A Brief Theoretical Background and Some Basic Economics

Theoretical Aspects

Environmental economists have been studying pollution problems for quite some time. Their recommendations on what to do about them are based on the concept of economic efficiency. According to this criterion, pollution control problems can be seen as an exercise in finding solutions that satisfy at least the following conditions: (1) the same result cannot be achieved at a lower cost, and (2) the net benefits (benefits minus costs) derived by society are maximized. The first condition implies simultaneously that inputs are not wasted (the activity/project works on the production possibility frontier) and that substitution possibilities among inputs are exploited in such a way as to minimize the costs of achieving every output level. The second condition implies that activities (projects) are sized so that marginal benefits from additional units are equal to marginal cost.

The traditional view of pollution problems has recognized that in most cases if they are left to themselves an economic efficient solution will not be found, because of the presence of externalities. From an economic point of view, an externality exist whenever an activity by one agent causes a loss of welfare to another agent for reasons other than the simple results of market effects¹ and the welfare loss is not compensated. It is important to recognize that this definition implies that the mere existence of physical effects does not guarantee the existence of an externality, and, probably more important, the existence of an externality does not mean that it is in the interest of society to eliminate it completely.

The last observation implies that, given an externality, there is an optimal level of mitigation. Determining this level requires knowledge of the marginal net private benefits (MNPB) derived from the activity that causes the pollution and the marginal economic costs (MEC) to those suffering from it. Maximization of society’s welfare implies that the optimal level of the externality, Q*, is achieved at a point at which the marginal net private benefits of the polluting activity equal the marginal economic costs to those suffering from its effects. This result can be presented in Figure 1, in which functions are represented by straight lines to simplify the presentation.

This graph recognizes that initial pollution levels may not cause any welfare losses (i.e., up to level Qa on the horizontal axis), owing to the ability of many ecosystems to handle small amounts of pollutants without significant damage, so marginal economic costs of wastes start to the right of the origin.

One school of thought contends that even if externalities exist, market-like forces can be introduced into the solution process without the intervention of any central authority. Ronald Coase (1960) showed that if property rights could be established and agents could trade at no cost (i.e., transaction costs were not significant) then the optimal solution presented above could be reached without any government intervention. The graph above can be used to identify the potential solutions that could be achieved under three different scenarios: (a) the right to pollute is assigned to the offender and no trade takes place; (b) the right to pollute is assigned to the sufferer and no trade takes place,² and (c) trade is allowed under either of the previous property-rights regimes. It is easy to see that the first two solutions correspond to points Qp and Qa respectively. If bargaining is possible and all Coasian assumptions are met, then Q* is achieved no matter who holds the right to pollute. If polluters have the right to pollute, they will try to produce at Qp. Sufferers face high MEC so they could bribe polluters to move to Q*, at which point they have no more bargaining power. On the other hand, if pollutees have the property rights, polluters will experience high net private benefits and could bribe sufferers to accept Q* level of pollution, at which point their offered bribes would be just enough to calm the pollutees.

The beauty of the classical Coasian solution is not achieved in practice because of several deviations from the basic assumptions, such as: (a) transaction costs (i.e., the cost of legal action plus the cost of getting together) may not be trivial when at least one of the parties is composed of many agents facing small costs or benefits relative to the total potential gains from the transaction; (b) information asymmetries exist to the extent that neither party knows exactly the cost/benefit function of the other one, and this information is also not perfectly known to the legal authorities responsible for deciding potential legal arguments; and (c) market imperfections other than the externality (e.g., monopoly on the offender’s side) imply that the bargaining does not achieve the social optimal solution. The environmental economics literature has explored many related issues such as non-conventional curvature properties of the costs and benefits curves, uncertainties about them, and others.

Owing to the criticism of the Coasian solution, many economists continue to advocate the Pigouvian tax solution by reason of its efficiency compared to the command-and-control approach. The Pigouvian tax achieves the optimal pollution level by increasing the marginal private cost to polluters so that they generate the desired amount of pollution. This tax is equal to the marginal external cost they induce on the affected parties, but it has to be calculated at the optimal level of pollution. Calculation of the optimal Pigouvian tax requires knowledge of the polluter’s private marginal benefits and marginal economic costs of pollution. Figure 2 shows how a Pigouvian tax equal to bQ* will reduce to zero the marginal net private benefits to polluters at the point Q*, so that private agents would not produce beyond this point.

Some critics of pollution charges argue that obtaining the information required to estimate an optimal Pigouvian tax is close to impossible given the private nature of the marginal benefits and the asymmetries that this condition generates, and the theoretical requirement to have a charge that varies according to source location and pollutant. Critics argue that, given these difficulties, most charges will not achieve optimal solutions and thus cannot be claimed to be more efficient than standards. Those in favor of charges argue that in practice these difficulties may not be so great, since in most cases authorities may be interested in getting things moving in the right direction rather than imposing the theoretical optimal tax.

Two aspects commonly argued by parties affected by Pigouvian taxes are worth discussing. The first can be seen in the figure above: polluters seem to be penalized twice. On the one hand, they are forced to reduce emissions (by adjusting production practices, reducing output, or installing pollution-abatement equipment) to achieve the optimal pollution level Q*, and on the other hand, they have to pay pollution charges for the amount they discharge. The answer to this seemingly unfair treatment rests on the definition of property rights. If pollutees have the right to a clean environment, pollution charges for emissions below the optimal amount are simply a payment for using property rights that belong to others. If a firm has the right to discharge any amount of pollutants, then both the Pigouvian payments and the forced reduction of discharges are completely mistaken.

A second point commonly argued is that a pollution subsidy (i.e., a negative tax on emissions) could achieve the same outcome, since a forgone subsidy is the same as a cost for a private agent. The answer here is a little bit more complicated because it is based on the market equilibrium over the long run. With free entry and exit from an industry, the total amount of production for a particular industry is achieved at a point where long-run marginal costs equal long-run average costs. A pollution subsidy will increase the long-run marginal cost in the same way as a pollution tax, but it will lower the long-run average cost. This implies that new firms will enter and total production, and discharges, will increase over those resulting from a pollution subsidy, a situation that may even imply a total increase in the amount of pollution.

Pollution charges are related to abatement costs. They encourage a reduction of discharges by virtue of the costs they imply. Discharges can be reduced by various means: cutting back production, changing technologies, and installing pollution-abatement equipment. Faced with a pollution charge, producers will look into these possibilities and will select a mix that equalizes marginal costs across pollution-reducing alternatives. Viewed this way, the optimal level of pollution is achieved when the marginal abatement costs equal the marginal economic damage from pollution.

Pigouvian taxes have several important economic properties. Figure 3 shows the behavior of three firms under a pollution charge. Marginal abatement costs differ among firms, so even though they face the same pollution charge they will select different levels of abatement. This solution means that polluters with high marginal abatement costs reduce pollution to a lesser extent than polluters with lower marginal abatement costs. The minimization of total abatement costs for any level of total discharges is consistent with the tax-induced solution but not with a solution attained by a standard with all polluters discharging effluents with similar characteristics.

Standards and effluent charges induce polluters to look for solutions that combine end-of-pipe treatment and production adjustments. Effluent charges are more efficient because they make the actual pollution abatement level variable too, so firms under this regimen have more freedom to look for a cost-minimizing solution.

Pollution charges have dynamic economic efficiency properties. The presence of the charge encourages polluters to search for new and more efficient ways to reduce emissions, thus promoting the adoption of new technologies that improve environmental conditions and reduce overall costs.

Even though the use of charges is increasing these days, why are they not more popular, given all their advantages and the perceived inefficiencies of standards? Possible answers, besides the simple rejection of new taxes, include the following: (a) polluters and legislators may fear that pollution taxes could go beyond the optimal point; (b) lack of knowledge about the cost functions, the damage functions, and the perceived possibility that advocates of a clean environment will “adjust” the estimates may make regulators see this approach as too risky; and (c) pollution regulation has grown from previous experiences in health areas where the standards approach was the rule.

Standards can achieve optimal pollution levels, but many variables have to be at the right level. There are many types of standards, which probably could be grouped into three: ambient, effluent, and technical. The use of the expression “command and control” makes reference to the use of any of them. Figure 4 indicates what happens when an effluent standard and a penalty for noncompliance are introduced for a particular industry.

Let us assume that a standard is fixed at Qs, below the optimal level Q*, and a penalty is set at P. The standard could be set at the optimal level provided that it can be identified. Given the level of the penalty, the polluter has the incentive to pollute up to Qu since it is cheaper to pay P than to get involved in abatement costs (i.e., lose private benefits). Strictly speaking, the polluter computes the expected value of polluting at Qu as the multiplication of the probability of being caught times the amount of the penalty. Even under perfect enforcement the polluter may choose to go up to Qu. It should be clear, then, that achieving the desired amount of pollution depends not only on the standard, but also on the penalty level and the quality of enforcement.

The discussion of taxes vs. standards was expanded at the end of the 1960s with the introduction of marketable pollution permits (MPP). The basic idea behind this tool is that authorities can define the maximum total discharge allowable in a defined area; issue a total number of permits equivalent to that amount, allowing the holders to discharge the face value of the permit; and control all sources so that nobody can discharge any amount except when backed by a permit. These instruments have important economic advantages that make them even more desirable than pollution charges in some circumstances. Some of these are the following:

1. MPP minimize overall costs by allowing polluters that face high abatement costs to buy permits from those with low abatement cost.

2. MPP handle new entrants in an automatic fashion. Given that total discharges are fixed, new entrants must decide whether to invest in pollution abatement or to buy permits from current permit holders on the basis of their marginal abatement costs and the market value of the permits. Marginal treatment costs are adjusted to their theoretical level without complex bureaucratic procedures.

3. Inflation problems and the need to add just charges are eliminated, since the market determines all prices.

4. Ambient quality improvements can be achieved by buying permits and retiring them from the market, so non-polluter groups (i.e., clean environment) can participate.

5. Since total discharges are clearly defined, uncertainties about final ambient quality are eliminated. Information needs about abatement costs and benefits are not necessarily lower than in the case of charges.

MPP are being used in a few areas, such as air-quality control in the USA, and their use is becoming more popular as they are better understood.

Three simple conclusions can be drawn from this review: