact, the incentives may be negative, for a firm that controls to less than permitted amounts may be inviting reductions in what is permitted. In many parts of the nation pollution control agencies are constantly struggling to find ways of meeting ambient environmental quality goals. Firms that demonstrate the possibility of making emission reductions below permitted amounts offer an easy target for obtaining some of the necessary emission reductions. These same innovative firms may supply the catalyst for regulations that require other firms in the same industry to undertake what has been demonstrated as possible.

The figure depicts graphically the difference in incentives for innovation between an emissions tax and a command and control policy. With marginal control costs of MCC1, a firm controls emissions to E1 with an emission standard set at that level, incurring costs equal to area (a+b). With an emissions tax set at t, the firm also would control emissions to E1, incurring costs equal to (a+b+c+d+e).

The incentive to the firm to find improved methods of pollution control are much stronger under the emissions tax, since total pollution control outlays are so much higher. If the firm finds a new pollution control technology with marginal control costs equal to MCC2, total abatement costs under the emissions standard approach would fall by an amount equal to area b. Under the emissions tax approach, total pollution control outlays would decline by an amount equal to area (b+c).

It should not be surprising that the theoretical and empirical literature concludes that emission taxes provide the greatest stimulus for technical change and innovation, with marketable permits offering a lesser stimulus and command and control the least. (Zerbe (1970), Wenders (1975), Downing and White (1986), and Milliman and Prince (1989)) Among command and control approaches, it is safe to say that performance-based standards should provide a greater incentive to innovate than would pure technology requirements. Fischer, Parry and Pizer (RfF DP 1999-04) use a simplified model to derive analytical and numerical estimates of the welfare impacts of three instruments (emission taxes, auctioned marketable permits and grandfathered marketable permits) in the presence of endogenous technical change. They conclude that there is no clear-cut case for recommending one instrument over another because of dynamic efficneicy effects as the results are dependent on many difficult-to-quantify factors.

Long-run changes in behavior and technology are among the most difficult economic effects to document. For that reason, relatively little is known of the effects that take place as a consequence of different pollution control policies. Yet these effects are thought to be very important. One author said the rate of technological change in pollution control is "the single most important criterion on which to judge environmental policies." Kneese and Schulze (1978)Another analyst termed innovation "the key to an effective solution" of environmental problems.(Orr (1976))

The available evidence suggests that command-and-control dominated environmental policies give only a mild stimulus for technical change and innovation. (Cramer et al. (1990)) In contrast, the incentive-based U.S. acid rain control program has seen dramatic reductions in control costs due to major technical and behavioral changes. Outlays for research and development in pollution control are between two and three percent of total pollution control expenditures. This is about the same as the average R&D expenditure in all of U.S. manufacturing, but far lower than one might expect in a new and rapidly changing industry. A more apt comparison might be provided by drugs, electronics and information processing where R&D runs between 6 and 10 percent of expenditures. Research and development in pollution control appears to lag behind largely because of the command and control framework that has been chosen, not because of any other inherent limitation. Pollution control based more heavily on economic instruments would be expected to stimulate greater R&D and in turn reduce over the long run the costs of improving the environment.

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