An Analysis of Pollution

Pollution can be defined as the 'harm or damage done to animals/plants and their ecosystems'. Pollution is an externality, the effects of which the costs and benefits are not fully reflected in potential or actual market exchanges. Since no-one owns the atmosphere, there is no market in it and therefore no market price for clean air etc. This means that firms have no incentive not to pollute. This means that forces outside the market must be used in order to ensure the socially optimum level of pollution. In this essay, I will first be tackling what the socially optimum level of pollution means, and then I will be discussing taxes, standards and tradable permits as means of ensuring it. Finally I will be offering loose comparison between them and deciding which of the three options I consider best as a means of achieving the socially optimum level of pollution.

In order to answer this question we must fist resolve what is meant by the socially optimum level of pollution. It is infeasible for example, to have no pollution at all, because no pollution would require no production, therefore some level of pollution must be tolerated. There is an opportunity cost associated with pollution abatement; a cleaner environment requires higher production costs and a lower level of output. The cost of reducing pollution is called the abatement cost, this includes inspection costs, pollution control costs and the value of forgone output due to a reduction in emissions.

The marginal cost of abatement curve (MCA) shows the extra cost of abatement arising from the reduction in pollution by one unit. In the above diagram this is measured by the level of emissions. The steepness of this curve will vary depending on the pollutant. The MCA increases as the units of pollution decrease, due to the fact that at lower levels of pollution more valuable resources are drawn in to further reduce the pollution.

The Marginal social cost of pollution (MSCP) curve measures the extra cost to society of one extra unit of pollutant. Up to a certain level, (EO) this can be zero due to the absorbent and dispersal properties of the surrounding environment.

E* is the socially optimal level of pollution, where the MSCP and the MCA of abatement are equal. Above this level the marginal costs of reducing the damage exceeds the marginal benefits to society of reducing pollution, and above the marginal benefits exceeds the marginal cost to society, leading to an inefficiently high level of pollution.

The socially optimum level of pollution is found where the marginal befits to society are equal to the marginal social costs, this is the marginal private costs of the firm plus the marginal external costs to society: MSC=MEC + MPC. It is found at the point where the price (Ps) of the product is equal to the marginal social cost of production at output Qs.

Due to the fact that the environment is a public good, the markets themselves will not take into account the externalities and will produce at a point not equal to the socially optimum level of pollution. This means that some government intervention is necessary, in the parameters of this question either tradable permits, standards or taxes.

What are taxes, how do they work and how will they help achieve a socially optimum level of pollution? The British economist Pigou first developed the basis for the concept of a pollution tax in The Economics of Welfare. In this book he states that a tax can be implemented to minimize the difference between marginal social net product and marginal private net product. Taxes alter the composition of production and consumption.

This graph shows how the producer would choose to produce at Q1 where his marginal costs equal the price i.e. at the output that maximises his profit. This does not take into account the external pollution cost. If the government imposes a tax on production equal to the marginal pollution cost, the externality is effectively internalised', this means that the producer will now choose to produce at Q2, as the tax leads to the firm's new marginal cost curve, the MSC, which is equal to the MSB at Q2, at the socially optimum level of output.

Emissions tax is the most effective tax at achieving the socially optimum level of pollution; this is because it deals directly with the source of damage. Nonetheless input taxes and output taxes can be used, but for the purpose of this essay I will be discussing emission taxes.

The advantage of so-called green tax in inducing the socially optimal level of pollution is that it effectively internalises the external cost. The firm will then have a choice over whether to lower their emissions or pay the taxes. This means that the firm will have a profit based incentive to lower their emissions to the socially optimum level; the pressure to reduce their emissions is continuous and might encourage firms to take on 'cleaner' production. Emission taxes have the advantage that they can minimise the cost of reducing production and mean that regulators do not have to specify how the pollution is to be abated. Taxes are also adjustable, making the system more flexible over time.

In an ideal world, there should be separate taxes for each polluter depending on the position of its marginal cost of pollution curve; even if two firms have exactly the same pollutants and emission rates, they may be situated in different places whereby the environment is better able to absorb pollutants in one area than another. This creates a problem as is infeasible to use different tax rates; it would be administratively difficult and expensive. There is also the problem of imperfect information, how serious is the damage? What is the monetary cost? How lasting is the damage? How do you apportion the blame?
The elasticity of the demand for the product also plays a part, the tax will not be very effective if the demand for the product with its associated pollution costs is highly inelastic.

There is also the question of domestic competitiveness, the tax will increase the cost to the firm making it uncompetitive with other companies abroad, meaning that exports will fall. Taxes would thus be a highly unpopular choice politically. Not only this, but firms will move to other countries with less or no green tax, meaning that the domestic economy loses out and that the globally optimum level of pollution is still not achieved.
So, what about the more politically acceptable move of enforcing standards instead?

Standards are a command and control system of achieving the socially optimum level of pollution. Standards set a maximum level of emission or resource use, or minimum acceptable levels of environmental quality. This is enforced with fines for transgressing firms. In order to ascertain if firms are complying with these standards regular inspections must be held and the fines must be large enough to be a good deterrent. There can be three different types of standard:

  1. Technology based standards - requires that a firm's emissions reflect the levels that could be achieved using the best available pollution control technology. (This is also known as BATNEEC)
  2. Ambient based standards - where the firms are required to meet minimum standards for the environment
  3. Social-impact standards- focusing on the effect on people i.e. health etc.

The advantages of standards are that they are relatively straightforward to devise, they are also easier to understand for the firms and consequently easier to implement. It is very difficult to get governments to agree on satisfactory international agreements when it comes to pollution taxes, standards in this case seem like a simpler, more politically efficient way of globally achieving the socially optimum level of pollution.
When it comes to pollution like nuclear waste, standards are an efficient way of reaching the socially optimum level of pollution; this is due to the high risk factor involved, as well as the inelasticity of the products.

Yet they tend to be economically inefficient. They fail to recognise that polluters face different cost curves in reducing pollution. Therefore, they do not minimise the costs of a given amount of pollution abatement. In cases where they mandate the use of a particular pollution abatement device, they stifle innovation in coming up with more cost efficient ways of reducing pollution. Standards are also very costly and difficult to enforce.

The third option presented to us ion reaching the socially optimum level of pollution is tradable permits. This is a mixture of both the market incentive approach and the command and control approach. Here a polluter receives a permit to emit a specified amount of waste. The total amount of permits for emissions of a pollutant is controlled and can be set at the socially optimum level for that pollutant. Within the limits, firms emitting that pollutant can buy and sell the permits. Assume for example, two firms W and Z. The government sets a standard for CO2 emissions, with an upper limit of 20 units. Each firm is given tradable permits, permitting them to emit 10 units of CO2 each. Without restrictions Firm W and Z would produce 12 units of CO2 each, this means that both would have to reduce their emissions by 2 units. Assume that firm w can, with his level of pollution abatement technology and lower abatement curve, lower his emissions to 8 units, firm Z on the other hand with his high abatement curve cannot. Firm W can then sell 2 units from his permits to firm Z. The total abatement of CO2 is still the desired 4units, and in the most cost-effective manner. This is due to the fact that companies that would otherwise have to buy extremely expensive technology in order to reduce their emissions can instead buy permits.

This system combines the simplicity of the control and command methods with the benefits of achieving pollution reduction in the most efficient way. The government can do this without having any specific knowledge of costs and benefits of individual firms. On the other hand this could lead to regional problems, whereby the intensity of pollution could be found in certain areas, leading to a regional non-optimal level of pollution. There will also be less pressure on the 'dirtier' factories to clean up their technology.

There have not been many instances of large-scale implementations of permit trading regimes. One example was the fade out of lead in gasoline in the US. To reduce the level of toxic lead in the environment, the U.S. EPA in 1973 instituted a program of mandated reductions in the amount of lead added to gasoline. In 1982, to provide small refiners with more flexibility in meeting new, lower lead limits, the EPA set up a system for allowing refineries to trade their rights to add specified quantities of lead to the gasoline they produced. The difference between the amount a refiner was allowed, and the reduced amount it actually added, could be sold to other refiners, or, beginning in 1985, banked for future use or sale. The program ended in 1986 with the complete phase-out of lead additives, although firms with banked rights were able to use them to the end of 1987.

It resulted in the elimination of lead in gasoline within a short timeframe and did it cost efficiently, it was estimated that the program saved refiners $226 million.
In deciding which of these three options to use to achieve socially optimal levels of pollution it is important to consider the cost. Is pollution being reduced in the most cost-effective manner, with incentives to achieve better pollution abatement technology?

Let us assume that the socially efficient level of emissions is 500, as in the above diagram. An emissions tax has been set at and an emissions standard at 500 units. From this diagram, it seems that both the standard and the emissions tax get exactly the same results, achieving the socially optimum level of pollution. Yet standards break the equi-marginal rule of cost minimisation and are less cost effective. The standard system is also open to regulatory capture and provides little incentive to carry on with innovation of pollution abatement techniques, as well as being less flexible than taxes to changes and discoveries in green economics. Standards, as politically popular and simple as they are, should probably be confined to extremely hazardous material, more in the name of safety than economics.

Yet taxes themselves have major drawbacks, how do you decrease emissions by taxation with monopolistic firms such as those dealing nuclear waste and other large monopoly firms producing pollutants? These monopolistic firms are have highly inelastic demand curves, and can easily pass the tax onto the consumers while barely reducing production, which would not achieve the socially optimum level of production. There is also the large problem of international lack of co-operation on the green tax issue. Without global co-operation, corporations will move to countries with less of a tax burden, meaning that globally pollution has not been reduced. Taxation is ideally suited to environmental problems like leaded and unleaded petrol. The use of taxation on this has over the years diminished the use of leaded petrol in the UK in favour of unleaded. It also acted as incentive for firms to switch to producing unleaded petrol.
I believe that in most cases tradable permits are the answer to closely achieving a socially optimal level of pollution, specifically in relation to emissions. It combines the best of the standards and market approach. It allows the government to set a limit on the total emissions, without compromising the competitiveness of the firms. It rewards those firms with good techniques, by letting them sell their permits.

In conclusion, in order to achieve the socially optimum level of pollution, the external costs of pollution must be taken into account. Where the marginal social cost of pollution equals the marginal cost of abatement, that point is the optimum point. The government must intervene for this to occur due to the fact that there is no market in the atmosphere, within the parameters of the question this can be done to a greater or lesser extent by taxes, standards or tradable permits. Theoretically green taxes or emission charges are an extremely effective way of reaching the optimum point, by internalising the externality. Yet in practice, they are often not due to inelasticity, lack of knowledge and loss of domestic competitiveness. The use of the more politically popular standards is a useful tool to reduce pollution, it is also simple and easy to implement. Yet it is difficult to enforce without high expense and is not cost effective. This leaves us with the hybrid market and command/control approach of tradable permits, which I believe is the most effective in practice, due to its simplicity and cost effectiveness.