ECON 310 Chapter 3 Notes

Government Intervention in Market Failure

Since its creation three decades ago, EPA has made great strides in protecting the environment. For the most part, these environmental improvements were made through the use of command-and-control regulation; that is, promulgation of uniform, source-specific emission of effluent limits. It is becoming increasingly clear that reliance on the command-and-control approach will not, by itself allow EPA to achieve its mission.... To maintain momentum in meeting environmental goals, we must move beyond prescriptive approaches by increasing our use of policy instruments such as economic incentives. Properly employed, economic incentives can be a powerful force for environmental improvement.

William K. Reilly, Administrator’s Preface

CHAPTER SUMMARY

In most high-income countries, the majority of the citizens accept the necessity for environmental policy, and the focus of the debate is how policy should be formulated. The major thrust of this chapter is a discussion of how policy should be formulated and the relative merits of alternative policy instruments.

This chapter begins with an examination of the intellectual arguments that would support or refute the necessity of government intervention. Since the existence of market failures implies losses in social welfare, the natural question to investigate is whether the mitigation of market failures can lead to improvements in social welfare. The early work of greatest significance arguing for government intervention was by A.C. Pigou. Ronald Coase provided the counter point argument.

A.C. Pigou was one of the first to recognize the existence of externalities and the associated divergence between private and social costs and benefits. Pigou argues that the externality cannot be mitigated by contractual negotiation between the affected parties and recommends either direct coercion on the part of the government or the judicious uses of taxes against the offending activity (often referred to as Pigouvian taxes).

The basic principle behind the use of an externality tax is that the tax eliminates the divergence between marginal private cost and marginal social cost. The use of an externality tax raises the marginal private costs of production to be equal to marginal social costs. This process is sometimes known as internalizing the externality. Subsequent examination of externalities taxes have shown that the tax should not be placed on the output of the good or service but on the externality (such as emissions of sulfur dioxide).

Ronald Coase argues that not only is an externality tax unnecessary, but it is often undesirable. Coase argues that a market for the externality will develop and that this market will allocate an optimal level of externality regardless of the initial assignment of property rights. Coase illustrates his point with an example of a rancher and a farmer.

Occasionally the rancher’s cows wander across and trample the farmer’s crops causing a cost to the farmer. Through negotiation the farmer and rancher can arrive at an optimal amount of cattle. If the rancher is allocated the “right” to have cows go where they want, then the farmer can pay the rancher to limit his number of cows. On the other hand, if the farmer is allocated the “right” to have his crops free of cows, the rancher can pay the farmer for the right to have more cows. Coase argues that regardless of the initial allocation of property rights, the optimal amount of cows will be the same.

One critical assumption that Coase makes is that transaction costs are insignificant. Transaction costs are those costs that would be associated with the negotiation process. In the case of two individuals of equal power, this may be an appropriate assumption. In the case of sulfur dioxide emissions in North America, the numbers are very large and as a result transaction costs would be significant. One way to reduce these transaction costs is to appoint an agent who acts in behalf of a large number of people (for example, the Sierra Club). Not everyone who benefits from the reduction of sulfur dioxide levels pays for the Sierra Club lobby effort. This is known as a free-rider problem.

Baumol and Oates argue that the need for asymmetric pricing in the market for the externality means that an efficient market will not develop for the externality. This is true in the presence or absence of transaction costs. Further, it is tenuous logic to use a one-on-one illustration of a negotiated solution to the problem of an externality to generalize to large numbers. In addition, the use of a one-on-one example misses the very real fact of firm entry and exit. In the case of the rancher/farmer example, the allocation of the “right” of cows to roam will assure more ranchers enter into the area. On the other hand, the “right” to prevent cows from roaming will assure that more farmers locate in the area. As a result, the allocation of property rights will have a critical impact upon the relative number of generators and victims.

Finally, property rights matter because there may be important differences between the victim’s willingness to pay for reducing the detrimental externality and the victim’s willingness to accept compensation to allow increases in the level of the externality. Part of the difference may be due to the existence of income effects, which may affect the marginal value of the externality.

The costs of government intervention must be compared to the benefits of government intervention before deciding that government is desirable. This comparison must be done on a case-by-case basis and should recognize that the costs and benefits of government intervention are a function of the type of intervention. There are five broad classes of government intervention to correct market failures associated with externalities. These are moral suasion, direct production of environmental quality, pollution prevention, command and control regulations, and economic incentives.

Moral suasion is a term that is used to describe the governmental attempts to influence behavior without actually stipulating any rules that constrain behavior. The federal government program Woodsy Owl’s “Give a hoot, don’t pollute” is an example of a relatively successful moral suasion program aimed at environmental problems. The effectiveness of moral suasion programs depends upon the extent to which the people (households, firms, or organizations) who are being asked to change their behavior believe that it is in their individual and collective interests to do so. Although moral suasion can be an effective method for generating environmental improvement, it may not be practical in many circumstances.

The direct production of environmental quality is another way in which the government can mitigate environmental market failures. Planting trees, stocking fish, creating wetlands, treating sewage, and cleaning up toxic sites are all examples of this type of activity. Government production of environmental quality is largely an ameliorative action, and in many cases it would have been better for society if the environmental degradation had been prevented. Both moral suasion and direct production of environmental quality have limited applicability to environmental problems such as global warming, water pollution and the depletion of the ozone.

Pollution prevention programs are not designed to control the externality but to address the related market failure. These programs are partnerships of business and government agencies designed to increase the profitability of reducing pollution by developing technologies that are both more profitable and cleaner. A proactive policy can lead to lower costs of abatement in the long run.

The basic premise underlying pollution prevention is that the knowledge to develop these cleaner and more profitable technologies is beyond the capability of an individual firm but not beyond government agencies, national lab, universities and private firms.

Command control regulations are a class of policy instruments that have greater ability to modify environmentally degrading behavior. Command and control regulations are distinguished from other policy instruments because they place constraints on the behavior of households and firms. These constraints generally take the form of limits on inputs or outputs to the consumption and production process. An example of a limit on inputs would be requiring sulfur-removing scrubbers on smokestacks of coal-burning utilities. An example of limits on outputs includes emissions limitations on the exhaust of automobiles.

Economic incentives make individual self-interests coincide with social interests. Economic incentives include pollution taxes, pollution subsidies and marketable pollution permits.

The determination of the optimal level of pollution or environmental degradation is based on the premise that all production and consumption activity will be associated with waste. The law of mass balance state that the mass of the outputs of any activity is equal to the mass of the inputs. As a result pollution is inevitable and zero pollution is not an attainable. The desired level of pollution will be a function of the social costs that are associated with the pollution. There are two categories of social cost, damages that pollution creates by degrading the physical, natural, and social environment and the cost of reducing pollution (this includes the opportunity cost of resources used to reduce pollution and the value of any foregone outputs).

The damage that pollution generates can be modeled with a marginal damage function, where additional damages are positively related to additional units of pollution. The marginal damage function is drawn with the origin as its vertical intercept. This means that marginal damages approach zero as emissions approach zero. This is probably a good assumption for all but the most toxic and long-lived pollutants or pollutants for which small emissions could have a strong localized impact.

Marginal abatement cost function can be used to represent the cost of reducing pollution by one more unit. The marginal abatement cost increases as the cheapest options for reducing pollution give way to the more expensive alternatives. The marginal abatement cost is negatively related to emissions levels. The intercept represents the cost of eliminating the last few units of pollutants.

The optimal level of emissions is the level that minimizes the total social costs of pollution, which is the sum of total abatement cost and total damages. As long as the marginal damages are greater than the marginal abatement costs, it makes sense to eliminate pollution. If marginal abatement costs are greater than marginal damages, it makes sense to have more pollution. The optimal level of pollution need not be static but may change over time. In the face of imperfect information about the marginal abatement and marginal damage functions, policy makers often set a goal that is consistent with “protecting the public health”.

Command and control regulations have been criticized as generating more abatement cost than necessary to achieve a given level of emissions. This is caused by the tendency to treat all polluters as homogeneous and to design pollution abatement policy without regard to differences in marginal abatement costs. In general, command and control policies ignore the differences in marginal abatement costs across firms. As a result total abatement costs are not minimized and there is a misallocation of resources from society’s point of view.

Command and control regulations may be the appropriate policy instrument under three sets of circumstances: when monitoring costs are high, when the optimal level of emissions is at or near zero, and during random events or emergencies that change the relationship between emissions and damages.

Most economists advocate general policies based on economic incentives for two primary reasons. Economic incentives minimize total abatement costs by equating the marginal abatement costs across polluters and encouraging a broader array of abatement options. In the face of a tax on each unit of pollution, each individual polluter will adjust his or her level of emissions to the point where marginal abatement cost is equal to the per unit tax. Economic incentives also encourage more research and development into abatement technologies and alternatives to the activities that generate pollution.

One potential problem associated with pollution taxes is the difficulty in achieving a specific level of pollution reduction when the true marginal abatement cost functions are not known. Introducing a level of uncertainty about marginal abatement cost also introduces uncertainty about meeting the desired goal. Marketable pollution permits are one economic answer to the problem of meeting a desired pollution goal.

The institution of a system of marketable pollution permits (sometimes referred to as transferable discharge permit or transferable emissions permit) begins wit the determination of the target level of pollution. Then this pollution goal is divided and these “rights to pollute” are allocated across the different firms in the industry. Initially each firm receives the same allocation. The ability to buy and sell these permits allows the firms to compare the marginal abatement cost to the permit price. The firm can choose to sell the permit for revenue or buy additional permits. Each firm can respond to its individual cost structure, which means total abatement costs are minimized while meeting the specified goal of pollution reduction. However, in order for any set of pollution controls to be effective, they must take into consideration the geographic variation in the effect of pollution on society.

Central to the importance of the location of the emissions is the manner in which the pollution disperses when it enters the environment. Pollutants that generate their damages in the upper atmosphere have the same effect regardless of the location of emissions. However, the release of carbon monoxide will tend to have a more localized effect. In order to modify marketable pollution permit system the overall region can be divided into subregions. Receptors can be located across the region and under this receptor based system (ambient based system) the polluter would need to purchase market pollution permits based on the effect of his or her pollution on each receptor.

An alternative to the above system is to establish markets for each subregion. This reduces the number of permits that polluter will have to buy but has the shortcoming of limiting interaction across subregions. This could lead to less efficient allocation of pollution permits and as a result, a less efficient pollution reduction policy.

Other types of economic incentives include deposit-refunds. A deposit-refund system is similar to a tax, but instead of making the individual pay for undesirable acts as they occur, the individual pays up front and then is regarded if he or she acts properly. Examples of products where deposit-refunds have been used include beverage containers, tires, batteries, and CFC’s. Deposit-refunds can be an effective way of employing economic incentives when monitoring costs are high.

A bonding system is closely related to deposit-refund systems. With bonding systems, a potential degrader of the environment is required to place a large sum of money in an escrow account. The money is returned if the environment is not damaged.

Liability systems are based on defining legal liability for the damages caused by certain types of environmental damage and facilitating the collection of these damages. The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA) defines legal rights to natural resources to local, sate, and federal governments and specifies methods by which damages may be measured. A related system would require potential polluters to obtain full insurance against damages they might generate. This alternative is associated with a problem of moral hazard, where people with insurance are more likely to engage in risky behavior.

Pollution subsidies pay the polluter a fixed amount of money for each unit of pollution that is reduced. There are several problems associated with the use of subsidies as opposed to taxes. These include the distributional shift of resources toward the polluter, the political unfeasibility of enacting a policy that pays polluters and the potential for polluting industries to appear more cost effective which would encourage firm entrance. In the case of small firms or farms in the informal sector of the economy in developing countries, subsidies could play an important role.

KEY CONCEPTS AND DEFINITIONS

A.C. Pigou - Was among the first to recognize the existence of externalities and the associated divergence between private and social costs and benefits.

Pigouvian taxes - Tax on externality equal to the divergence between private and social costs. First advocated by A.C. Pigou. Most appropriate target of tax is level of offending byproduct rather than output of the firm.

Ronald Coase - Argued against taxing externalities. Believed that a market would develop to correct externality, regardless of property rights allocation.

Coase theorem - In the presence of an externality, as long as negotiation costs are negligible and affected consumers can negotiate freely with each other (when the number of affected parties is small), either party can be allocated the "right" (either to pollute or to not have pollution) and an efficient allocation will result through market transactions.

Transactions costs - those costs that would be associates with the victim and the generator of the externality arriving upon a negotiated level of the externality.

Moral suasion - a term used to describe governmental attempts to influence behavior without actually stipulating any rules which constrain behavior. "Give a Hoot, Don't Pollute"

Command and Control Regulations - also referred to as direct controls. These place constraints on the behavior of households and firms. Violation can result in penalties as specified by law.

Law of Mass Balance - states that an activity can not destroy the material in the reaction, it can only change its form. An implication is that production and consumption will necessarily produce waste.

Marginal damage function - represents the addition to pollution damage that result from an additional unit of pollution emission. Examines the damage that pollution created by degrading the physical and natural environment. This includes effects on flora, fauna, humans, and aesthetics.

Marginal abatement cost function - represents the addition to cost associated with reducing pollution by one additional unit. These costs include costs of labor, capital and energy needed to lessen the emission. May also include the opportunity costs.

Optimal level of pollution emissions - the level which minimizes the total social costs of pollution. This minimization occurs at the point where marginal abatement costs are equal to marginal damages.

Total social costs of pollution - the sum of total abatement costs and total damages.

Marketable pollution permits - sometimes referred to as transferable discharge permits or transferable emission permits. Marketable pollution permits allow firms to bid for necessary permits to achieve economically efficient level of pollution emission.

Ambient based system for permit allocation - through establishment of pollution measuring locations throughout a region (receptors) a measurement could be made of the impact of firm emissions throughout a region and differing permits allocated accordingly. Also allows analysis of the level of impact for pollution emissions across a region.

Deposit-refunds -refunds set up to reward specific recycling behavior. Original price reflects cost of product plus refund. Return of product package results in payment of deposit back to consumer.

Bonding systems - an alternative market method for regulating pollution emission. A large sum of money is placed in escrow by a potential degrader of the environment. This is returned is environment is left in original condition at completion of project.

Liability systems - establishment of rules for allocating legal liability for damage caused by certain types of environmental damages and facilitating the collection of these damages.

Pollution subsidies - built on same premise as tax penalties. Here the firm is paid a per unit subsidy not to pollute, rather than taxed per unit of pollution. Author argues that this changes the incentives in place for market entrance. A subsidy makes this firm more profitable and attracts entrance into industry, which results in more pollution. However, this may be an option in developing countries for small firms and farms.

Chapter 3 Short-answer questions

1. A.C. Pigou was among the first to recognize the existence of externalities. Illustrate and discuss Pigou's approach to correcting market externalities.

· Pigou argued that it would be possible to change behavior within the market through the imposition of taxes. These taxes would raise the cost associated with externality-creating behavior.

2. Ronald Coase argued that the imposition of a tax would not be necessary to correct for market externalities. What was the basis for Coase's belief? Under what circumstances does the Coase theorem apply?

· Coase argued that a market would dvelop for the externality. Those individuals involved I the externality would arrive at an agreement about the appropriate level of the externality. The Coase Theorum applies if the transactions costs associated with the negotiation are small.

3. What are the various problems (as presented in your text) associated with use of Coase theorem?

· Optimal outcome may require asymmetric prices which an efficient market can not develop.

· Coase example of one-to-one negotiation may not generalize to larger numbers.

· Transactions costs are not small.

· It does matter who is assigned the “right” with respect to the externality because there are income effects associated with this right.

· Model ignores the potential for entry into the market in response to the assignment of “rights”.

4. Compare and contrast the four broad classes of government intervention to correct market failure.

· Government influence through moral suasion.

· Government production of environmental quality.

· Government reduction of pollution through partnership with business in the development of new technology.

· Government command and control regulations that mandate the type of actions which will be taken.

· Government tax and subsidies to provide incentives or disincentives which result in environmental improvement.

5. Under what circumstances is it appropriate to use:

- moral suasion

· It is appropriate when people are not being asked to change behavior to a great degree, and when people believe that government policy will develop if they do not respond to moral suasion.

- direct government production of environmental quality

· It is appropriate when costs are very large or problem is spread across large area, for example toxic waste cleanup.

- command and control regulations

· It is appropriate when the optimal amount of pollution is very small and the detrimental effect of the pollutant is very high.

6. What is the law of mass balance and how does it relate to the development of environmental policy?

· Law of mass balance states that the quantity that comes into the economic and social system must be equal to the quantity that flows out of the system. The implication is that production and consumption activities will generate waste. Because the waste that is generated can often have a negative impact on current and future production, it is necessary to consider an optimal use of resources and an optimal level of waste.

7. Define and illustrate a marginal damage function. What happens to marginal damages as pollution levels rise?

· A marginal damage function illustrates the addition to damages associated with pollution as an additional unit of pollution is emitted. Marginal damages can increase, decrease, or stay the same as pollution levels rise. It depends on the type of pollution and the impact on the system.

8. Define and illustrate a marginal abatement cost function. What happens to marginal abatement costs as pollution levels rise?

· A marginal abatement cost function examines the addition to cost of eliminating one addition unit of pollution (abatement). Again, marginal abatement costs can rise, fall, or stay the same depending on the costs associated with eliminating pollution.

9. Illustrate the optimal level of pollution abatement if MAC = 18 - E, where E represents pollution emission and a tax of $4 is applied to the market. How would your graph change if the MAC = 12 - E? What is the new optimal level of emission?

· The optimal level of polluton emissions when MAC = 18 – E and a tax = 4 is where 18-E=4. E = 14. This optimal level will change with the change in MAC. The optimal level of pollution emissions when MAC = 12 – E and a tax = 4 is where 12 – E = 4; E = 8.

10. When is it appropriate to have command and control policies in place to regulate pollution emissions?

· When monitoring costs are high.

· When the optimal level of emissions is at or near zero.

· During random events or emergencies that change the relationship between emissions and damages.

11. Compare and contrast the different economic incentives that can be used to achieve the optimal level of pollution emissions?

· Pollution taxes – here the firm is taxed per unit of pollution. Unlike a subsidy, this will not make the industry more attractive.

· Marketable pollution permits – sometimes referred to as transferable discharge permits or transferable emission permits. Marketable pollution permits allow firms to bid for necessary permits to achieve economically efficient level of pollution emission.

· Deposit-refunds – refunds set up to reward specific recycling behavior. Original price reflects cost of product plus refund. Return of product package results in payment of deposit back to consumer.

· Bonding systems – an alternative market method for regulating pollution emission. A large sum of money is placed in escrow by a potential degrader of the environment. This is returned if environment is left in original condition at completion of the project.

· Liability systems – establishment of rules for allocating legal liability for damage caused by certain types of environmental damages and facilitating the collection of these damages.

· Pollution subsides – built on same premise as tax penalties. Here the firm is paid a per unit subsidy not to pollute, rather than taxed per unit of pollution. Author argues that this changes the incentives in place for market entrance. A subsidy makes this firm more profitable and attracts entrance into industry, which results in more pollution.

12. Define marketable pollution permits and explain how this method of pollution control addresses the shortcoming of command and control policies and emission tax policies.

· Pollution permits are designed to allow firms to choose the optimal level of pollution relative to their individual production process. A pollution permit is an allocation of a set number of pollution emission levels to each firm. A firm can use all of these emissions or sell some of these rights to other firms. A total emission level can be set through the issuance of a limited number of permits. It is also possible to design a pollution permitting system that addresses regional differences in pollution levels.

13. What are the difficulties associated with using marketable pollution permits when pollution emissions cross state boundaries?

· It is necessary to have regulators across state boundaries as well. It is also necessary to have a monitoring system that would operate across state boundaries.