II -The market fails to deal with environmental matters ̃ need for public policy
For economists, pollution is a problem that cannot be solved by the market mechanism because it is an externality.
A - Definition of an externality
1 - No feed back mechanism
Externalities are cases where there is no feedback mechanism leading the agent to take accounts of their of its behaviour's effects on other agents.
It is not the existence of an effect on others that constitutes an externality but the lack of incentive to take full account of it.
2 - Private costs and social costs
Another way of expressing an externality is to define it as when the marginal private cost (benefit) is not equal to the marginal social cost (benefit).
B - Pollution is the textbook example of externality
Most textbooks on microeconomics use pollution as the classic example of an externality. Two diagrams are used to analyse the problem of pollution and its consequences.
1 - Prices are too low and output level too high (Social and private costs of pollution)
This first diagram emphasises the implications of a negative externality. Prices and output level do not maximise the society's welfare : prices are too low and the output level is too high.
The diagram shows the divergence between social and private cost in the context of a competitive industry, which causes pollution during the production process.
The
supply curve of the industry is the sum of the marginal costs of the firms.
Given the demand curve, Q0
is produced and sold at a price P0. This is not socially optimal.
If the pollution emitted during
production is allowed for, the true sum of the marginal social costs for the
firm is given by MSC. The optimal output is where P=MSC, i.e. at Q1 and P1.
From this diagram it is clear that the price to consumer is too low and therefore the consumption too high. It is therefore that both employers and trade unions are sometimes opposing policies.
2 - The optimal level of pollution is not zero (Costs and benefits of pollution abatement)
The previous diagram has the disadvantage of neither explicitly showing what happens to pollution nor showing whether pollution can be reduced by means other than a drop in production. For these reasons, an alternative diagram is now often used, which draws attention to these aspects.
In this figure, pollution is measured explicitly. It shows the abatement of some particular form of pollution for some particular industry.
The marginal benefits (MB) of pollution abatement are the avoidance of the external costs placed on others (health problems, noise, and loss of amenity). The MB curve, is usually drawn downwards, although the justification is not firmly founded. It can fit the effects of pollution on human health but does not its effects amenity - for instance.
The marginal costs (MS) of pollution abatement to the firms in the industry are 1) the costs associated with various abatement techniques 2) as well as the loss of profits if output has to be reduced, therefore decreasing the final product sold. The shape of the MC curve, follows from the fact that some abatement is often easy but, removal of the 5 percents remaining is usually much more expensive.
The major conclusion here is that less than 100 percents of abatement is usually desirable. The optimum level which maximises welfare, is where the marginal costs of further abatement just equal the marginal benefits, level A0.
This is an implication of the economists' approach (human welfare maximisation) which is uncongenial to some in the Green movement.
III - The market can internalise these externalities ̃ no need for public policy
Given the need for pollution limitation, does the society need to set up a public policy ? Can this market failure be managed by market forces ?
A -The Coase theorem (1960)
Theory has shown that under perfect competition, when property rights are clearly defined and there is a precisely determined polluter and pollute(s), completely free trade of all property rights will lead to economic efficiency. Furthermore, the efficient outcome is independent of how the property rights are assigned (Coase, 1960).
1 - Hypothesises
1) if the legal rights to use all natural resources are well defined (including air, water, land,
etc...)
2) if the market system is perfectly competitive
2 - Conclusion
1) the efficient allocation of those resources should be automatically achieved
2) irrespective what is the distribution of rights.
3) therefore government intervention is not needed : bargaining between economic agents is sufficient to deal with environmental externalities
3 - The key for internalisation : property rights
The Coase theorem is an example of externality internalisation by the setting up of property rights, distributed to private agents.
4 - Method of demonstration
We will justify this theorem on an example. Let us consider a case where industrialists produce a given level of output and have to discharge waste-waters into a river where fishermen work. We aim at showing that :
1) the optimal level of abatement is reached by mutual bargaining
2) without government intervention
3)
irrespective who has
the property rights over the river.
B - Optimal allocation is achievable by private bargaining
1 -Fishermen own the water rights and industrialists pollute
Industrialists, producing a given level of output, negotiate with fishermen (who own the water rights) to accept the discharge of their waste-water into the river. The payments will depend upon the damage which the waste-water will cause to their fishing activities.
The downwards slope of the MRD curve (marginal reduction in damage) reflects that pollution treatment prior to waste disposal makes the damage fall, but less and less efficiently.
The upward slope of the MPTC curve ( marginal pollution treatment cost) reflects the fact that some abatement is often easy but, removal of the 5 percents remaining is usually far more expensive.
The outcome of the negotiations is that the industrialists reduce their pollution by an amount of BC and pay compensation for the actual pollution of CD. The compensation equals the area ACD. Industrialists are prepared, on a voluntary basis, in order to maximise their profit, to treat their waste-water so long as the reduction in damage to fishing activities exceeds the increase in their treatment costs
Conclusion : Pollution treatment is performed on a voluntary basis by industrialists. No need for any public regulation.
2 - Optimality
At this level, again, the combined total pollution-damaged and pollution-control costs are at a minimum, which is consistent with the efficiency objective. In other words, the costs to society as a whole are minimum.
What is happening is that the environmental costs are being fully internalised within the costing and decision making system of the industrialists.
C - Optimal allocation is reached irrespective who has the property rights
1 - Industrialists own the water rights
Let
us now assume that the water rights are now held by the industrialists. As a
consequence the Fishermen have to make payments to cover the costs of the
pollution treatment.
E
Industrialists will treat the
waste-waters so long as the extra payments exceed their marginal
pollution-treatment costs. The amount of money fishermen are willing to pay
must be lower than EBCA. If they know the Marginal Pollution Treatment Cost
curve (MPTC), fishermen can convince industrialists to treat up to BC, by
paying BCA + epsilon. Since industrialists are profit-maximising, they would be
happy to treat their wastes in order to gain epsilon.
The important point is that the outcome, in terms of the mutually agreed level of treatment, is the same.
2 - Optimality, irrespective who has initial rights
At this level, again, the combined total pollution-damaged and pollution-control costs are at a minimum, which is consistent with the efficiency objective. In other words, the costs to society as a whole are minimum.
D - Conclusion
There is no need for governmental involvement. Indeed, property rights internalise the externality. All what we need is a well defined system of property rights. Private bargaining between private economic agents will do the trick.
The above analysis is used to show how markets might respond, in the absence of government intervention, to the presence of an environmental pollution. However, its practical value is limited, given that:
1) real markets are often imperfect
2) legal rights to the use of the environment are often inadequately or unsatisfactorily (from an equity view points) defined.
A - Limitations related to legal rights
1 - Distributional (income) effects can lead to importance of initial rights
Even though social welfare efficiency is attained, outcomes of bargaining between private parties can have huge distributional consequences, reflecting the different distribution of property rights. Income effects can be tremendous, especially were markets are imperfect, as in the case of oligopoly.
2 -Impossibility of clearly defined property rights
The legal rights to the use of the environment are not easy to establish. Who owns the air we all breath ? Who own the river ? Who own the landscape in its aesthetic dimension ? Rights are often logically in multiple ownership. This has two consequences : and
3 -Therefore no clear liability
There are many source of a pollutant, many receptors are affected by it. Therefore it will always be difficult, in both a technical and legal sense, to establish liability without great uncertainty.
B - Limitations due to the bargaining process
1 - Non localised problems : non-viable bargaining process
There are many source of a pollutant, many receptors are affected by it. The great number of actors involved can even the mere feasibility if the bargaining process. greatly increase the transaction cost
2 - Imperfect information / uncertainty
The scientific knowledge over these issues is limited. Controversies are unavoidable. This can hinder the bargaining process.
C - Limitations due to imperfect markets
1 - Localised problems : markets are likely to be oligopolistic (coalition)
When the pollutant is more localised (example of the fishermen and the industrialists using the same river), because of the small numbers involved, the market may be oligopolistic and the efficient solution may not emerge.
2 - Free rider (public good)
Some actors might benefit from an arrangement that they are not part of. Environmental quality is a public good. The price that the fishermen might pay to preserve the water quality of the river should also be born by other actors, like tourists, inhabitants of the area, farmers who use the water.
D - Relevance for interstate bargaining. No relevance for private agents
1 - Direct relevance only for inter-State bargaining over transfrontier pollution
What it special about inter-State bargaining over transfrontier pollution is that :
1) small number of actors involved
2) easy geographic localisation of emitters and receptors (because of the larger scale)
3) convenient level of liability (states)
4) important financial means
2 - Bargaining between private actors needs to be sustained by public policies
On the other hand, the Coase approach seems not to be manageable at the level sub-national private actors (for all the reasons we have seen). However, surprisingly enough, a set of public policies can help to implement this free market approach to environmental problems.
The next section sets out the public policies needed to set up a viable bargaining system between private actors.