Markets, Pollution, and Solutions

Danielle Tonnies




            Pollution in the world today is a problem for the environment and the people living there.  The pollution problem arises from the use of the environment by producers and consumers as a dumping ground for wastes.  The environment can be defined as the air, water, and land around us.  It provides with a variety of important services, including a place for humans to live and resources with which to produce goods and services.  As humans use the environment to transform raw materials into final goods and services to satisfy human wants, it is affected in three major ways.  First of all, some of the earth’s nonreplicable resources, such as coal, petroleum, and many mineral deposits, may be diminished.  Second, humans also may use replaceable resources like timber, grassland, oxygen, and nitrogen.  Third, the environment is used as a place to dispose of the wastes of production and consumption. 

This third point is of most concern to us.  Humans litter the land with cans, paper, and other materials, dump the emissions from our automobiles and factories into the atmosphere, and empty sewage directly and indirectly into streams, rivers, and lakes.  As these wastes from production and consumption are dumped into the environment, nature sets in motion recycling processes.  However, pollution consists of piling the environment with wastes that are not completely recycled, are not recycled fast enough, or are not recycled at all.  It also involves a lessening of the capacity of the environment to yield environmental services.  Pollution happens when recycling processes fail to prevent wastes from accumulating in the environment.

Pollution is not a new concept.  It has been around just as long as the human race has.  Wherever people came together to live, their wastes would pile up faster than the forces of nature could digest and recycle them.  Then, as places became denser with people, and cities and towns were formed, pollution got worse and worse.  There are three main forms of pollution:  air pollution, water pollution, and land pollution.  Air pollution results from five major wastes being dumped into the atmosphere:  carbon monoxide, sulfur dioxide, nitrogen oxides, hydrocarbons, and particulates.  Water pollution results from certain materials and toxins being disposed of in bodies of water, such as lakes, rivers, and streams, and is measured in terms of the capacity of water to support aquatic life.  Land pollution results from the dumping of a variety of wastes on the terrain and from tearing up the Earth’s surface.

Why does pollution occur?  Ordinarily, pollution results from one or both of two factors.  First, property rights that exist in the environment being polluted are either nonexistent or not enforced.  If no one owns a portion of the environment or if an owner cannot regulate it or have it regulated, then it becomes possible for people to use a river, the air, or land as a wastebasket without being charged for doing so.  Second, the entire population shares much of the environment’s services, so no one person takes responsibility of keeping it clean.  When values cannot be placed on the amounts of environmental services used by any one person, it is difficult to persuade people not to pollute by charging them for doing so.

Pollution affects resource allocation.  First of all, supply curves indicate the marginal private cost of producing a good or service.  This includes both explicit costs and implicit costs.  Explicit costs are the costs of production incurred by the producer to buy or hire the resources required to carry on business.  Implicit costs, however, are the costs of production incurred by the producer for the use of self-owned, self-employed resources required to carry on business.  What would not be included in the supply curve would be costs for resources used that firms do not pay for.  For example, if companies use a local river or stream for waste disposal and do not pay for the right to do so, no charge is incurred by the companies.

Although the use of the river does not show up on the companies’ cost ledger, society, as a whole is who pays for it.  The use of the river for waste disposal creates a negative externality (a cost to society) in production.  In turn, the marginal social cost of production will be greater than the marginal private cost of producing.  This can be shown in a graph like the one below.  The graph represents a market for some good where the producer pollutes.  The curve labeled MSC represents the cost to society to produce this good, while the curve labeled MPC represents the private cost to the producer.  Notice that the MPC curve shows that it would cost them $25 to produce 6 units of this good.  Then, notice that the MSC curve exceeds the MPC.  This is because society bears the burden of the negative externality created by the firm’s pollution.  The cost to society to produce 6 units of this good is $35.   

When a company is not required to bear the full cost of production, they are able to shift some of their costs onto society.  This artificial reduction in cost to producers induces an overproduction of goods.  For this reason, we can say that polluters face an incentive to overproduce and use relatively too much of society’s scarce resources.  This overproduction causes social well being to be restricted below its maximum potential level. 

Sometimes, another producer will bear the cost of the externality caused by a producer that polluted instead of society.  This artificially raises the cost of production for the producer who bears the pollution cost, and then they are faced with an incentive to underproduce, using too few of resources.  Any time the cost of production arises, whether artificially or not, the logical thing for a producer to do is to reduce supply.  In summary, when a negative externality in production exists, like pollution, the outcomes in the markets for both the polluting company and the company who bears some costs do not reflect an allocation of resources that maximizes social well-being.   In each market, then, there is resource misallocation, and when resources are misallocated, it is the general public that suffers lost well-being.

What is the appropriate level of pollution control?  Humans feel that we are entitled to clean air, clean water, and clean land, but how clean is clean?  Cleanliness, like goodness, is a relative rather than an absolute quality.  The appropriate level of pollution control should be determined by comparing the costs and benefits of keeping the environment clean. 

Pollution controls have some costs associated to them.  An industrial plant that scrubs or cleans its combustion gases before discharging them into the atmosphere must use resources in the process.  Labor and capital go into the making and operation of antipollution devices, and these resources used are not available to produce other goods and services.  The value of the goods and services that must be given up is the cost of the plant’s pollution control activities.   (Helfand)

There are also benefits to controlling pollution.  The main benefit is the increase in well-being that members of society feel when they are living in a cleaner environment.  To measure the benefits of a pollution control activity, the value of the increase in well-being that it generates must be accurately estimated.  An estimate is gathered by asking individuals living in the area that needs pollution control how much the reduction in pollution would be worth to him/her personally.  By totaling the replies, we could arrive at a dollar value of the expected benefits.

Once the costs and benefits of pollution control are determined, it becomes possible to begin the appropriate level of control by implementing a cost-benefit analysis.  If the marginal social benefit of additional control is greater than the marginal social cost, then pollution control should be expanded.  Thereafter, pollution control should only be expanded up to the point where the marginal social benefit just ceases to exceed the marginal social cost, because marginal social benefit may decline as the level of pollution control increases.  This may occur because the greater amount of control, the less urgent additional control becomes.  Therefore, the appropriate level of control is the one that approaches as closely as possible the level where the marginal social benefit equals marginal social cost.

We, as humans, want things that are bad for us, such as pollution, to go away as fast as they came.  We also often react to problems with our emotions rather than with logic.  Policies recommended to control pollution reflect this human characteristic.  A typical recommendation calls for direct control of pollution by the state.  This is only one of many different ways to reduce pollution problems.  Others include indirect control by the state through a system of incentives encouraging potential polluters not to pollute or at least to limit their pollution, and the creation by the state of markets for the right to pollute. 

Direct controls are used by the government to control pollution and are appealing and simple.  They consist of simply banning pollution activities or agents.  For example, if phosphates contaminate water, then the government would ban the use of phosphates in detergents.  If DDT pollutes water and land, they would ban the use of DDT.  If the burning of fuel oil and coal increases the sulfur dioxide content of the atmosphere, they would prohibit their use, and so on. 

Government agencies such as the Environmental Protection Agency (EPA) use direct controls to reduce many kinds of polluting activities.  They set and attempt to enforce emission standards for polluters, such as automobiles, power plants, and steel mills.  The EPA in general, supervises state regulation of polluters, to the extent it is completed.  Again, direct controls should usually aim at a less idealistic goal than a pollution-free environment.

There a few problems that arise from the use of direct controls.  First of all, they give one regulatory body the full responsibility of determining the economically desirable levels of pollution.  However, this is not an insoluble problem.  Tolerance limits on the amount of pollution to be allowed can be logically set.  Within those limits, overall costs can be weighed continually against benefits to establish an approximation of the desirable levels of pollution.

Another problem with direct controls is the difficulty facing the regulatory body in reaching an efficient allocation of the permissible pollution among different polluters.  For example, it may cost less for a power company to eliminate their pollution than for a steel mill to do so.  Therefore, in the interests of economic efficiency, it should be required that the power plant reduce its pollution instead of the steel mill because it is less costly.  This is a difficult decision for a regulatory body to do because it is responsible to a political body for which economic efficiency is not a primary goal.  Also, it is unrealistic to assume that the regulatory body has a working knowledge of the nature of costs for every polluter.

A third trouble for direct controls is that it would be hard for the regulatory body to enforce the standards of emissions once it has been determined what those standards should be.  Direct controls fail to provide polluters with an economic incentive not to pollute.  In fact, it will pay them to seek ways and means to avoid the pollution standards set for them.  However, we should not overstate the enforcement problem; almost any prohibition of activities that individuals and business firms want to engage in creates enforcement problems.

Indirect controls are an alternative way to control pollution.  The government uses indirect controls by placing taxes on pollution activities.  Where the amounts of polluting discharges can be measured for individual polluters, a tax can be placed directly on each “unit” of discharge.  This will encourage the polluter to reduce the amount or units of pollution that is discharged.  However, in some cases, such a measurement is not possible.  Polluters, then, may be taxed indirectly.  For example, automobiles not equipped with pollution control devices can be subjected to a tax on a mileage basis.  This would persuade the owners of the automobiles to install pollution control devices or drive less (or carpool).

Taxes on polluting activities have its negative aspects.  At some point along a firm’s marginal cost curve the tax charged for pollution is less than the cost of pollution control to the firm.  At this point and beyond it, the firm is going to choose to just pay the tax and not control its pollution.  How effective, then, is the tax? 

It is also equally important to realize that these taxes can lead to less than optimal outcomes.  For example, a tax too high will result in too much pollution control effort and, thus, too much of the economy’s scarce resources devoted to pollution control.  In the same respect, a tax too low will result in too little control and too little of the economy’s resources dedicated to this purpose.  We can see this in a graphical form.  Notice that at T1, the marginal cost greatly exceeds the marginal benefit; therefore the tax is too high.  Also, at T2 the marginal cost is way less than the marginal benefit; therefore the tax is too low.  An ideal tax rate lies at T* where the costs and benefits are equal.

The use of taxes to control pollution has its advantages.   The major one is that it encourages the polluter to seek improved ways and means of avoiding or cleaning up its discharge.  Also, it prevents the polluter from shifting some of its production costs to others and reduces the incentive to overproduce. 

Along with its advantages, a tax to control pollution also has its disadvantages.  First of all, it is difficult to determine the total and marginal benefits to society of cleaning the discharge.  However, this critique should not be carried too far, since it applies to any attempt at controlling pollution.  Like direct controls, indirect controls (taxes) are also hard to enforce.  Policing is necessary to determine that the discharge is indeed properly cleaned.  Lastly, taxes are put into effect by political rather than economic bodies, and politics may well get in the way of the enactment of appropriate tax levels.

As discussed earlier, the absence of well-defined property rights to the use of the environment’s services is the primary source of pollution problems.  The creation of pollution rights markets just may be the answer to bring about the optimal level of pollution control in a cost-efficient manner.  A pollution rights market exists when firms are allowed to buy and sell government-issued licenses granting the holder the right to create a certain amount of pollution.  Specifically, the state can determine how much discharge it wishes to allow based on marginal social benefit and marginal social cost analysis.  They then print licenses or permits that in total permit the holders the right to discharge the optimal amount, and then allocate to the polluting firms a share of these licenses. 

Suppose, then, that after a market for pollution rights has been in operation for some time in a specific area, an equilibrium price is recognized such that a firm can purchase the right to dump 100,000 gallons of discharge for $1,000.  Any firm or plant that is capable of making a 100,000-gallon reduction in discharge for less than $1,000 could increase it’s profits by making the reduction and then selling its license to dump 100,000 gallons of discharge to another firm.  Plus, any firm that could only reduce its discharge of 100,000 gallons of discharge at a cost higher than $1,000 would be happy to buy this license because the difference between the license price of $1,000 and the cost of the reduction in discharge would be directly added to profits.  The good thing about a pollution rights market is that if the state government decides later down the road that the overall level of pollution must be reduced, they would need only to buy back some of the licenses it had previously made available to the market.  In this way, the state can achieve any particular level of pollution control it wishes and it can be sure that any needed reductions in pollution will be made where it is cheapest to do so. 

Interestingly, the use of pollution rights licenses and the resulting creation of a pollution rights market has been put into effect.  In the Clean Air Act of 1990, the federal government took its first steps in the direction by allowing electric companies to trade in sulfur dioxide licenses.  Particularly, the act allowed roughly 100 utilities operating mainly in the Midwest to produce a certain amount of sulfur dioxide discharge each year.  Firms that could reduce their discharge cheaply were allowed to sell their licenses, and then firms that could not reduce their discharge as cheaply could purchase the right to continue to pollute, just as discussed above.  The program has been into effect now for just a little over a decade and it is clearly working out well, leading to a fall in sulfur dioxide emissions of more than half, easily surpassing the targets embodied in the program’s authorized legislation.  Equally important, these emission reductions have occurred in a cost-effective manner, with some estimates suggesting that the reductions were achieved at about one-fourth the expense predicted at the program’s beginning.

The Clean Air Act was not always such a success, however.  In the 1970s, a Clean Air Act was passed that set strict rules on pollution control, but only for “new” sources of pollution.  Existing power plants, factories and so on were safe from the regulations of the Act.  The idea was that over time, old, dirty facilities would close down.  The result, however, was predictable:  Polluters kept those old facilities operating, precisely because they were exempted from the new rules.  Indeed, corporations poured money into existing power plants and factories, expanding their capacity, rather than build new ones.  (Krugman, Paul)

Economics has had a growing role in the United States’ environmental decision making.  This is because given the high level of current U.S. expenditures on environmental quality, it is reasonable to ask whether the improvements such expenditures make possible are large enough and important enough to justify them.  This question, of course, lies in economics, which not only focuses on the efficiency of resource use in general, but also provides specific analytical tools for addressing such issues.  Therefore, Bills debated in Congress have tried to enlarge the role of economics by forcing the use of cost-benefit analysis.  (Portney, Paul R.)

While economics may be more and more influencing environmental issues, there are some that say economists can do more to help protect the environment.  Keith Suter from the Contemporary Review states that, “Economists prefer dead trees”.  He says that a tree standing in a forest has no standing in economics, and does not carry out an “economic” role.  However, as soon as the tree is cut down, broken into small components, and made into paper or matchsticks it becomes important to economics.  However true this may be, economics has still proved to aid in the decision-making of environmental issues and will continue to do so.  (Suter)

In summary, we have concluded that the pollution problem arises from the use of the environment by producers and consumers as a dumping ground for wastes and also from the lack of property rights.  Also, that pollution can cause an artificial reduction or rise in the cost of production, which in turn can cause an incentive to overproduce or underproduce, respectively, causing resource misallocation.  The appropriate level of pollution control should be determined by preparing a cost-benefit analysis.  The government can use either direct controls or indirect controls, both having advantages and disadvantages, to regulate pollution.  We have found that the most successful way of controlling pollution has been through the establishment of a pollution rights market where the state can make certain that any desired level of pollution control can be accomplished in the way that places the least burden on the economy’s scarce resources.


Works Cited

Helfand, Gloria E.  “Pollution Permits and the Economics of Pollution Reduction”

Johnson, Huey D.  “Whose Earth Is It Anyway?”  UN Chronicle.  September-November, 2002.

Krugman, Paul.  “Economics and Pollution Control”.  April 26, 2002.

Portney, Paul R.  “Counting the Cost:  The Growing Role of Economics In Environmental Decision Making.”  Environment.  March, 1998.

Sharp, Ansel M., Charles A. Register, and Paul W. Grimes.  Economics of Social Issues.  New York:  McGraw-Hill/Irwin, 2004.

Suter, Keith.  “Making the Environment Count.”  Contemporary Review.  April 2003.