I am going to address the question of the best way to achieve the optimal level of pollution by focusing on market-based systems to control carbon emissions. By discussing this area of the debate about environmental protection I will consider the strengths and weaknesses of the various ways available to governments of controlling pollution before consolidating my view that the best way to achieve the optimal level of pollution is (although not through this method alone) through market-based emissions control mechanisms. These will play a huge, and; I believe increasingly larger role in the fight against CO2 pollution, which (almost unequivocally) contributes to global warming.
When doing their accounting and setting the price level in a competitive market, firms usually consider only the explicit costs of production; this includes wages, materials and rent for the production of its goods. Assuming a competitive market, on the supply and demand diagram, this would be the supply curve and the marginal private cost curve as well (MPC).
An externality in production occurs when the firm produces one or more additional products, as an undesired by-product in the pursuit of producing the desired or target good. Externalities can be either negative or positive, although are more often negative (hence pollution occurring).
The production of these additional products can be plotted on a supply & demand diagram by giving the externality a cash value. This will usually be an upward sloping curve. If we add the value of the externality to the value of the supply curve, and assuming pollution occurs, then this will mean that the new figures will give us the marginal social cost curve, which we would expect to be above the MPC curve (see diagram below).
If the firm’s production of its goods involves a negative externality, then it thus under-estimates the value of its goods, and sells its goods too cheaply if it does not also make a charge to cover the cost of this externality. The firm in this example has failed to consider the true and full cost of the production of its product and the marginal social cost (MSC) to society.
The economist would argue that the best way to reduce pollution is to make the private marginal cost of production equal the marginal social cost of production. That would the give the full cost of production back to a producer. To do this a variety of market-based pollution control mechanisms can be employed.
Considering an example of a paint manufacturer, the firm sells a tin of paint at a cost that covers its rent, materials, wages of staff and some return for the owners of the factory (assuming only normal profit). This means that any cost associated with the externality, (in this case the pollution of the atmosphere with gases, the local river with pollution and the surrounding soil contaminated with the pollution from the river,) is not accounted for by the firm. Assuming a competitive market, our firm will produce paint and sell it at the equilibrium price for that quantity of units; therefore, the MPC curve is also our supply curve.
The externality is plotted on the diagram below as the marginal pollution cost, and the (horizontal) sum of the marginal pollution cost and the marginal private cost is the marginal social cost curve. This is the true cost of production taking into account the private cost of production (those already considered by the firm) plus the cost of neutralising the negative externality, in this case the pollution of gas into the atmosphere.
The air pollution caused by the paint manufacturers could also have an adverse affect on the crop farmer nearby who grows vegetables. This excess pollution causes her crops to be stunted in growth due to a poorer quality of soil, influenced by the pollution of the local atmosphere. This outcome, does not reflect an allocation of resources which maximises total social well-being. The paint manufacturer is encouraged to over-produce paint and the farmer is discouraged from producing what would otherwise be the optimal level of production. The farmer is under-using the natural resources of the environment and the paint manufacturer is over-using the same natural resources of the environment.
In the diagram below, production would naturally reach the equilibrium point, assuming a competitive market. This would be at point ‘a’ (P0Q0) where our supply curve (S0) crosses the demand curve (D). As we can see this is below point B on the MSC curve and the difference here is the amount by which social well-being is being reduced by.
Therefore, for each unit of production Society’s well-being is reduced by the difference between points ‘a’ and ‘c’. If production is cut to point ‘b’, this will mean a lower production of the good, paint. What is produced will be sold for a price that covers the true cost to society of producing the good. What must happen for this to truly increase society’s well-being is that it must then be used to offset the pollution created, not simply go as profit for the company or its shareholders.
(adapted from Economics of Social Issues. p102 & 105)
In this economic view, there is obviously some pollution, but as we can see, the problem is that the cost of dealing with or neutralising the pollution is not intrinsic in production. The firm is able to avoid paying for this neutralisation in an attempt to increase its sales and profit. Rational firms aim to maximize profit and this must be understood when dealing with pollution. Rational firms are not in business to maximise social well-being. The firm sells its goods too cheaply and it is therefore passing on the cost of the externality to others using the environment. This may be in terms of reduced air quality for other firms or it may have a personal cost for individuals who may have reduced air quality or being exposed to poisonous toxins leading to poor health.
Market-based mechanisms as well as direct environmental taxation attempt to deal with the cost of externalities by making it the responsibility of the firms that produce the pollution, either directly and proportionally; or indirectly and with less precise results, if any.
Economists would argue that when a product is sold at the equilibrium point where supply=demand; then if no externalities are produced, they would conclude that a market equilibrium of necessity is achieved and this must truly be the optimal situation. This is the point at which social well-being is maximised, natural equilibrium. However, when there is an externality, this means that social well-being is being damaged by each additional unit of production.
The economist in this situation appears to be discussing a magic wand situation. The ideas above appear to suppose:
- There is a method of calculating the marginal cost of pollution and then the marginal social cost.
- There is a way to rectify the imbalance of firms who produce a negative externality but do not pay for the neutralisation of it.
Market-based methods are varied in their approach. Below is a very short summary of ones I have read about and will discuss below:
- Direct controls, includes banning and limiting the volume of pollution that is allowed to be released into the atmosphere by producers.
- Direct taxes as indirect control, such as direct taxes per unit of production, or direct taxes per unit of pollution for example a tax per packet of cigarettes manufactured/sold.
- Indirect taxes as indirect control, such as a general tax per mile on drivers of cars without pollution gauges fitted.
- A pollution rights market has the primary aim of removing the incentive to discharge pollutants into the environment, by limiting the amount by which firms are able to pollute. Firms have the incentive to successfully meet their limits then (to reduce further and) to sell their excess as a credit to other less successful firms, such as the one implemented by the European Union for industry within the European Union.
There are problems with each of these methods and so it is difficult for governments to implement one alone as the preferred option of control for all industries.
The amount of an externality produced can be difficult to quantify scientifically in the case of firms with varying output; this makes economically quantifying the output of an externality almost impossible to do accurately.
It is argued that an emissions target of 5.2% as is the goal of the Kyoto protocol will make only an insignificant difference to climate change. I personally feel strongly that the target of 5.2% had to be so low to get a significant number of the world’s nation states on board. As we have seen recently in the news, Australia’s new Prime Minister has recently signed the Kyoto Protocol. His predecessor John Howard, felt differently; and would not agree to Australia’s inclusion. If more countries can be persuaded and eventually encouraged to ratify while the target is low and considered achievable; then this will give us a fantastic starting point for future more challenging targets, once new rounds of talks begin for an agreement that might replace the Kyoto protocol in 2012.
It is argued that limiting the emissions of developing nations will also be to restrict their development and limit their opportunity for Economic growth. This would lead to increased tensions between the North (developed (typically Western nations) and the South (developing (typically Asian, South American and African nations). Tensions such as these could lead to hostility and a rebuff of international climate change Protocols by the developing nations, which may cause a domino effect and would in effect create a stalemate situation that could last for many years, and more importantly could last for many thousands of tonnes of CO2 pollution.
It is argued by President Bush of America, that the Kyoto protocol could have negative and economically devastating consequences on America. He cites economic stagnation and a possibly unfair disadvantage for America, as it would experience an inability to compete competitively with developing nations such as China and India if America were to ratify the treaty.
The pollution rights trading scheme comes under criticism of its allowances. It is a possibility that if the allowance is too high, then the price will fall to no real value, although through careful management by the government, it could control the price of the pollution rights. The state’s optimal level of pollution could be reached by buying back from the market surplus stock of rights and thus increasing the scarcity in the market. This would be along similar lines as to how the government (of the UK for example) controls the value of its money supply in the money market.
An advantage of the tradable market permits scheme is that it gives firms a direct knowledge of the costs of their pollution. In an economy where no pollution rights market exists, firms have no incentive to reduce their pollution, as they will usually still have to pay their industry tax in addition to meeting the cost of the new technology to decrease their pollution output.
I have considered the question of the best way to achieve the optimal level of pollution by focusing on market-based systems to control carbon emissions released into the atmosphere. Whilst discussing this area of the environmental protection debate, I have considered the strengths and weaknesses of the opinions, in favour and against the variety of pollution control mechanisms available to governments; including the difficulty in ascertaining the level of pollution produced by individual firms and the difficulty of nation states’ governments to implement control of this and monitoring to effectively manage the pollution levels, whether direct, indirect or pollution rights markets is the preferred and employed option. I have discussed the difficulty of taxes and the lack of ring-fenced taxation to ensure parity of pollution neutralisation and pollution taxation. I have discussed the weaknesses of indirect taxation as an ineffective tool to reduce pollution as it has little or no incentive for firms to take action to achieve the optimal level of pollution.
I have argued that although market-based emissions control is not the whole solution to the problem, it appears to me, from the research I have done, the material I have read and lectures I have attended to be the best method to achieve the economically optimal level of pollution. These will play a huge, and, I believe increasing role in the fight against CO2 pollution, with organisations such as the United Nations and the European Union leading in the implementation of these policies.
* Bannock, Baxter & Davis. (1992), Dictionary of Economics, Penguin, London.
* Harford, T. (2006), The Undercover Economist, Little Brown Book Group, London.
* O’Riordan, T. (ed.) (1997), Ecotaxation, Earthscan, London.
* Sloman, J. (2006), Economics, sixth edition, Prentice Hall, Essex.
* Sharp, Register & Grimes. (2006), Economics of Social Issues, seventeenth edition, McGraw Hill, New York.