Key Concepts

After completing this chapter, you will be able to:

1. Know how economists define environmental outcomes that make society as well off as possible.
2. Understand what externalities are, and how they can lead to outcomes with too much pollution and resource exploitation.
3. Be able to define public goods and common-property resources, and understand how those things are prone to under-provision and over-exploitation, respectively.
4. Understand why it might be useful to develop estimates of the values of environmental goods in dollar terms.
5. Know the difference between the two economic measures of value, willingness to pay and willingness to accept.
6. Be familiar with valuation methods in all three parts of the environmental valuation toolkit: direct, revealed preference, and stated preference methods.
7. Understand the strengths and weaknesses of those valuation methods.
8. Know five important features of how economists think about costs.
9. Understand why discounting is both important and controversial, and be able to calculate the net present value of a project or policy.
10. Know what cost-benefit analysis is, and be aware of some of its limitations.
11. Identify four criteria for evaluating a project that are not captured in a basic cost-benefit analysis.
12. Know why having clearly defined property rights might improve environmental outcomes and be aware of the limitations of that approach.
13. Define several different types of command and control regulations, and understand their comparative advantages.
14. Know what incentive policies (taxes and tradable permits) are, what they do, and what their strengths and weaknesses are.

Introduction

The field of environmental and natural resource economics sounds to many like an oxymoron. Most people think economists study money, finance, and business—so what does that have to do with the environment? Economics is really broadly defined as the study of the allocation of scarce resources. In other words, economics is a social science that helps people understand how to make hard choices when there are unavoidable tradeoffs. For example, a company can make and sell more cars, which brings in revenue, but doing so also increases production costs. Or a student can choose to have a part-time job to reduce the size of the loan she needs to pay for college, but that reduces the time she has for studying and makes it harder for her to get good grades. Some economists do study business, helping companies and industries design production, marketing, and investment strategies that maximize their profits. Other economists work to understand and inform the choices individuals make about their investments in education and how to divide their time between work, leisure, and family in order to make themselves and their families better off. Environmental and natural resource economists study the tradeoffs associated with one of the most important scarce resources we have—nature.

Economists contribute to the study of environmental problems with two kinds of work. First, they do normative studies of how people should manage resources and invest in environmental quality to make themselves and/or society as well off as possible. Second, they do positive analyses of how human agents—individuals, firms, and so forth—actually do behave. Normative studies give recommendations and guidance for people and policy makers to follow. Positive studies of human behavior help us to understand what causes environmental problems and which policies are most likely to work well to alleviate them.

This chapter gives an overview of a few of the key ideas that have been developed in this field. First, we will learn the economic theories that help us understand where environmental problems come from and what makes something a problem that actually needs to be fixed. This section of the chapter will introduce the concepts of externalities, public goods, and open access resources, and explain how in situations with those features we often end up with too much pollution and excessive rates of natural resource exploitation. Second, we will learn the tools economists have developed to quantify the value of environmental amenities. It is very difficult to identify a monetary value for things like clean air and wildlife, which are not traded in a marketplace, but such value estimates are often helpful inputs for public discussions about environmental policies and investments. Third, we will discuss a set of approaches economists use to evaluate environmental policies and projects. We want to design policies that are “good,” but what exactly does that mean? Finally, we will learn about the different policy tools that can be used to solve problems of excess environmental degradation and resource exploitation, including a set of incentive policies that were designed by economists to work with rather than against the way that people really behave, and we will discuss the strengths and weaknesses of those different tools.

Tragedy of the Commons

To identify and solve environmental problems, we need to understand what situations are actually problems (somehow formally defined) and what circumstances and behaviors cause them. We might think that it is easy to recognize a problem—pollution is bad, saving natural resources is good. However, critical thinking often reveals snap judgments to be overly simplistic. Some examples help to illustrate this point.

• Running out! Oil is a depletable resource, and many people worry that rapid extraction and use of oil might cause us to run out. But would it really be a bad thing to use up all the oil as long as we developed alternative energy technologies to which we could turn when the oil was gone? Is there any intrinsic value to keeping a stock of oil unused in the ground? Running out of oil someday may not be a problem. However, subsidies for oil extraction might cause us to run out more quickly than is socially optimal. Other inefficiencies arise if multiple companies own wells that tap the same pool of oil, and each ends up racing to extract the oil before the others can take it away—that kind of race can increase total pumping costs and reduce the total amount of oil that can be gleaned from the pool.
• Biological pollution! Horror stories abound in the news about the havoc raised by some nonnative animal and plant species in the United States. Zebra mussels clog boats and industrial pipes, yellow star thistle is toxic to horses and reduces native biodiversity in the American West, and the emerald ash borer kills ash trees as it marches across the landscape. From the current tone of much media and scientific discourse about nonnative species, one could conclude that all nonnative species are problems. But does that mean we should forbid farmers in the U.S from growing watermelons, which come from Africa? Or should we ship all the ring-necked pheasants back to Eurasia whence they originally came, and tell North Dakota to choose a new state bird? The costs and benefits of nonnative species vary greatly – one policy approach is not likely to apply well to them all.

This section first explains the way economists think about whether an outcome is good. Then it describes some of the features of natural resources and environmental quality that often trigger problematic human behaviors related to the environment.

Efficiency and Deadweight Loss

Ask anyone who lived during the centrally-planned, nonmarket economy years of the Soviet Union—markets are very good at many things. When a product becomes scarcer or more costly to produce we would like to send signals to consumers that would cause them to buy less of that thing. If an input is more valuable when used to produce one good than another, we would like to send signals to firms to make sure that input is put to its best use. If conditions are right, market prices do these useful things and more. Markets distribute inputs efficiently through the production side of the economy: they ensure that plant managers don’t need to hoard inputs and then drive around bartering with each other for the things they need to make their products, and they arrange for efficient quantities of goods to be produced. Markets also distribute outputs among consumers without surpluses, shortages, or large numbers of bathing suits being foisted upon consumers in Siberia.

Economists mean something very specific when they use the word efficient. In general, an allocation is efficient if it maximizes social well-being, or welfare. Traditional economics defines welfare as total net benefits—the difference between the total benefits all people in society get from market goods and services and the total costs of producing those things. Environmental economists enhance the definition of welfare. The values of environmental goods like wildlife count on the “benefit” side of net benefits and damages to environmental quality from production and consumptive processes count as costs.

Under ideal circumstances, market outcomes are efficient. In perfect markets for regular goods, goods are produced at the point where the cost to society of producing the last unit, the marginal cost, is just equal to the amount a consumer is willing to pay for that last unit, the marginal benefit, which means that the net benefits in the market are maximized. Regular goods are supplied by industry such that supply is equivalent to the marginal production costs to the firms, and they are demanded by consumers in such a way that we can read the marginal benefit to consumers off the demand curve; when the market equilibrates at a price that causes quantity demanded to equal quantity supplied at that price (Q_market in Figure 29.1), it is also true that marginal benefit equals marginal cost.

Figure 29.1. Market Equilibrium. A private market equilibrates at a price such that the quantity supplied equals the quantity demanded, and thus private marginal cost equals private marginal benefit. Source: Amy Ando

Even depletable resources such as oil would be used efficiently by a well-functioning market. It is socially efficient to use a depletable resource over time such that the price rises at the same rate as the rate of interest. Increasing scarcity pushes the price up, which stimulates efforts to use less of the resource and to invest in research to make “backstop” alternatives more cost-effective. Eventually, the cost of the resource rises to the point where the backstop technology is competitive, and the market switches from the depletable resource to the backstop. We see this with copper; high prices of depletable copper trigger substitution to other materials, like fiber optics for telephone cables and plastics for pipes. We would surely see the same thing happen with fossil fuels; if prices are allowed to rise with scarcity, firms have more incentives to engage in research that lowers the cost of backstop technologies like solar and wind power, and we will eventually just switch.

Unfortunately, many conditions can lead to market failure such that the market outcome does not maximize social welfare. The extent to which net benefits fall short of their potential is called deadweight loss. Deadweight loss can exist when not enough of a good is produced, or too much of a good is produced, or production is not done in the most cost-effective (least expensive) way possible, where costs include environmental damages. Some types of market failures (and thus deadweight loss) are extremely common in environmental settings.

Externalities

In a market economy, people and companies make choices to balance the costs and benefits that accrue to them. That behavior can sometimes yield outcomes that maximize total social welfare even if individual agents are only seeking to maximize their own personal well-being, because self-interested trades lead the market to settle where aggregate marginal benefits equal aggregate marginal costs and thus total net benefits are maximized.

However, people and companies do not always bear the full costs and benefits associated with the actions they take. When this is true, economists say there are externalities, and individual actions do not typically yield efficient outcomes.

A negative externality is a cost associated with an action that is not borne by the person who chooses to take that action. For example, if a student cheats on an exam, that student might get a higher grade. However, if the class is graded on a curve, all the other students will get lower grades. And if the professor learns that cheating happened, she might take steps to prevent cheating on the next exam that make the testing environment more unpleasant for all the students (no calculators allowed, no bathroom breaks, id checks, etc.). Negative externalities are rampant in environmental settings:

• Companies that spill oil into the ocean do not bear the full costs of the resulting harm to the marine environment, which include everything from degraded commercial fisheries to reduced endangered sea turtle populations).
• Commuters generate emissions of air pollution, which lowers the ambient quality of the air in areas they pass through and causes health problems for other people (See Image 29.1).
• Developers who build houses in bucolic exurban settings cause habitat fragmentation and biodiversity loss, inflicting a cost on the public at large.

Image 29.1. Negative Externality: Smog. A NASA photograph of the atmosphere over upstate New York, with Lake Eire (top) and Lake Ontario (bottom) featured. Both natural, white clouds and man-made smog (grey clouds below) are visible. The smog is an example of a negative externality, as the cost of the pollution is borne by everyone in the region, not just by the producers. Source: NASA.

In situations where an action or good has a negative externality, the private marginal cost that shapes the behavior of an agent is lower than the marginal cost to society as a whole, which includes the private marginal cost and the external environmental marginal cost. The efficient outcome would be where the social marginal cost equals the social marginal benefit (labeled Q_efficient in Figure 29.2). Unfortunately, the free-market outcome (labeled Q_market in Figure 29.2) will tend to have more of the good or activity than is socially optimal because the agents are not paying attention to all the costs. Too much oil will be shipped, and with insufficient care; people will drive too many miles on their daily commutes; developers will build too many new homes in sensitive habitats. Thus, there is deadweight loss (the shaded triangle in the figure); the marginal social cost associated with units in excess of the social optimum is greater than the marginal benefit society gets from those units. Public policy that reduces the amount of the harmful good or activity could make society as a whole better off.

Figure 29.2. Inefficiency from Negative Externality. When there is a negative externality, the market equilibrates where the total social marginal cost exceeds the marginal benefit of the last unit of a good and society is not as well off as it could be if less were produced. Source: Amy Ando

Conversely, a positive externality is a benefit associated with an action that is not borne by the person who chooses to take that action. Students who get flu shots in October, for example, gain a private benefit because they are less likely to get the flu during the winter months. However, their classmates, roommates, and relatives also gain some benefit from that action because inoculated students are less likely to pass the flu along to them. Positive externalities exist in the world of actions and products that affect the environment:

• A homeowner who installs a rain barrel to collect unchlorinated rainwater for her garden also improves stream habitat in her watershed by reducing stormwater runoff. 
• A delivery company that re-optimizes its routing system to cut fuel costs also improves local air quality by cutting its vehicle air pollution emissions.
• A farmer who plants winter cover crops to increase the productivity of his soil will also improve water quality in local streams by reducing erosion.

In situations where an action or good has a positive externality, the private marginal benefit that shapes the behavior of an agent is lower than the marginal benefit to society as a whole, which includes the private marginal benefit and the external environmental marginal benefit. The efficient outcome would be where the social marginal cost equals the social marginal benefit (labeled Q_efficientin Figure 29.3). In the presence of a positive externality, the free-market outcome will tend to promote less of the good or activity than is socially optimal because the agents do not reap all the benefits. Too few rain barrels will be installed; not enough delivery routes will be re-optimized; too few acres of agricultural fields will have cover crops in the winter months. Again there is deadweight loss (the shaded triangle in the figure), but this time because the marginal social benefit associated with some of the units not produced would have been greater than the marginal costs of producing them. Just because an externality is positive rather than negative doesn’t mean there isn’t a problem; public policy could still make society as a whole better off.

Figure 29.3. Positive Externality. When there is a positive externality, the market equilibrates where the total social marginal benefit exceeds the marginal cost of the last unit of a good and society is not as well off as it could be if more were produced. Source: Amy Ando

Public Goods and Common-pool Resources

Market outcomes are almost never efficient in two broad kinds of cases: public goods and common-pool resources. The market failures in these settings are related to the problems we saw with negative and positive externalities.

A pure public good is defined as being nonexclusive and nonrival in consumption. If something is nonexclusive, people cannot be prevented from enjoying its benefits. A private house is exclusive because doors, windows, and an alarm system can be used to keep nonowners out. A lighthouse, on the other hand, is non-exclusive because ships at sea cannot be prevented from seeing its light. A good that is nonrival in consumption has a marginal benefit that does not decline with the number of people who consume it. A hot dog is completely rival in consumption: if I eat it, you cannot. On the other hand, the beauty of a fireworks display is completely unaffected by the number of people who look at it. Some elements of the environment are pure public goods:

• Clean air in a city provides health benefits to everyone, and people cannot be prevented from breathing.
• The stratospheric ozone layer protects everyone on earth from solar UV radiation.

The efficient amount of a public good is still where social marginal benefit equals the marginal cost of provision. However, the social marginal benefit of one unit of a public good is often very large because many people in society can benefit from that unit simultaneously. One lighthouse prevents all the ships in an area from running aground in a storm. In contrast, the social marginal benefit of a hot dog is just the marginal benefit gained by the one person who gets to eat it.

Society could figure out the efficient amount of a public good to provide—say, how much to spend on cleaner cars that reduce air pollution in a city. Unfortunately, private individuals acting on their own are unlikely to provide the efficient amount of the public good because of the free rider problem. If my neighbors reduce pollution by buying clean electric cars or commuting via train, I can benefit from that cleaner air; thus, I might try to avoid doing anything costly myself in hopes that everyone else will clean the air for me. Evidence suggests that people do not behave entirely like free riders – they contribute voluntarily to environmental groups and public radio stations. However, the levels of public-good provision generated by a free market are lower than would be efficient. The ozone layer is too thin; the air is too dirty. Public goods have big multilateral positive externality problems.

In contrast, a common-pool resource (also sometimes called an open-access resource) suffers from big multilateral negative externality problems. This situation is sometimes called the “tragedy of the commons.” Like public goods, common-pool resources are nonexcludable. However, they are highly rival in use. Many natural resources have common-pool features:

• Water in a river can be removed by anyone near it for irrigation, drinking, or industrial use; the more water one set of users removes, the less water there is available for others.
• Swordfish in the ocean can be caught by anyone with the right boat and gear, and the more fish are caught by one fleet of boats, the fewer remain for other fishers to catch.
• Old growth timber in a developing country can be cut down by many people, and slow regrowth means that the more timber one person cuts the less there is available for others.

One person’s use of a common-pool resource has negative effects on all the other users. Thus, these resources are prone to overexploitation. One person in Indonesia might want to try to harvest tropical hardwood timber slowly and sustainably, but the trees they forebear from cutting today might be cut down by someone else tomorrow. The difficulty of managing common-pool resources is evident around the world in rapid rates of tropical deforestation, dangerous overharvesting of fisheries (see Case study: Marine Fisheries), and battles fought over mighty rivers that have been reduced to dirty trickles.

The tragedy of the commons occurs most often when the value of the resource is great, the number of users is large, and the users do not have social ties to one another, but common-pool resources are not always abused. Elinor Ostrom’s Nobel prize-winning body of work, for example, has studied cases of common-pool resources that were not over-exploited because of informal social institutions.

Case Study: Marine Fisheries

Fisheries are classic common-pool resources. The details of the legal institutions that govern access to fisheries vary around the globe. However, the physical nature of marine fisheries makes them prone to overexploitation. Anyone with a boat and some gear can enter the ocean. One boat’s catch reduces the fish available to all the other boats and reduces the stock available to reproduce and sustain the stock available in the following year. Economic theory predicts that the market failure associated with open access to a fishery will yield socially excessive levels of entry into the fishery (too many boats) and annual catch (too many fish caught) and inefficiently low stocks of fish (Beddington, Agnew, & Clark, 2007). See Figure 29.4 below on current (2021) overfishing and overfished stocks in the U.S.

Figure 29.4. Overfished Stocks in the U.S. as of March 31, 2021. This figure lists stocks on the overfished and overfising lists by region. Source: NOAA Fisheries.

Unfortunately, the state of fisheries around the globe seems to indicate that the predictions of that theory are being borne out. Bluefin tuna are in danger of extinction. Stocks of fish in once-abundant fisheries such as North Atlantic cod and Mediterranean swordfish have been depleted to commercial (and sometimes biological) exhaustion (Montaigne, 2007). Scientists have documented widespread collapse of fish stocks and associated loss of marine biodiversity from overfishing; this devastates the ability of coastal and open-ocean ecosystems to provide a wide range of ecosystem services such as food provisioning, water filtration, and detoxification (Worm et al., 2006). Scholars have documented isolated cases such as the “lobster gangs” of coastal Maine where communal informal management prevented overexploitation of the resource (Acheson, 1988), but such cases are the exception rather than the rule.

Early efforts to control overfishing used several kinds of regulations on quotas, fishing effort, and gear. For example, fishing boats are forbidden in some places from using conventional longlines because that gear yields high levels of bycatch and kills endangered leatherback turtles. Some forms of fishery management limit the number of fish that can be caught in an entire fishery. Under a total allowable catch (TAC) system, fishers can fish when and how they want, but once the quota for the fishery has been met, fishing must stop until the next season.

Unfortunately, TAC policies do not solve the underlying problem that fishermen compete for the fish, and often yield perverse incentives and undesirable outcomes such as overcapitalization of the industry (Beddington, Agnew, & Clark, 2007) and races between fishing boat crews to catch fish before the quota is reached. In the well-known case of the Alaskan halibut fishery, the race became so extreme that the fishing season was reduced to a single 24-hour mad dash; given that fish are perishable, this temporal clumping of the catch is not a desirable outcome.

Resource economists developed the idea of a tradable permit scheme to help manage fisheries. Individual tradable quota (ITQ) schemes are cap-and-trade policies for fish, where total catch is limited but fishers in the fishery are given permits that guarantee them a right to a share of that catch. Players in the fishery can sell their quota shares to each other (helping the catch to flow voluntarily to the most efficient boats in the industry) and there is no incentive for captains to buy excessively large boats or fish too rapidly to beat the other boats to the catch. ITQ policies have rationalized the Alaskan halibut fishery completely: the fish stock is thriving, overcapitalization is gone, and the fish catch is spread out over time (Levy, 2010). ITQs have also been implemented in the fisheries of New Zealand, yielding large improvements in the biological status of the stocks (Annala, 1996). There is some general evidence that ITQ systems have been relatively successful in improving fishery outcomes (Costello, Gaines, & Lynham et al. 2008), though other research implies that evidence of the superiority of the ITQ approach is more mixed (Beddington, Agnew, & Clark, 2007) Scholars and fishery managers continue to work to identify the details of ITQ management that make such systems work most effectively, and to identify what needs to be done to promote more widespread adoption of good fishery management policy worldwide.

Environmental Valuation

Use Values

Externality, public good, and common-pool resource problems yield suboptimal levels of environmental quality and excessive rates of resource exploitation. Many factors complicate the process of deciding what to do about these problems. One is that environmental goods are not traded in any marketplace, and hence analysts struggle to identify quantitative measures of their values to society.

Environmental valuation is controversial. Some environmentalists object to efforts to place dollar values on elements of the environment that might be viewed as priceless. Such values are important, however, for making sure that society does not fail to take the value of nature into account when making policy and investment choices. All U.S. government regulations, for example, are subjected to benefit-cost analyses to make sure that government actions don’t inadvertently make society worse off. If we do not have dollar values for the environmental benefits of things like clean water and air, then estimates of the benefits of pollution control will be consistently lower than the true social benefits, and government policy will chronically underinvest in efforts to control pollution.

Environmental and natural resource economists have worked for decades to develop valuation methods that can be used to generate reasonable estimates of the dollar values of environmental amenities. Thousands of journal articles have been published in this effort to refine valuation methodology. In the early years of valuation studies, most of the work was focused on generating estimates of the social values of water and air quality. Over time, economists broadened their focus to study how to value a broader range of amenities such as wetland habitat and endangered species.

The United Nations launched an international effort in 2000 called the Millennium Ecosystem Assessment which was to evaluate the current state of earth’s ecosystems (and the services that flow from nature to humans) and identify strategies for conservation and sustainable use. Reports from this effort have helped scientists and policy makers develop a new framework for thinking about how nature has value to humans by providing a wide range of ecosystem services. Since then, a surge of multidisciplinary research has emerged to quantify the physical services provided by the environment and estimate the values to humanity of those services. Economists recognize two broad categories of environmental values: use and non-use. Use values flow from services that affect people directly, such as food production, flood regulation, recreation opportunities, and potable water provision (Image 29.2). Non-use values are less tangible: the desire for endangered tigers to continue to exist even on the part of people who will never see them in the wild (Image 29.3); concern about bequeathing future generations a planet with healthy fish populations; a sense that people have an ethical responsibility to be good stewards of the earth. Economic valuation methods exist to capture all of these environmental values.

Image 29.3. Non-use Value: Sumatran Tiger. Although wild tigers do not directly impact people living in the United States, many Americans wish for the species to continue existing in their natural environment. This is an example of a non-use value. Source: “Sumatran tiger” by Nevin Dilmen is licensed under CC BY-SA 3.0.

Willingness to Pay/Accept

Economists use measures of value that are anthropocentric, or human centered. A rigorous body of theory about consumer choice lies beneath those measures. Mathematical complexity can make that theory seem like unreliable trickery, but in truth, consumer theory rests on only a very small number of fundamental assumptions: 

• People have preferences over things.
• People are able to rank any two bundles of goods to identify which one they prefer.
• People are rational in that they will choose the bundle they prefer (over bundles they do not prefer) if they can afford it.

Those uncontroversial axioms are actually enough to derive all the results economists use when working with valuation methodology. However, the derivations are easier and sometimes more intuitive with a little more structure added to our hypothetical consumer choice problem:

• People face budget constraints (total expenditures can’t exceed their income).
• People make choices to make themselves as well off as possible (“maximize their utility”) within the rationing forced by their budget constraints.

This framework yields two ways to think about the values of changes to the quality or quantity of environmental goods. Consider first a situation where we are trying to determine the value of a project that yields an environmental improvement—say, for example, water in the Chicago River will be cleaner. The social benefit of that project turns out to be what people are willing to pay for it. The second measure of value is appropriate if we want to measure the value of environmental goods that will be lost or degraded by a deleterious change—say, for example, climate change leading to the extinction of polar bears. In that context, the value of the change is given by the amount of money you would have to pay people in order to make them willing to accept it.

“Willingness to pay” (WTP) is a budget-constrained measure of a change in welfare; a person cannot be willing to pay more money for a change than they have income. In contrast, “willingness to accept” (WTA) is not a budget constrained measure of value—you might have to increase a person’s income many times over in order to fully compensate them for the loss of an environmental amenity they hold dear—and can theoretically approach infinity. Empirical studies tend to find that WTA value estimates are larger than equivalent estimates of WTP.

Analysts usually choose whether to use WTA or WTP approaches as a function of the context of the analysis. The “right” measure to use may depend on whether you want value estimates to inform a policy that would improve conditions relative to the current legal status quo, or to understand the consequences of a change that would cause deterioration of some environmental good citizens currently enjoy. Another factor in choosing a valuation method is that WTP is budget constrained while WTA is not. WTP estimates of value tend to be lower in places where people have lower incomes. That variation captures a realistic pattern in the size of willingness to pay for environmental improvements. However, equity problems clearly plague a study that concludes, for example, that improvements in air quality are more valuable to society if they happen in rich areas rather than poor.

All valuation methodologies—WTP and WTA—are designed to estimate values of fairly small changes in the environment, and those values are often setting-specific. Careful analysts can do benefit transfer studies in which they use the results of one valuation study to inform value estimates in a different place. However, such applications must be carried out carefully. The value of a unit change in a measure of environmental integrity is not an immutable constant, and the values of very large changes in either quantity or quality of an environmental amenity usually cannot be estimated. A cautionary example is an influential but widely criticized paper published in Nature by Robert Costanza and colleagues that carried out sweeping benefit transfer estimates of the total social values of a number of Earth’s biomes (open oceans, forests, wetlands, etc.). The resulting estimates were too large to be correct estimates of WTP because they exceeded the value of the whole world’s GDP, and too small to be correct estimates of WTA because life on earth would cease to exist if oceans disappeared, so WTA for that change should be infinity (Costanza et al., 1997).

An Economist’s Environmental Valuation Toolkit: Direct, Revealed Preference, and Stated Preference Methods

Early work on environmental valuation estimated the benefits of improved environmental quality using direct methods that exploit easily obtained information about the monetary damage costs of pollution. These methods are still sometimes used (most often by people who are not environmental economists) because of their simple intuitive appeal. An analyst can measure costs associated with pollution; the benefits of environmental cleanup are then the reductions in those costs. Following are some examples:

• Production damage measures: Pollution has a deleterious effect on many production processes. For example, air pollution lowers corn yields, thus increasing the cost of producing a bushel of corn. An analyst could try to measure the benefits of eliminating air pollution by calculating the increase in net social benefits that would flow from the corn market as a result of higher yields.
• Avoided cost measures: Environmental degradation often forces people to spend money on efforts to mitigate the harm caused by that degradation. One benefit of reversing the degradation is not having to spend that money on mitigation—the avoided cost. For example, hydrological disruption from impervious surfaces in urban areas forces cities to spend money on expensive storm sewer infrastructure to try to reduce floods. A benefit of installing rain gardens and green roofs to manage stormwater might be avoided storm sewer infrastructure costs.
• Health cost measures: Pollution has adverse effects on human health. For example, toxic chemicals can cause cancer, and ground level ozone causes asthma. Some measures of the damages caused by pollution simply count the financial costs of such illnesses, including the costs of cancer treatment and lost wages from adults missing work during asthma attacks.

These measures seem appealing, but are in fact deeply problematic. One of the most serious problems with direct measures is that they often yield woefully incomplete estimates of the benefits of environmental cleanup. Consider the example of cancer above. Suppose a woman gets cancer from drinking contaminated well water. By the time her illness is diagnosed, the cancer is so advanced that doctors can do little to treat her, and she dies a few months later. The medical expenditures associated with this illness are not very large; she and her family would surely have been willing to pay much more money to have eliminated the toxins so she did not ever get sick. The direct health cost measure of the benefits of cleaning up the contaminated water is a serious underestimate of the true benefit to society of that environmental improvement.

A second set of valuation tools called revealed preference methods work to estimate WTP for environmental amenities and quality by exploiting data on actual behaviors and market choices that are related to the environmental good in question. People reveal their WTP for environmental goods with their actions. Three examples of such methods are below.

• Hedonic price analysis: We often cannot observe individuals taking direct action to change the quality of the environment to which they are exposed in a given location because they simply cannot effect such change; no one person, for example, can reduce the concentration of fine particles in the air near his house. We do, however, observe market data about the choices people make about where to live. If two houses are otherwise identical but one house is situated in a place with much cleaner air than the other, the benefit of breathing cleaner air will get capitalized in the value of that house. All else equal, neighborhoods with better environments will have more expensive homes. Analysts can gather data on housing prices and house characteristics (both environmental and nonenvironmental) and use a statistical analysis to estimate marginal WTP for elements of environmental quality that vary among the houses in the data set. The hedonic price analysis approach has been used to value amenities such as air quality, hazardous waste site cleanup, and open space.
• Hedonic wage analysis: Some forms of pollution cause people to face higher risk of death in any given year. Thus, one important goal of valuation is to estimate a dollar value of reduced mortality resulting from pollution cleanup. Except in the movies, we rarely observe people choosing how much money they are willing to pay to save a specific person from certain death. However, all of us make choices every day that affect our risk of death. One important choice is which job to accept. Elementary school teachers face little job-related mortality risk. In contrast, coal miners, offshore oil rig workers, and deep sea fishermen accept high rates of accidental death when they take their jobs. By analyzing data on wage rates and worker death rates in a variety of different industries, we can estimate WTP to reduce the risk of death. Using such hedonic wage analysis, economists have developed measures of the value of a statistical life (VSL), which can be applied to physical estimates of reductions in pollution-related deaths to find the benefits of reduced mortality.
• Travel cost analysis: Many natural amenities, such as forests, lakes, and parks are enjoyed by the public free of charge. While there is no formal market for “hours of quality outdoor recreation,” people do incur costs associated with such recreation—gas purchased to drive to the site, hotel expenses for overnight trips, and the opportunity cost of the time spent on the trip. If environmental quality is valued, people will be willing to pay higher travel costs to visit recreation sites with higher levels of environmental quality (e.g., cleaner water in the lake, more fish to catch, a better view from a mountain with low air pollution). In travel cost analysis, researchers gather data on the environmental features of a set of recreation sites and the choices people make about visiting those sites—which they choose to visit, and how often—and apply statistical analysis to those data to estimate WTP for improved quality of natural amenities.

One of the greatest strengths of revealed preference valuation methods is that they use information about real behavior rather than hypothetical choices. These approaches also yield estimates of WTP that are often more complete than the results of direct market measure studies.

Revealed preference studies do, however, have weaknesses and limitations. First, they only give good estimates of WTP for environmental goods if people have full and accurate information about environmental quality and associated risks. For example, hedonic estimates of WTP to avoid living with polluted air will be biased downward if people in a city do not know how air pollution varies among neighborhoods. Second, some revealed preference approaches are only valid if the relevant markets (labor markets for a wage study, housing markets for a hedonic price study) are not plagued by market power and transaction costs that prevent efficient equilibria from being reached. For example, if workers find it too daunting and costly to move from one region to another, then coal miners may fail to earn the wage premium that would be associated with such a risky job in the absence of relocation hurdles. Third, revealed preference approaches cannot be used to estimate values for levels of environmental quality that are not observed in real-world data. If all the lakes in a region are terribly polluted, we cannot use a travel cost study of lake site choice to identify WTP for very clean lakes. Fourth, revealed preference methods can capture only use values, not non-use values.

The limitations of revealed preference valuation tools motivated environmental and natural resource economists to develop valuation methods that do not require analysts to be able to observe real-world behavior related to the amenity being valued. These stated preference methods are now highly refined, but the essential idea is simple. These studies design a survey that presents people with information about hypothetical scenarios involving an environmental good, gather data on their responses to questions about how much they would pay for something or whether they would choose one scenario over another, and then analyze the data to estimate WTP for the good or WTA compensation for elimination or degradation of the good.

• Contingent valuation: The methodology called contingent valuation (or CV) gained prominent attention when it was used by economists to estimate the damage done to society by the oil spilled by Exxon’s Valdez oil tanker in Prince William Sound in 1989 (Carson et al., 2003). A CV survey gives a clear description of a single environmental amenity to be valued, such as a wetland restoration, whale populations, or improved water quality in a local lake. The description includes details about how the amenity would be created, and how the survey respondent would pay any money they claim to be willing to pay in support of the amenity. Respondents are then asked a question to elicit their WTP. This value elicitation question can be open ended (“How much would you be willing to pay in taxes to increase whale populations?) or closed ended (“Would you be willing to pay $30 to increase whale populations?). The resulting data set is analyzed to find the average WTP of people in the sample population.
• Conjoint analysis: Conjoint analysis is also referred to as choice experiment survey analysis. It was developed first by analysts in business marketing and psychology, and only later adopted by economists for environmental valuation. The main difference between conjoint analysis and CV is that CV elicits WTP for an environmental amenity with a single fixed bundle of features, or attributes. Conjoint analysis estimates separate values for each of a set of attributes of a composite environmental amenity. For example, grasslands can vary in bird species diversity, wildflower coverage, and distance from human population centers. A conjoint analysis of grassland ecosystems would construct a set of hypothetical grasslands with varied combinations of attributes (including the cost to the respondent of a chosen grassland). The survey would present respondents with several choice questions; in each choice, the respondent would be asked to pick which of several hypothetical grasslands they would prefer. The resulting data would be analyzed to find how each attribute affects the likelihood that one grassland is preferred over another. This would yield estimates of marginal values for each attribute; those values could then be used to find WTP for composite grasslands with many different combinations of features.

Both CV and conjoint analysis methods can be designed to estimate WTP for improvement or WTA degradation depending on which context is most appropriate for the problem at hand. These stated preference methods have two main strengths. First, they can capture non-use values. Second, their hypothetical nature allows analysts to estimate WTP for improvements out of the range of current experience (or WTA for degradation we have fortunately not yet experienced).

However, stated preferences approaches do have weaknesses and limitations. For example, many economists are uncomfortable using value estimates derived from hypothetical choices, worrying whether consumers would make the same choices regarding payment for public environmental goods if the payments were real. Scholars also worry about whether people give responses to stated preference surveys that are deliberately skewed from their true WTP. Understatements of value could arise to protest a government policy (“Why should I have to pay to clean up the environment when someone else made it dirty in the first place?”) or out of a desire to free ride. Finally, the hypothetical nature of stated preference surveys can mean that some respondents are not familiar with the thing being valued, and thus may have trouble giving meaningful responses to the questions. Stated preference surveys must be designed to give respondents enough information without biasing their responses.

Evaluating Projects and Policies

Environmental valuation methods help analysts to evaluate the benefits society would gain from policies or cleanup and restoration projects that improve environmental quality or better steward our natural resources. Another set of tools can yield information about the costs of such actions (a brief description is below). But even if we have plausible estimates of the costs and benefits of something, more work needs to be done to put all that information together and make some rational choices about public policy and investments. This module discusses the challenges of policy evaluation when costs and benefits accrue over time, outlines the main features of cost-benefit analysis, and presents several other criteria for policy evaluation.

Net Present Value, Discounting, and Cost-benefit Analysis

Cost estimation has not generated the same amount of scholarly research as benefit valuation because the process of estimating the costs of environmental improvement is usually more straightforward than the process of estimating the benefits. Economists do think differently about costs than engineers or other physical scientists, and several key insights about the economics of cost evaluation are important for policy analysis. Viewed through an inverse lens, all these ideas are important for benefit estimation as well.

Opportunity Cost

Not all costs involve actual outlays of money. An opportunity cost is the foregone benefit of something that we choose (or are forced) not to do. The opportunity cost of a year of graduate school is the money you could have made if you had instead gotten a full-time job right after college. Endangered species protection has many opportunity costs: timber in old-growth forests can’t be cut and sold (Image 29.4); critical habitat in urban areas can’t be developed into housing and sold to people who want to live in the area. Opportunity costs do not appear on firms’ or governments’ accounting sheets and are thus often overlooked in estimates of the costs of a policy. Studies of U.S. expenditures on endangered species’ recoveries have used only information about costs like direct government expenditures because opportunity costs are so challenging to measure (e.g. Dawson and Shogren, 2001).

Image 29.4. A Redwood Forest in California. Forests can’t both be cut down and preserved for habitat. The dollar cost of lumber is straightforward to quantify, but it is more difficult to quantify the value of ecosystems. Cutting down the forest therefore has an opportunity cost that is hard to measure, and this can bias people and governments towards resource extraction. Source: “Redwoods in Muir Woods” by Michael Barera is licensed under CC BY-SA 4.0.

Transfers Are Not Costs

Cost totals should only include real changes in behavior or resource use, and not transfers of money from one party to another. For example, imagine a program in which a wastewater treatment plant can pay a farmer for the cost of taking land out of production and installing a wetland on the land that will soak up nutrients that would otherwise flow into a local river. The cost of those nutrient reductions is the cost of installing the wetland and the opportunity cost of the foregone farming activity. If payments for multiple services are permitted, the farmer might also be able to get paid by a conservation group for the wildlife benefit associated with the new wetland. However, that additional payment to the farmer is a pure transfer. The social cost of the wetland has not gone up just because the farmer was paid more for it.

Use the Correct Counterfactual

Many cursory analyses of the costs of a policy find the difference between the cost of something before and after the policy was put in place and claim that any increase was caused by the policy. For example, the U.S. government put temporary restrictions on offshore oil drilling after the Deepwater Horizon explosion and oil spill to consider new environmental regulations on such drilling. After those restrictions were put in place, the price of crude oil in the U.S. went up. A sloppy analysis would attribute all the costs of that price increase to the drilling restrictions. However, during the same period of 2010, the U.S. economy was beginning to pull out of a very deep recession; this caused increased manufacturing activity and consumer driving, and thus an increased call for fossil-fuel energy. Therefore, some of the increase in oil prices might have been driven by the increased demand for oil. A careful analysis would compare the price of oil with the restrictions in place to what the price of oil would have been during the same time period if the restrictions had not been implemented—that hypothetical scenario is the true counterfactual.

Additionality

A careful analysis of the costs of a program includes only costs that are additional, that is, new additions to costs that would have existed even in the absence of the program. For example, current regulations require developers to use temporary controls while constructing a new building to prevent large amounts of sediment from being washed into local rivers and lakes. Suppose EPA wants to estimate the costs of a new regulation that further requires new development to be designed such that stormwater doesn’t run off the site after the building is finished. A proper analysis would not include the costs of the temporary stormwater controls in the estimate of the cost of the new regulation, because those temporary controls would be required even in the absence of the new regulation (Braden and Ando, 2011). The concept of additionalityhas been made famous in the context of benefit estimation by a debate over whether programs that pay landowners not to deforest their lands have benefits that are additional; some of those lands might not have been deforested even without the payments, or the landowners may receive conservation payments from multiple sources for the same activity.

Control for Associated Market Changes

A careful cost analysis must pay attention to market changes associated with cost increases. To illustrate, suppose the government is thinking of passing a ban on agricultural use of methyl bromide. This ozone-depleting chemical is widely used as an agricultural fumigant, and is particularly important in strawberry production and shipping. A ban on methyl bromide might, therefore, increase the marginal cost of producing strawberries. A simple approach to estimating the cost of the proposed methyl bromide ban would be to find out how many strawberries were sold before the ban and calculate the increase in the total cost of producing that many strawberries. However, the increase in production costs will drive up the price of strawberries and lower the number of strawberries sold in the marketplace. There is a cost to society with two parts: (a) deadweight loss associated with the net benefits of the strawberries not sold, and (b) the increased cost of producing the strawberries that still are sold. That total social cost is lower, however, than the estimate yielded by the simple approach outlined above because the simple approach includes increased production costs for strawberries that are not sold. An accurate cost estimate must take into account market changes. 

The concept of net benefits was introduced above; in the context of policy or project evaluation, net benefits are, quite simply, the difference between the benefits and the costs of a policy in a given year. However, environmental policies typically have benefits and costs that play out over a long period of time, and those flows are often not the same in every year. For example, wetland restoration in agricultural areas has a large fixed cost at the beginning of the project when the wetland is constructed and planted. Every year after that there is an opportunity cost associated with foregone farm income from the land in the wetland, but that annual cost is probably lower than the fixed construction cost. The wetland will yield benefits to society by preventing the flow of some nitrogen and phosphorus into nearby streams and by providing habitat for waterfowl and other animals. However, the wildlife benefits will be low in the early years, increasing over time as the restored wetland vegetation grows and matures. It is not too difficult to calculate the net benefits of the restoration project in each year, but a different methodology is needed to evaluate the net benefits of the project over its lifetime.

Some analysts simply add up all the costs and benefits for the years that they accrue. However, that approach assumes implicitly that we are indifferent between costs and benefits we experience now and those we experience in the future. That assumption is invalid for two reasons. First, empirical evidence has shown that humans are impatient and prefer benefits today over benefits tomorrow. One need only ask a child whether they want to eat a candy bar today or next week in order to see that behavior at work. Second, the world is full of investment opportunities (both financial and physical). Money today is worth more than money tomorrow because we could invest the money today and earn a rate of return. Thus, if there is a cost to environmental cleanup, we would rather pay those costs in the future than pay them now.

Economists have developed a tool for comparing net benefits at different points in time called discounting. Discounting converts a quantity of money received at some point in the future into a quantity that can be directly compared to money received today, controlling for the time preference described above. To do this, an analyst assumes a discount rate r, where r ranges commonly between zero and ten percent depending on the application. If we denote the net benefits t years from now as Vt (in the current year, t=0), then we say the present discounted value of Vt is  .

Figure 29.5 shows how the present value of $10,000 declines with time, and how the rate of the decrease varies with the choice of discount rate r. If a project has costs and benefits every year for T years, then the net present value of the entire project is given by .

Figure 29.5. The Impact of a Discount Rate on Present Value Estimates. Source: California Department of Transportation.

A particular cost or benefit is worth less in present value terms the farther into the future it accrues and the higher the value of the discount rate. These fundamental features of discounting create controversy over the use of discounting because they make projects to deal with long-term environmental problems seem unappealing. The most pressing example of such controversy swirls around analysis of climate-change policy. Climate-change mitigation policies typically incur immediate economic costs (e.g. switching from fossil fuels to more expensive forms of energy) to prevent environmental damages from climate change several decades in the future. Discounting lowers the present value of the future improved environment while leaving the present value of current costs largely unchanged.

Cost-benefit analysis is just that: analysis of the costs and benefits of a proposed policy or project. To carry out a cost-benefit analysis, one carefully specifies the change to be evaluated, measures the costs and benefits of that change for all years that will be affected by the change, finds the totals of the presented discounted values of those costs and benefits, and compares them. Some studies look at the difference between the benefits and the costs (the net present value), while others look at the ratio of benefits to costs. A “good” project is one with a net present value greater than zero and a benefit/cost ratio greater than one.

The result of a cost-benefit analysis depends on a large number of choices and assumptions. What discount rate is assumed? What is the status quo counterfactual against which the policy is evaluated? How are the physical effects of the policy being modeled? Which costs and benefits are included in the analysis—are non-use benefits left out? Good cost-benefit analyses should make all their assumptions clear and transparent. Even better practice explores whether the results of the analysis are sensitive to assumptions about things like the discount rate (a practice called sensitivity analysis). Scandal erupted in 2000 when a whistle-blower revealed that the Army Corps of Engineers was pressuring its staff to alter assumptions to make sure a cost-benefit analysis yielded a particular result (EDV&CBN, 2000). Transparency and sensitivity analysis can help to prevent such abuses.

Efficiency, Cost Effectiveness, Innovation, and Equity

Cost-benefit analysis gives us a rough sense of whether or not a project is a good idea. However, it has many limitations. Here we discuss several other measures of whether a project is desirable. Economists use all these criteria and more when evaluating whether a policy is the right approach for solving a problem with externalities, public goods, and common-pool resources.

Efficiency

A policy is efficient if it maximizes the net benefits society could get from an action of that kind. Many projects and policies can pass a cost-benefit test but still not be efficient. Several levels of carbon dioxide emission reduction, for example, could have benefits exceeding costs, but only one will have the largest difference between benefits and costs possible. Such efficiency will occur when the marginal benefits of the policy are equal to its marginal costs. Sometimes a cost-benefit analysis will try to estimate the total costs and benefits for several policies with different degrees of stringency to try to see if one is better than the others. However, only information about the marginal benefit and marginal cost curves will ensure that the analyst has found the efficient policy. Unfortunately, such information is often very hard to find or estimate. 

Cost Effectiveness

As we saw in the Module Environmental Valuation, it can be particularly difficult to estimate the benefits of environmental policy, and benefit estimates are necessary for finding efficient policies. Sometimes policy goals are just set through political processes—reducing sulfur dioxide emissions by 10 million tons below 1980 levels in the Clean Air Act acid rain provisions, cutting carbon dioxide emissions by 5% from 1990 levels in the Kyoto protocol—without being able to know whether those targets are efficient. However, we can still evaluate whether a policy will be cost effective and achieve its goal in the least expensive way possible. For example, for total pollution reduction to be distributed cost-effectively between all the sources that contribute pollution to an area (e.g. a lake or an urban airshed), it must be true that each of the sources is cleaning up such that they all face the same marginal costs of further abatement. If one source had a high marginal cost and another’s marginal cost was very low, total cost could be reduced by switching some of the cleanup from the first source to the second.

Incentives to Innovate

At any one point in time, the cost of pollution control or resource recovery depends on the current state of technology and knowledge. For example, the cost of reducing carbon dioxide emissions from fossil fuels depends in part on how expensive solar and wind power are, and the cost of wetland restoration depends on how quickly ecologists are able to get new wetland plants to be established. Everyone in society benefits if those technologies improve and the marginal cost of any given level of environmental stewardship declines. Thus, economists think a lot about which kinds of policies do the best job of giving people incentives to develop cheaper ways to clean and steward the environment.

Fairness

A project can have very high aggregate net benefits, but distribute the costs and benefits very unevenly within society. We may have both ethical and practical reasons not to want a policy that is highly unfair. Some people have strong moral or philosophical preferences for policies that are equitable. In addition, if the costs of a policy are borne disproportionately by a single group of people or firms, that group is likely to fight against it in the political process. Simple cost-benefit analyses do not speak to issues of equity. However, it is common for policy analyses to break total costs and benefits down among subgroups to see if uneven patterns exist in their distribution. Studies can break down policy effects by income category to see if a policy helps or hurts people disproportionately depending on whether they are wealthy or poor. Other analyses carry out regional analyses of policy effects. For example, climate-change mitigation policy increases costs disproportionately for poor households because of patterns in energy consumption across income groups. Furthermore, the benefits and costs of such policy are not uniform across space in the U.S. The benefits of reducing the severity of climate change will accrue largely to those areas that would be hurt most by global warming (coastal states hit by sea level rise and more hurricanes, Western states hit by severe water shortages) while the costs will fall most heavily on regions of the country with economies dependent on sales of oil and coal. 

Some of our evaluative criteria are closely related to each other; a policy cannot be efficient if it is not cost-effective. However, other criteria have nothing to do with each other; a policy can be efficient but not equitable, and vice versa. Cost-benefit analyses provide crude litmus tests—we surely do not want to adopt policies that have costs exceeding their benefits. However, good policy development and evaluation considers a broader array of criteria.

Solutions: Property Rights, Regulations, and Incentive Policies

Governments have implemented many policies to solve problems with environmental quality and natural resource depletion. Every policy is unique and deserves detailed individual analysis in the policymaking process—the devil is always in the details. However, economists have developed a taxonomy of policy types. This taxonomy helps us to understand general principles about how policies of different types are likely to perform and under which circumstances they are likely to work best. Policies are broadly characterized as either command-and-control or incentive policies. Command and control includes several types of standards. Incentive policies include taxes, tradable permits, and liability.

Property Rights

In 1960, Ronald Coase wrote the pioneering article “The Problem of Social Cost” in which he put forth ideas about externalities that have come to be known as the Coase theorem (Coase, 1960). The basic idea of the Coase theorem is that if property rights over a resource are well specified, and if the parties with an interest in that resource can bargain freely, then the parties will negotiate an outcome that is efficient regardless of who has the rights over the resource. The initial allocation of rights will not affect the efficiency of the outcome, but it will affect the distribution of wealth between the parties because the party with the property rights can extract payment from the other parties as part of the agreement.

To bring this abstract idea to life, we will draw on the classic example employed by generations of economists to think about the Coase theorem. Suppose a farmer and a rancher live next door to each other. There is land between them on which the farmer wants to plant crops, but the rancher’s cows keep eating the crops. The farmer would like to have no cows on the land, and the rancher would like the farmer to stop planting crops so the cows could eat as much grass as they like. The efficient outcome is where the marginal benefit of a cow to the rancher is just equal to the marginal cost to the farmer of that cow’s grazing. If the farmer is given property rights over the land, the rancher will have an incentive to pay the farmer to allow the efficient number of cows rather than zero; if the rancher has the rights, then the farmer will have to pay the rancher to limit the herd to just the efficient size. Either way they have incentives to negotiate to the efficient outcome because otherwise both of them could be made better off.

The Coase theorem is invoked by some scholars and policy analysts to argue that government policy is not needed to correct problems of externalities; all you need is property rights, and private negotiations will take care of the rest. However, Coase himself recognized in his writing that often the real world does not have the frictionless perfect negotiation on which the conclusions of the theorem rest. For example, there are transaction costs in bargaining, and those transaction costs can be prohibitively large when many people are involved, as in the case of air pollution from a factory. Furthermore, perfect bargaining requires perfect information. People often are unaware of the threats posed to their health by air and water pollution, and thus do not know what kind of bargaining would actually be in their own best interests.

Despite these limitations, there is a move afoot to use property right development to effect environmental improvement and improve natural resource stewardship, particularly in developing countries. In parts of Africa, new systems have given villages property rights over wildlife on their lands, yielding stronger incentives to manage wildlife well and demonstrably increasing wildlife populations. In South America, land-tenure reform is promoted as a way to reduce deforestation.

Command and Control Regulations

Most environmental policy in the United States is much more rigid and controlling than property-rights reform. Our policies for things like clean air and water, toxic waste cleanup, and endangered species protection have largely been composed of rigid rules and regulations. Under such policies, people are given strict and specific rules about things they must or must not do regarding some facet of pollution control or natural resource use, and then a government agency enforces the rules. Here we discuss and explore examples of a few kinds of such “command-and-control” regulations.

Ambient Standard

Some policies have targets for the quality of some element of the environment that results from human behavior and natural processes. An ambient standard establishes a level of environmental quality that must be met. The Clean Air Act directs the U.S. Environmental Protection Agency (EPA) to establish National Ambient Air Quality Standards (NAAQSs) for a range of air pollutants such as ozone and fine particles. The Clean Water Act directs state offices of the EPA to set ambient water quality standards for rivers and streams in their boundaries. In practice, however, such standards are binding only on state regulators. State EPA offices are responsible for developing plans to ensure that air and surface water bodies meet these ambient quality standards, but they cannot do the clean up on their own. They need to use a different set of tools to induce private agents to actually reduce or clean up pollution such that the ambient standards can be met.

Some ambient standards (such as the NAAQSs) have provoked criticism from economists for being uniform across space. Every county in the country has to meet the same air quality goals, even though the efficient levels of air quality might vary from one county to the next with variation in the marginal benefits and marginal costs of cleaning the air. However, uniform ambient standards grant all people in the U.S. the same access to clean air—a goal that has powerful appeal on the grounds of equity. 

Individual Standards

First, we discuss a kind of policy applied to individual people or companies called a technology standard. Pollution and resource degradation result from a combination of human activity and the characteristics of the technology that humans employ in that activity. Behavior can be difficult to monitor and control. Hence, lawmakers have often drafted rules to control our tools rather than our behaviors. For example, automakers are required to install catalytic converters on new automobiles so that cars have lower pollution rates, and people in some parts of the country must use low-flow showerheads and water-efficient toilets to try to reduce water usage.

Technology standards have the great advantage of being easy to monitor and enforce; it is easy for a regulator to check what pollution controls are in the design of a car. Under some circumstances technology standards can reduce pollution and the rate of natural resource destruction, but they have several serious limitations. First, they provide no incentives for people to alter elements of their behavior other than technology choice. Cars may have to have catalytic converters to reduce emissions per mile, but people are given no reason to reduce the number of miles they drive. Indeed, these policies can sometimes have perverse effects on behavior. Early generations of water-efficient toilets performed very poorly; they used fewer gallons of water per flush, but people found themselves flushing multiple times in order to get waste down the pipes. Thus, these standards are neither always efficient nor cost effective. Second, technology standards are the worst policy in the toolkit for promoting technological innovation. Firms are actively forbidden from using any technology other than the one specified in the standards. Automakers might think of a better and cheaper way to reduce air pollution from cars, but the standard says they have to use catalytic converters.

A second type of policy applied to individual agents is called a performance standard. Performance standards set strict limits on an outcome of human activity. For example, in order to meet the NAAQSs, state EPA offices set emission standards for air pollution sources in their states. Those standards limit the amount of pollution a factory or power plant can release into the air, though each source can control its pollution in any way it sees fit. The limits on pollution are the same for all sources of a given type (e.g., power plant, cement factory, etc.). Performance standards are also used in natural resource regulation. For example, because stormwater runoff causes flooding and harms aquatic habitat, the city of Chicago requires all new development to be designed handle the first inch of rainfall in a storm onsite before runoff begins.

To enforce a performance standard the regulator must be able to observe the outcome of the agents’ activities (e.g. measure the pollution, estimate the runoff). If that is possible, these policies have some advantages over technology standards. Performance standards do give people and firms some incentive to innovate and find cheaper ways to reduce pollution because they are free to use any technology they like to meet the stated requirements. Performance standards are also more efficient because they give people and firms incentives to change multiple things about their activity to reduce the total cost of pollution abatement; a power plant can reduce sulfur dioxide emissions by some combination of installing scrubber technology, switching to low-sulfur coal, and reducing total energy generation. 

Performance standards also have some drawbacks and limitations, however. It is difficult for a regulator to figure out the cost effective allocation of total pollution reduction between sources and then set different performance standards for each source to reach that cost effective allocation. Hence, performance standards tend to be uniform across individual pollution sources, and so pollution reduction is not done in the cheapest way possible for the industry and society overall. This problem is particularly severe where there is great variation among sources in their abatement costs, and thus the cost-effective allocation of cleanup among sources is far from uniform.

Incentive Policies

Other approaches to environmental policy give firms and individuals incentives to change their behavior rather than mandating specific changes. These incentive policies try to make use of market forces for what they do best—allocating resources cost-effectively within an economy—while correcting the market failures associated with externalities, public goods, and common pool resources.

Tax/Subsidy

Environmental taxes are based on a simple premise: if someone is not bearing the full social costs of their actions, then we should charge them an externality tax per unit of harmful activity (e.g. ton of pollution, gallon of stormwater runoff) that is equal to the marginal cost that is not borne by the individual. In this way, that person must internalize the externality, and will have the incentive to choose a level of activity that is socially optimal. Thus, if we think the social marginal cost of ton of carbon dioxide (because of its contribution to climate change) is $20, then we could charge a tax of $20 per ton of carbon dioxide emitted. The easiest way to do this would be to have a tax on fossil fuels according to the amount of carbon dioxide that will be emitted when they are burned. 

If a price is placed on carbon dioxide, all agents would have an incentive to reduce their carbon dioxide emissions to the point where the cost to them of reducing one more unit (their marginal abatement cost) is equal to the per unit tax. Therefore, several good things happen. All carbon dioxide sources are abating to the same marginal abatement cost, so the total abatement is accomplished in the most cost-effective way possible. Furthermore, total emissions in the economy overall will go down to the socially efficient level. Firms and individuals have very broad incentives to change things to reduce carbon dioxide emissions—reduce output and consumption, increase energy efficiency, switch to low carbon fuels—and strong incentives to figure out how to innovate so those changes are less costly. Finally, the government could use the revenue it collects from the tax to correct any inequities in the distribution of the program’s cost among people in the economy or to reduce other taxes on things like income. 

While taxes on externality-generating activities have many good features, they also have several drawbacks and limitations. First, while an externality tax can yield the efficient outcome (where costs and benefits are balanced for the economy as a whole), that only happens if policy makers know enough about the value of the externality to set the tax at the right level. If the tax is too low, we will have too much of the harmful activity; if the tax is too high, the activity will be excessively suppressed.

Second, even if we are able to design a perfect externality tax in theory, such a policy can be difficult to enforce. The enforcement agency needs to be able to measure the total quantity of the thing being taxed. In some cases that is easy—in the case of carbon dioxide for example, the particular fixed link between carbon dioxide emissions and quantities of fossil fuels burned means that through the easy task of measuring fossil fuel consumption we can measure the vast majority of carbon dioxide emissions. However, many externality-causing activities or materials are difficult to measure in total. Nitrogen pollution flows into streams as a result of fertilizer applications on suburban lawns, but it is impossible actually to measure the total flow of nitrogen from a single lawn over the course of a year so that one could tax the homeowner for that flow.

Third, externality taxes face strong political opposition from companies and individuals who don’t want to pay the tax. Even if the government uses the tax revenues to do good things or to reduce other tax rates, the group that disproportionately pays the tax has an incentive to lobby heavily against such a policy. This phenomenon is at least partly responsible for the fact that there are no examples of pollution taxes in the U.S. Instead, U.S. policy makers have implemented mirror-image subsidy policies, giving subsidies for activities that reduce negative externalities rather than taxing activities that cause those externalities. Environmental policy in the case of U.S. agriculture is a prime example of this, with programs that pay farmers to take lands out of production or to adopt environmentally friendly farming practices. A subsidy is equivalent to the mirror-image tax in most ways. However, a subsidy tends to make the relevant industry more profitable (in contrast to a tax, which reduces profits), which in turn can stimulate greater output and have a slight perverse effect on total pollution or environmental degradation; degradation per unit output might go down, but total output goes up.

Tradable Permits

Another major type of incentive policy is a tradable permits scheme. Tradable permits are actually very similar to externality taxes, but they can have important differences. These policies are colloquially known as “cap and trade”. If we know the efficient amount of the activity to have (e.g., number of tons of pollution, amount of timber to be logged) the policy maker can set a cap on the total amount of the activity equal to the efficient amount. Permits are created such that each permit grants the holder permission for one unit of the activity. The government distributes these permits to the affected individuals or firms, and gives them permission to sell (trade) them to one another. In order to be in compliance with the policy (and avoid punishment, such as heavy fines) all agents must hold enough permits to cover their total activity for the time period. The government doesn’t set a price for the activity in question, but the permit market yields a price for the permits that gives all the market participants strong incentives to reduce their externality-generating activities, to make cost-effective trades with other participants, and to innovate to find cheaper ways to be in compliance. Tradable permit policies are similar to externality taxes in terms of efficiency, cost-effectiveness, and incentives to innovate.

Tradable permit policies have been used in several environmental and natural resource policies. The U.S. used tradable permits (where the annual cap declined to zero over a fixed number of years) in two separate policy applications to reduce the total cost to society of (a) phasing out the use of lead in gasoline and (b) eliminating production of ozone-depleting chlorofluorocarbons. The Clean Air Act amendments of 1990 put in place a nationwide tradable permit program for emissions of acid-rain precursor sulfur dioxide from electric power plants. The European Union used a tradable permit market as part of its policy to reduce carbon dioxide emissions under the Kyoto protocol. Individual tradable quotas for fish in fisheries of Alaska and New Zealand have been used to rationalize fishing activity and keep total catches down to efficient and sustainable levels (see Case Study: Marine Fisheries).

Tradable permits have been adopted more widely than externality taxes. Two factors may contribute to that difference. First, tradable permit policies can have different distributional effects from taxes depending on how the permits are given out. If the government auctions the permits to participants in a competitive marketplace, then the tradable permit scheme is the same as the tax; the industry pays the government an amount equal to the number of permits multiplied by the permit price. However, policy makers more commonly design policies where the permits are initially given for free to participants in the market, and then participants sell the permits to each other. This eliminates the transfer of wealth from the regulated sector (the electric utilities, the fishing boats, etc.) to the government, a feature that has been popular with industry. Second, taxes and tradable permits behave differently in the face of uncertainty. A tax policy fixes the marginal cost to the industry, but might yield more or less of the harmful activity than expected if market conditions fluctuate. A cap and trade program fixes the total amount of the harmful activity, but can yield costs to industry that are wildly variable. Environmentalists have liked the outcome certainty of tradable permits.

Liability

A third type of environmental policy was not designed by economists, but still functions to give agents incentives to take efficient actions to reduce environmental degradation: liability. Liability provisions can make people or firms pay for the damages caused by their actions. If the expected payment is equal to the total externality cost, then liability makes the agent internalize the externality and take efficient precautions to avoid harming the environment.

Two kinds of liability exist in the U.S.: statutory and common law. Common law derives from a long tradition of legal history in the U.S.—people have sued companies for damages from pollution under tort law under doctrines such as nuisance, negligence, or trespass. This approach has been highly problematic for a number of reasons. For example, tort law places a high burden of proof on the plaintiff to show that damages resulted directly from actions taken by the defendant. Plaintiffs have often struggled with that burden because pollution problems are often caused by many sources, and the harm caused by pollution can display large lags in space and time. If the defendant expects with high probability not to be held responsible by the courts, then liability does not function effectively to make agents internalize the externality costs of their actions.

Frustration with common law has led to several strong statutory liability laws in the U.S. which make explicit provisions for holding firms liable for damages from pollution with much more manageable burdens of proof. The Oil Pollution Act of 1990 holds companies like Exxon and British Petroleum strictly liable for the damages caused by oil spills from accidents such as the Valdez grounding in Prince William Sound or the Deepwater Horizon explosion in the Gulf of Mexico. Under a rule of strict liability, a party is liable for harm if the harm occurred as a result of their actions regardless of the presence (or absence) of negligence or intent. The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA, or “Superfund”) holds companies strictly liable for damages from toxic waste “Superfund” sites.

These laws have surely increased the extent to which oil and chemical companies take precautions to avoid spills and other releases of hazardous materials into the environment. However, enforcement of these provisions is very costly. The legal proceedings for a big case like Deepwater Horizon entail court, lawyer, and expert witness activity (and high fees) for many years. The transaction costs are so burdensome to society that liability may not be a viable approach for all environmental problems.

Review questions

1. What does it mean for an outcome to be efficient?
2. How do externalities cause market outcomes not to be efficient?
3. How are the free rider problem and the common pool resource problem related to basic problems of externalities?
4. What are some of the strengths and weaknesses of command and control regulation? When would these be the best policy tool to use?
5. What are some of the strengths and weaknesses of incentive policies? When would these be the best policy tool to use?
6. Did Coase think government policy was not necessary to solve externality problems? Briefly explain.
7. How do liability laws function as incentive policies? What are some of their limitations?
8. Why might it be useful to estimate dollar values for features of the environment?
9. What are the three types of valuation tools? List at least one strength and one weakness of each.
10. What are some common mistakes people make in evaluating the costs of a policy or project, and what should you do to avoid them?
11. What is discounting, and how do we use it in calculating the costs and the benefits of a project that has effects over a long period of time?
12. Why is discounting controversial?
13. How does cost-benefit analysis complement some of the other measures people use to evaluate a policy or project?

References and Further Reading

Acheson, J. M. (1988). The Lobster Gangs of Maine. Lebanon, NH: University of New England Press.

Annala, J. H. (1996). New Zealand’s ITQ system: have the first eight years been a success or a failure? Reviews in Fish Biology and Fisheries. 6(1), 43–62. doi: 10.1007/BF00058519.

Beddington, J. R., Agnew, D.J., & Clark, C. W. (2007). Current problems in the management of marine fisheries. Science, 316(5832), 1713-1716. doi:10.1126/science.1137362.

Braden, J. B. & A. W. Ando. 2011. Economic costs, benefits, and achievability of low-impact development based stormwater regulations, in Economic Incentives for Stormwater Control, Hale W. Thurston, ed., Taylor & Francis, Boca Raton, FL.

Carson, R. T., Mitchell, R. C., Hanemann, M., Kopp, R. J., Presser, S., and Ruud, P. A. (2003). Contingent valuation and lost passive use: Damages from the Exxon Valdez oil spill. Environmental and Resource Economics, 25(3), 257-286. doi: 10.1023/A:1024486702104.

Coase, R.H. 1960. The problem of social cost. Journal of Law and Economics, 3, 1-44.

Costanza, R., d’Arge, R., de Groot, R., Farber, S., Grasso, M., Hannon, B., Limburg, K., Naeem, S., O’Neill, R. V., Paruelo, J., Raskin, R. G., Sutton, P., & van den Bel, M. (1997). The value of the world’s ecosystem services and natural capital. Nature, 387, 253–260. doi:10.1038/387253a0.

Costello, C., Gaines, S. D., & Lynham, J. (2008). Can catch shares prevent fisheries collapse? Science, 321(5896), 1678 – 1681. doi10.1126/science.1159478.

Dawson, D. & Shogren, J. F. (2001). An update on priorities and expenditures under the Endangered Species Act. Land Economics, 77(4), 527-532.

EDV&CBN (2000). Environmental groups protest alteration of U.S. Army Corps cost benefit analysis. Environmental Damage Valuation and Cost Benefit News, 7(4), 1-3. http://www.costbenefitanalysis.org/newsletters/nws00apr.pdf.

Levy, S. (2010). Catch shares management. BioScience, 60(10), 780–785. doi:10.1525/bio.2010.60.10.3.

Montaigne, F. (2007, April). Still waters, the global fish crisis. National Geographic Magazine. Retrieved from http://ngm.nationalgeographic.com/print/2007/04/global-fisheries-crisis/montaigne-text.

Worm, B., Barbier, E. B., Beaumont, N., Duffy, J. E., Folke, C., Halpern, B. S., Hackson, J. B. C., Lotze, H. K., Micheli, F., Palumbi, S. R., Sala, E., Selkoe, K. A., Stachowicz, J. J., & Watson, R. (2006). Impacts of biodiversity loss on ocean ecosystem services. Science, 314(5800), 787 – 790. doi:10.1126/science.1132294.