Start Up: A Market for Carbon Emissions

Pollution and Scarcity

Pollution exists whenever human activity generates a sufficient concentration of a substance in the environment to cause harm to people or to resources valued by people. Many potentially harmful substances are natural features of the environment, but they are not generally regarded as pollutants. Pollution is the product of people, not nature.

Pollution implies scarcity. If an activity emits harmful by-products into the environment, then the emission of the by-products is an alternative to some other activity. A scarcity problem exists at the point where harm occurs. A fire burning in a fireplace at a cabin in the forest whose smoke goes unnoticed does not suggest a scarcity problem. But when there are other people who will be harmed by the smoke, then one person’s enjoyment of the fire becomes an alternative to another person’s enjoyment of fresh air. Fresh air has become scarce, and pollution has become an economic problem.

Economists generally argue that pollution that harms plants or animals imposes a cost if the plants or animals are valued by people. When a farmer uses a pesticide that damages another farmer’s crop, for example, a pollution problem occurs. If an oil spill in the ocean damages sea animals that people care about, there is a pollution problem. It is, after all, people who make the choices that lead to pollution. It is people who can choose to limit their pollution. Economists therefore examine pollution problems from the perspective of the preferences of people.

The Efficient Level of Pollution

The efficient level of pollution is the quantity at which its total benefits exceed its total costs by the greatest possible amount. This occurs where the marginal benefit of an additional unit of pollution equals its marginal cost.

Figure 18.1 “Determining the Efficient Level of Pollution” shows how we can determine an efficient quantity of pollution. Suppose two neighbors in a remote mountain area, Mary and Jane, burn fires in their cabins that generate air pollution that harms two other individuals, Sam and Richard, who live downwind. We shall assume that Mary and Jane are the only polluters and that Sam and Richard are the only people harmed by the pollution. We shall ignore, for example, the effect of Mary and Jane’s emissions on the possible problem of global warming.

Suppose, as is often the case, that no mechanism exists to charge Mary and Jane for their emissions; they can pollute all they want and never have to compensate society (that is, pay Sam and Richard) for the damage they do. Alternatively, suppose there is no mechanism for Sam and Richard to pay Mary and Jane to get them to reduce their pollution. In either situation, the pollution generated by Mary and Jane imposes an external cost on Sam and Richard. Mary and Jane will pollute up to the point that the marginal benefit of additional pollution to them has reached zero—that is, up to the point where the marginal benefit matches their marginal cost. They ignore the external costs they impose on “society”—Sam and Richard.

Mary’s and Jane’s demand curves for pollution are shown in Panel (a). These demand curves, D_M and D_J, show the quantities of emissions each generates at each possible price, assuming such a fee were assessed. At a price of $13 per unit, for example, Mary will emit 20 units of pollutant per period and Jane will emit 14. Total emissions at a price of $13 would be 34 units per period. If the price of emissions were zero, total emissions would be 60 units per period. Whatever the price they face, Mary and Jane will emit additional units of the pollutant up to the point that their marginal benefit equals that price. We can therefore interpret their demand curves as their marginal benefit curves for emissions. Their combined demand curve D_T gives the marginal benefit to society (that is, to Mary and Jane) of pollution. Each person in our problem, Mary, Jane, Sam, and Richard, follows the marginal decision rule and thus attempts to maximize utility.

In Panel (b) we see how much Sam and Richard are harmed; the marginal cost curves, MC_S and MC_R, show their respective valuations of the harm imposed on them by each additional unit of emissions. Notice that over a limited range, some emissions generate no harm. At very low levels, neither Sam nor Richard is even aware of the emissions. Richard begins to experience harm as the quantity of emissions goes above 5 pounds per day; it is here that pollution begins to occur. As emissions increase, the additional harm each unit creates becomes larger and larger—the marginal cost curves are upward sloping. The first traces of pollution may be only a minor inconvenience, but as pollution goes up, the problems it creates become more serious—and its marginal cost rises.

Because the same emissions affect both Sam and Richard, we add their marginal cost curves vertically to obtain their combined marginal cost curve MC_T. The 34th unit of emissions, for example, imposes an additional cost of $9 on Sam and $4 on Richard. It thus imposes a total marginal cost of $13.

The efficient quantity of emissions is found at the intersection of the demand (D_T) and marginal cost (MC_T) curves in Panel (c) of Figure 18.1 “Determining the Efficient Level of Pollution”, with 34 units of the pollutant emitted. The marginal benefit of the 34th unit of emissions, as measured by the demand curve D_T, equals its marginal cost, MC_T, at that level. The quantity at which the marginal benefit curve intersects the marginal cost curve maximizes the net benefit of an activity.

We have already seen that in the absence of a mechanism to charge Mary and Jane for their emissions, they face a price of zero and would emit 60 units of pollutant per period. But that level of pollution is inefficient. Indeed, as long as the marginal cost of an additional unit of pollution exceeds its marginal benefit, as measured by the demand curve, there is too much pollution; the net benefit of emissions would be greater with a lower level of the activity.

Just as too much pollution is inefficient, so is too little. Suppose Mary and Jane are not allowed to pollute; emissions equal zero. We see in Panel (c) that the marginal benefit of dumping the first unit of pollution is quite high; the marginal cost it imposes on Sam and Richard is zero. Because the marginal benefit of additional pollution exceeds its marginal cost, the net benefit to society would be increased by increasing the level of pollution. That is true at any level of pollution below 34 units, the efficient solution.

The notion that too little pollution could be inefficient may strike you as strange. To see the logic of this idea, imagine that the pollutant involved is carbon monoxide, a pollutant emitted whenever combustion occurs, and it is deadly. It is, for example, emitted when you drive a car. Now suppose that no emissions of carbon monoxide are allowed. Among other things, this would require a ban on all driving. Surely the benefits of some driving would exceed the cost of the pollution created. The problem in pollution policy from an economic perspective is to find the quantity of pollution at which total benefits exceed total costs by the greatest possible amount—the solution at which marginal benefit equals marginal cost.

Property Rights and the Coase Theorem

The problem of getting the efficient amount of pollution arises because no one owns the right to the air. If someone did, then that owner could decide how to use it. If a nonowner did not like the way the owner was using it, then he or she could try to pay the owner to change the way the air was being used.

In our earlier example, if Mary and Jane own the right to the air, but Sam and Richard do not like how much Mary and Jane are polluting it, Sam and Richard can offer to pay Mary and Jane to cut back on the amount they are polluting. Alternatively, if Sam and Richard own the air, then in order to pollute it, Mary and Jane would have to compensate the owners. Bargaining among the affected parties, if costless, would lead to the efficient amount of pollution. Costless bargaining requires that all parties know the source of the pollution and are able to measure the quantity emitted by each agent.

Specifically, suppose Mary and Jane own the right to dump pollutants into the air and had been emitting 60 units of the pollution per day. If Sam and Richard offer to pay them $13 for each unit of pollutant they cut back, Mary and Jane will reduce their pollution to 34 units, since the marginal benefit to them of the 35th to 60th unit is less than $13. Sam and Richard are better off since the marginal cost of those last 26 units of pollution is greater than $13 per unit. The efficient outcome of 34 units of pollution is thus achieved. Mary and Jane could reduce their emissions by burning their fires for less time, by selecting more efficient fireplaces, or by other measures. Many people, for example, have reduced their emissions by changing to gas-burning fireplaces rather than burning wood.

While the well-being of the affected parties is not independent of who owns the property right (each would be better off owning rather than not owning the right), the establishment of who owns the air leads to a solution that solves the externality problem and leads to an efficient market outcome. The proposition that if property rights are well defined and if bargaining is costless, the private market can achieve an efficient outcome regardless of which of the affected parties holds the property rights is known as the Coase theorem, named for the Nobel-Prize-winning economist Ronald Coase who generally is credited with this idea.

Suppose instead that Sam and Richard own the right to the air. They could charge Mary and Jane $13 per unit of pollution emitted. Mary and Jane would willingly pay for the right to emit 34 units of pollution, but not for any more, since beyond that amount the marginal benefit of each unit of pollution emitted is less than $13. Sam and Richard would willingly accept payments for 34 units of pollution at $13 each since the marginal cost to them for each of those units is less than $13.

In most cases, however, Coase stressed that the conditions for private parties to achieve an efficient outcome on their own are not present. Property rights may not be defined. Even if one party owns a right, enforcement may be difficult. Suppose Sam and Richard own the right to clean air but many people, not just two as in our example, contribute to polluting it. Would each producer that pollutes have to strike a deal with Sam and Richard? Could the government enforce all those deals? And what if there are many owners as well? Enforcement becomes increasingly difficult and striking deals becomes more and more costly. Finally, monitoring is extremely difficult in most environmental problems. While it is generally possible to detect the presence of pollutants, determining their source is virtually impossible. And determining who is harmed and by how much is a monumental undertaking in most pollution problems.

Nonetheless, it is the insight that the Coase theorem provides that has led economists to consider solutions to environmental problems that attempt to use the establishment of property rights and market mechanisms in various ways to bring about the efficient market outcome. Before considering alternative ways of controlling pollution, we look first at how the benefits and costs might be measured so that we have a better sense of what the efficient solution is.

Another insight that comes from Coase’s analysis is that the notion of “harm” is a reciprocal one. In our first example, it is tempting to conclude that Mary and Jane, by burning fires in their fireplaces, are “harming” Sam and Richard. But if Sam and Richard were not located downwind of the smoke, there would be no harm. In effect, Mr. Coase insists that the harm cannot be attributed to one party or another. Sam and Richard “cause” the harm by locating downwind of the fireplaces. While there is clearly harm in this situation, we could as easily attribute it to either the generators of the smoke or the recipients of the smoke. Before Coase wrote his article, “The Problem of Social Cost” in 1960, the general presumption was that decision makers such as Mary and Jane “cause” the harm and that they should be taxed for the costs they impose. Mr. Coase pointed out the alternative that Sam and Richard could avoid the harm by moving. Indeed, all sorts of alternative solutions come to mind even in this simple example. Mary and Jane could select types of wood that emit less smoke. They could use fireplaces that emit less smoke. They could make arrangements to time their burning to minimize the total amount of smoke that affects Sam and Richard. The goal, Coase said, is to select the most efficient from the alternatives available.R. H. Coase, “The Problem of Social Cost,” Journal of Law and Economics 3 (October 1960): 1–44.

Consider a different problem. Suppose that an airport has been built several miles outside the developed portion of a small city. No one lives close enough to the airport to be “harmed” by the noise inevitably generated by the operation of the airport. As time passes, people are likely to build houses near the airport to take advantage of jobs at the airport or to gain easy access to it. Those people will now be “harmed” by noise from the airport. But what is the cause of this harm? By definition, there was no “harm” before people started living close to the airport. True, it is the airport that generates the noise. But the noise causes harm only because people now live near it. Just as Mary and Jane’s campfires only generate “harm” if someone is downwind of the smoke, the noise from the airport causes damage only if someone lives near the airport. The problem of the noise could be mitigated in several ways. First, people could have chosen not to live near the airport. Once they have chosen to live near the airport, they could reduce the noise with better insulation or with better windows. Alternatively, the airport management could choose different flight patterns to reduce noise that affects neighboring homeowners. It is always the case that there are several potential ways of mitigating the effects of airport operations; the economic problem is to select the most efficient from among those alternatives.

The Measurement of Benefits and Costs

Saying that the efficient level of pollution occurs at a certain rate of emissions, as we have done so far, is one thing. Determining the actual positions of the demand and marginal cost curves that define that efficient solution is quite another. Economists have devised a variety of methods for measuring these curves.

The Efficient Level of Emissions and Abatement

Whether economists measure the marginal benefits and marginal costs of emissions or, alternatively, the marginal benefits and marginal costs of abatement, the policy implications are the same from an economic perspective. As shown in Panel (a) of Figure 18.4 “The Efficient Level of Emissions and Pollution Abatement”, applying the marginal decision rule in the case of emissions suggests that the efficient level of pollution occurs at six pounds of CO emitted per week. At any lower level, the marginal benefits of the pollution would outweigh the marginal costs. At a higher level, the marginal costs of the pollution would outweigh the marginal benefits.

Figure 18.4 The Efficient Level of Emissions and Pollution Abatement

In Panel (a) we combine the marginal benefit of emissions (MB_E) with the marginal cost of emissions (MC_E). The efficient solution occurs at the intersection of the two curves. Here, the efficient quantity of emissions is six pounds of CO per week. In Panel (b), we have the same curves read from right to left. The marginal cost curve for emissions becomes the marginal benefit of abatement (MB_A). The marginal benefit curve for emissions becomes the marginal cost of abatement (MC_A). With no abatement program, emissions total ten pounds of CO per week. The efficient degree of abatement is to reduce emissions by four pounds of CO per week to six pounds per week.

As shown in Panel (b) of Figure 18.4 “The Efficient Level of Emissions and Pollution Abatement”, application of the marginal decision rule suggests that the efficient level of abatement effort is to reduce pollution by 4 pounds of CO produced per week. That is, reduce the level of pollution from the 10 pounds per week that would occur at a zero price to 6 pounds per week. For any greater effort at abating the pollution, the marginal cost of the abatement efforts would exceed the marginal benefit.

KEY TAKEAWAYS

• Pollution is related to the concept of scarcity. The existence of pollution implies that an environmental resource has alternative uses and is thus scarce.
• Pollution has benefits as well as costs; the emission of pollutants benefits people by allowing other activities to be pursued at lower costs. The efficient rate of emissions occurs where the marginal benefit of emissions equals the marginal cost they impose.
• The marginal benefit curve for emitting pollutants can also be read from right to left as the marginal cost of abating emissions. The marginal cost curve for increased emission levels can also be read from right to left as the demand curve for improved environmental quality.
• The Coase theorem suggests that if property rights are well-defined and if transactions are costless, then the private market will reach an efficient solution. These conditions, however, are not likely to be present in typical environmental situations. Even if such conditions do not exist, Coase’s arguments still yield useful insights to the mitigation of environmental problems.
• Surveys are sometimes used to measure the marginal benefit curves for emissions and the marginal cost curves for increased pollution levels. Marginal cost curves may also be inferred from other relationships. Two that are commonly used are the demand for housing and the relationship between pollution and production.

TRY IT!

The table shows the marginal benefit to a paper mill of polluting a river and the marginal cost to residents who live downstream. In this problem assume that the marginal benefits and marginal costs are measured at (not between) the specific quantities shown.

Plot the marginal benefit and marginal cost curves. What is the efficient quantity of pollution? Explain why neither one ton nor five tons is an efficient quantity of pollution. In the absence of pollution fees or taxes, how many units of pollution do you expect the paper mill will choose to produce? Why?

Quantity of pollution (tons per week)	Marginal benefit	Marginal cost
0	$110	$0
1	100	8
2	90	20
3	80	35
4	70	70
5	60	150
6	0	300

Case in Point: Estimating a Demand Curve for Environmental Quality

How do economists estimate demand curves for environmental quality? One recent example comes from work by Louisiana State University economist David M. Brasington and Auburn University economist Diane Hite. Using data from Ohio’s six major metropolitan areas (Akron, Cincinnati, Cleveland, Columbus, Dayton, and Toledo), the economists studied the relationship between house prices and the distance between individual houses and hazardous waste sites. From this, they were able to estimate the demand curve for environmental quality—at least in terms of the demand for locations farther from environmental hazards.

The economists used actual real estate transactions in 1991 to get data on house prices. In that year, there were 1,192 hazardous sites in the six metropolitan areas. The study was based on 44,255 houses. The median distance between a house and a hazardous site was 1.08 miles. The two economists found, as one would expect, that house prices were higher the greater the distance between the house and a hazardous site. All other variables unchanged, increasing the distance from a house to a hazardous site by 10% increased house value by 0.3%.

Other characteristics of the demand curve shed light on the relationship between environmental quality and other goods. For example, the study showed that people substitute house size for environmental quality. A house closer to a hazardous waste site is cheaper; people take advantage of the lower price of such sites to purchase larger houses.

While house size and environmental quality were substitutes, school quality, measured by student scores on achievement tests, was a complement. If the price of school quality were to fall by 10%, household would buy 8% more environmental quality. The cross-price elasticity between environmental quality and school quality was thus estimated to be −0.80.

There is no marketplace for environmental quality. Estimating the demand curve for such quality requires economists to examine other data to try to infer what the demand curve is. The study by Professors Brasington and Hite illustrates the use of an examination of an actual market, the market for houses, to determine characteristics of the demand curve for environmental quality.

Source: David M. Brasington and Diane Hite, “Demand for Environmental Quality: A Spatial Hedonic Analysis,” Regional Science & Urban Economics, 35(1) (January 2005): 57–82.

ANSWER TO TRY IT! PROBLEM

The efficient quantity of pollution is four tons per week. At one ton of pollution, the marginal benefit exceeds the marginal cost. If the paper mill expands production, the additional pollution generated leads to additional benefits for it that are greater than the additional cost to the residents nearby. At five tons, the marginal cost of polluting exceeds the marginal benefit. Reducing production, and hence pollution, brings the marginal costs and benefits closer.

In the absence of any fees, taxes, or other charges for its pollution, the paper mill will likely choose to generate six tons per week, where the marginal benefit has fallen to zero.

Moral Suasion

Back in the days when preventing forest fires was a goal of public policy, a cartoon character called Smokey the Bear once asked us to be careful with fire. Signs everywhere remind us not to litter. Some communities have mounted campaigns that admonish us to “Give a hoot—don’t pollute.”

These efforts to influence our choices are examples of moral suasion, an effort to change people’s behavior by appealing to their sense of moral values. Moral suasion is widely used as a tactic in attempting to reduce pollution. It has, for example, been fairly successful in campaigns against littering, which can be considered a kind of pollution. Efforts at moral suasion are not generally successful in reducing activities that pollute the air and water. Pleas that people refrain from driving on certain days when pollution is very great, for example, achieve virtually no compliance.

Moral suasion appears to be most effective in altering behaviors that are not already widespread and for which the cost of compliance is low. It is easy to be careful with one’s fires or to avoid littering.

Moral suasion does not, however, appear to lead to significant changes in behavior when compliance costs are high or when the activity is already widely practiced. It is therefore not likely to be an effective tool for reducing most forms of pollution.

Command and Control

In the most widely used regulatory approach to environmental pollution, a government agency tells a polluting agent how much pollution it can emit or requires the agent to use a particular production method aimed at reducing emissions. This method, in which the government agency tells a firm or individual how much or by what method emissions must be adjusted, is called the command-and-control-approach.

Economists are generally critical of the command-and-control approach for two reasons. First, it achieves a given level of emissions reduction at a higher cost than what would be required to achieve that amount of reduction if market incentives (discussed below) were implemented. Second, it gives polluters no incentive to explore technological and other changes that might reduce the demand for emissions.

Suppose two firms, A and B, each dump 500 tons of a certain pollutant per month and that there is no fee imposed (that is, the price for their emissions equals zero). Total emissions for the two firms thus equal 1,000 tons per month. The pollution control authority decides to cut this in half and orders each firm to reduce its emissions to 250 tons per month, for a total reduction of 500 tons. This is a command-and-control regulation because it specifies the amount of reduction each firm must make. Although it may seem fair to require equal reductions by the two firms, this approach is likely to generate excessive costs.

Suppose that Firm A is quite old and that the reduction in emissions to 250 tons per period would be extremely costly. Suppose that removing the 251st ton costs this firm $1,000 per month. Put another way, the marginal benefit to Firm A of emitting the 251st ton would be $1,000.

Suppose Firm B, a much newer firm, already has some pollution-control equipment in place. Reducing its emissions to 250 tons imposes a cost, but a much lower cost than to Firm A. Indeed, suppose Firm B could reduce its emissions to 249 tons at an additional cost of $100; the marginal benefit to Firm B of emitting the 249th ton is $100.

If two firms have different marginal benefits of emissions, the allocation of resources is inefficient. The same level of emissions could be achieved at a lower cost. Suppose, for example, Firm A is permitted to increase its emissions to 251 tons while Firm B reduces emissions to 249. Firm A saves $1,000, while the cost to Firm B is just $100. Society achieves a net gain of $900, and the level of emissions remains at 500 tons per month.

As long as Firm A’s marginal benefit of emissions exceeds Firm B’s, a saving is realized by shifting emissions from B to A. At the point at which their marginal benefits are equal, no further reduction in the cost of achieving a given level of emissions is possible, and the allocation of emissions is efficient. When a given reduction in emissions is achieved so that the marginal benefit of an additional unit of emissions is the same for all polluters, it is a least-cost reduction in emissions. A command-and-control approach is unlikely to achieve a least-cost reduction in emissions.

The inefficiency of command-and-control regulation is important for two reasons. First, of course, it wastes scarce resources. If the same level of air or water quality could be achieved at a far lower cost, then surely it makes sense to use the cheaper method. Perhaps even more significant, reliance on command-and-control regulation makes environmental quality far more expensive than it needs to be—and that is likely to result in an unwillingness to achieve the improvements that would be economically efficient.

There is a further difficulty with the command-and-control approach. Once firms A and B have been told to reduce their emissions to 250 tons per period, neither firm has an incentive to try to do better. Neither firm will engage in research seeking to reduce its emissions below 250 tons.

Another way to see the difficulty with command-and-control approaches to pollution control is to imagine that a similar method were in use for other resource allocation problems. Suppose, for example, that labor were allocated according to a command-and-control mechanism. Rather than leaving labor allocation to the marketplace, suppose that firms were simply told how much labor to use. Such a system would clearly be unworkable.

Incentive Approaches

Markets allocate resources efficiently when the price system confronts decision makers with the costs and benefits of their decisions. Prices create incentives—they give producers an incentive to produce more and consumers an incentive to economize. Regulatory efforts that seek to create market-like incentives to encourage reductions in pollution, but that allow individual decision makers to determine how much to pollute, are called incentive approaches.

Public Policy and Pollution: The Record

Federal efforts to control air and water pollution in the United States have produced mixed results. Air quality has generally improved; water quality has improved in some respects but deteriorated in others.

Figure 18.5 “U.S. Air Pollution Levels, 1980–2009” shows how annual average concentrations of airborne pollutants in major U.S. cities have declined since 1980. Lead concentrations have dropped most dramatically, largely because of the increased use of unleaded gasoline.

Public policy has generally stressed command-and-control approaches to air and water pollution. To reduce air pollution, the EPA sets air quality standards that regions must achieve, then tells polluters what adjustments they must make in order to meet the standards. For water pollution, the Environmental Protection Agency (EPA) has set emissions limits based on the technologies it considers reasonable to require of polluters. If the implementation of a particular technology will reduce a polluter’s emissions by 20%, for example, the EPA will require a 20% reduction in emissions. National standards have been imposed; no effort has been made to consider the benefits and costs of pollution in individual streams. Further, the EPA’s technology-based approach pays little attention to actual water quality—and has produced few gains.

Moreover, environmental problems go beyond national borders. For example, sulfur dioxide emitted from plants in the United States can result in acid rain in Canada and elsewhere. Another possible pollution problem that extends across national borders is suggested by the global warming hypothesis.

Many scientists have argued that increasing emissions of greenhouse gases, caused partly by the burning of fossil fuels, trap ever more of the sun’s energy and make the planet warmer. Global warming, they argue, could lead to flooding of coastal areas, losses in agricultural production, and the elimination of many species. If this global warming hypothesis is correct, then carbon dioxide is a pollutant with global implications, one that calls for a global solution.

At the 1997 United Nations conference in Kyoto, Japan, the industrialized countries agreed to cuts in carbon dioxide emissions of 5.2% below the 1990 level by 2010. At the 1998 conference in Buenos Aires, Argentina, 170 countries agreed on a two-year action plan for designing mechanisms to reduce emissions and procedures to encourage transfers of new energy technologies to developing countries.

While the delegates to the conferences sign the various protocols, countries are not bound by them until ratified by appropriate governmental bodies. By 2005, the vast majority of the world’s nations had ratified the agreement. The United States had neither signed nor ratified the agreement.

Debates at these conferences have been over the extent to which developing countries should be required to reduce their emissions and over the role that market mechanisms should play. Developing countries argue that their share in total emissions is fairly small and that it is unfair to ask them to give up economic growth, given their lower income levels. As for how emissions reductions will be achieved, the United States has been the strongest advocate for emissions trading in which each country would receive a certain number of tradable emissions rights. This provision has been incorporated in the agreement.

That market approaches have entered the national and international debates on dealing with environmental issues, and to a large extent have even been used, demonstrates the power of economic analysis. Economists have long argued that as pollution-control authorities replace command-and-control strategies with incentive approaches, society will reap huge savings. The economic argument has rested on acknowledging the opportunity costs of addressing environmental concerns and thus has advocated policies that achieve improvements in the environment in the least costly ways.