ENVIRONMENTAL ECONOMICS: POLLUTION

Issues and Questions

1. How bad is the environment? The degradation of the environment can be measured in numerous ways. We have air, water, land, and noise pollution. We also have deforestation, toxic land-fills, the erosion of soil, and a reduction in our fishing stock, just to name a few.
2. Are things getting worse? The answer to this question depends upon which type of pollution one is referring to. If one is talking about air and water pollution in the US, a general answer is 'no.' We have made substantial improvements in our air and water quality over the last 25 years. But most would argue that we still have a long way to go. Moreover, many other types of pollution are getting worse. Our land-fills, for example, keep growing.
3. Should we try to eliminate pollution completely? No. This is far too costly (and impossible as long as we are living on the planet). Then how much pollution should we have? One answer to this question is to use the efficiency standard. This standard suggests that the appropriate level of pollution is where the marginal benefits of the pollution (i.e. the benefits from the jobs created, the good or service consumed, etc.) just equals the marginal costs of pollution (i.e. the damage to the environment). In essence, the level of pollution is determined by a series of cost-benefit analyses.
4. What is the best way to reduce pollution? There are three major avenues to reducing pollution. We can use voluntary measures, direct controls, or market incentives. Each of these is explained below.

Pollution and Externalities

Why do we have pollution at all? Obviously, noone wants pollution. Pollution occurs as a by-product of some other activity. We throw away trash when we consume goods, we pollute the air when we drive to work; we pollute the water when we produce steel and dump the emissions into the water.

Pollution is undesirable, but also unavoidable. The question is "How much pollution should we have?" If we accept the efficiency standard (there are other alternatives), then the answer is that we should only pollute until the marginal benefits of that pollution equal the marginal costs. Will the market forces inherently give us the efficiency standard? The answer is no. Market forces, if left to themselves, generate too much pollution. The reason for this is that pollution is a negative externality.

An activity generates a negative externality when the activity imposes unwanted costs on an uninvolved party, and those who bear the costs are not compensated by those responsible.

An example of a negative externality is air pollution by an oil refinery. If the pollution spills over into the neighborhood and damages people's lungs and houses, then a negative externality exists. The social costs of production exceed the private costs of production that the oil refinery directly incurs. Those living near the firm pay some of the costs yet are not compensated by the oil refinery.

Another example is the building of a dam that prevents the fish from swimming upstream, thus destroying the fishing industry in towns upstream. Note that if the fishermen are compensated by the dam builders for the full value of their loss, then no negative externality exists.

Because of negative externalities we have too much pollution, even if we use the efficiency standard to decide the appropriate amount of pollution. This is shown to the right. Taking the oil refinery as an example, the marginal benefits (MB) are derived from the production (and ultimate consumption) of gasoline. The marginal private costs (MPC) are the costs that the refinery must pay, i.e. the wages, cost of materials, rent, etc. The marginal social costs (MSC) are the total costs that sociey must pay for production of the gasoline. These include the private costs plus the externalities, i.e. the costs imposed on those who live near the refinery who must breathe the dirty air and repair their homes and cars more often. Notice that the MSC curve lies above the MPC curve. For any given quantity of output, MSC are greater than MPC.

The efficient level of production for the refinery occurs at Qe where MB=MSC. If pollution is "free" for the oil refinery, then the level of production occurs at Qa becuase the firms operates such that MB=MPC. In other words, more production and hence more pollution is generated than is efficient.

This inefficiency leaves room for government intervention. The role of government should not be to eliminate pollution completely (as discussed above) but to force the oil refinery to behave efficiently. One way for the government to do this is to tax the refinery by the amount of the externality that is generated. This will shift the MPC upward until it lies on top of the MSC curve and the efficient outcome will prevail at Qe.

Another example is trash service. Often trash service is paid for by tax dollars and the family can throw away as much trash as it wishes. The graph of this situation is below. Notice that the marginal private cost of throwing away trash is zero. Under this scenario, the family throws every bit of trash away that it wishes. The quantity of trash is Qa. However, the costs to society are obviously greater than zero so the outcome is inefficient. The efficient solution is a trash service that charges per bag or per trash can. The fee should be equal to society's costs of disposing of the trash. Suppose the per-bag charge is $2.00. Now the MC curve shifts upward and the level of trash is reduced to Qe.

There is a catch with the per-bag policy. For this type of policy to be effective, the city must be able to deter people from simply dumping their trash on the street or in a neigbor's trash can, or down the sewer. If trash-dumping is likely to be a big concern, then a per-bag policy will not work and the city must deal with the higher volume of trash. Large cities often are forced with this dilemma.

Externalities and Property Rights

Why do we have externalities? The simple answer is that the property rights to the pollution are not well-defined and/or enforced. In the case of the oil refinery, as the pollution rises into the air, magically, the refinery property rights over that pollution disappear. If the law stated that the refinery must "own" the pollution entirely, even after the pollution leaves the factory, then the firm would be responsible for the damage the pollution did. The negative externality would disappear. In the trash service example, if the producer of the trash (i.e. the family) had well-specified and enforced property rights to the trash, then the family would be responsible for disposing of the trash. The problem arises because these types of property rights are often difficult to enforce. Many externalities will disappear when the property rights to the pollution are well-defined and enforced.

Three Basic Approaches to Environmental Policy

We have described the theoretical problem of pollution and negative externalities. Because of the inefficiency, there is a role for the government to play in limiting pollution. The question becomes how should pollution be dealt with? We discuss three alternatives.

1. Voluntary Programs. This includes recycling, car pools, bicycling to work, etc. While these programs are worthwhile and vital to limiting pollution, they are small contributers and often unreliable.

2. Direct Controls. Attempts to reduce pollution by legislation and rules set by the EPA. The majority of our environmental policy is dealt with via direct controls. In order for direct contols to be effective, the government agency (EPA) must specify the property rights over the pollution, monitor the firms' actions, detect violations, and then prosecute the violator in court. For example, the EPA mandates that the oil refinery must use certain scrubbers. If the firm does not use the scrubbers, the EPA must detect this and take the firm to court. If the EPA is successful, the firm is fined. The process is very long and expensive. Tax dollars are used primarily to detect and prosecute violators.

3. Market-Based Approach: Emissions Taxes and Permits. Under an emissions tax system, pollution is automatically monitored by a metering system and a tax bill is then sent to each firm according to the amount it pollutes. There is no provision as to how much the firm can pollute nor what type of technology it should use. If the EPA decides to reduce pollution, it simply raises the pollution tax.

   Under this system the enforcement is immediate and much less costly. The EPA generates money instead of spending it. The funds can be used to support the EPA's activities or be put towards cleaning up the environment. A tax system is also much more efficient in that it can reduce a given amount of pollution at lower costs to society. This is because it gives firms the flexibility in deciding how they are going to reduce their emissions, if at all. With this flexibility, the firms who find it easiest to clean up their emissions will do so first.

   For example, suppose it costs Firm A $.03/gallon to reduce emissions and Firm B $.20/gallon to reduce emissions. The combined pollution of the two firms is 2,000 gallons per day (1,000 gallons each). The EPA wants to cut this in half to 1,000 gallons per day, and to do so can either mandate that each firm cuts emissions in half to 500 gallons per day, or it can imposes a $.10/gallon tax on pollution. This is the cost to society under each alternative:

   Direct Controls:

   Firm A pays (500 x $.03) = $15 to cut its emissions in half, Firm B pays (500 x $0.20) = $100. The total cost under the direct control plan is $115.

   $.10 Emissions Taxes:

   Since it costs Firm A $.03 to clean up its emissions, it will emit zero pollution rather than pay the $0.10 tax. Therefore, Firm A cuts its pollution by 1,000 gallons per day. Firm B will opt to pay the tax since it is cheaper to pay the tax rather than reduce emissions. However, the EPA's goal is met and pollution is cut in half. The total cost to society in this case is the costs that Firm A incurs to clean up its emissions which is (1000 x $.03) = $30.

   The tax system "saved" society $85 and pollution was reduced by the same amount in both scenarios. A tax system is more efficient because those who are able to reduce pollution the cheapest (in this case, Firm A) will do so first.

   Sometimes people object to the tax system because it is not as "fair." However, this is argument can easily be reversed. Suppose Firm A has been a good environmental citizen all along and has worked hard to reduce emissions. Firm B has poured its pollution into the atmosphere without much thought or concern. If the EPA decides to force both firms to cut emissions in half, is this "fair" to Firm A? Hardly. Firm B comes out ahead. On the other hand, if a pollution tax is imposed, Firm B will rightly pay more in taxes.

   The other market-based approach to environmental policy is a system of emissions permits. Under this scenario, the EPA decides what quantity of emissions in a particular area over a certain amount of time is allowable. Then it sells permits or "rights" to those emissions. The firms who need to pollute the most will buy the permits. Ideally the sale is public so environmental groups can purchase the permits as well, reducing pollution even further. If the firm does not hold a permit, it cannot pollute. The EPA can then reduce the quantity of permits over time, forcing firms to gradually cut emissions, but to do so in a flexible way.

   Emissions permit systems have been called "licenses to pollute." In some sense, this is true. Firms are in fact purchasing licenses that allow them to pollute the air. But direct controls also give firms the right to pollute. Moreover, direct controls allow the pollution with no monetary compensation expected from the polluter!

Direct Controls vs. Emissions Taxes

Despite the benefits of a pollution tax, there are at least three situations where direct controls are better:

1. The emissions is so dangerous that it must be banned altogether. Selling the rights to nuclear waste emissions is probably not a good idea.
2. A crisis situation arises which calls for fast action, i.e. Mexico City or L.A. smog crisis. In this case, there is little time for a market system to work.
3. Information costs of monitoring the emissions are so high that it is very costly or impossible to tax the pollution. In this case, market incentives may not be possible and mandated "clean" technology may be the best alternative.

PowerPoint slides are available for viewing in this module.