Government intervention may be needed to correct for market failure.
The term market failure is used when the private market generates less than optimal outcomes. If the invisible hand of the market produces a mix of output that’s different from the mix that is most desired by society, the market has failed. The failure of the private market to include pollution related external costs in production and consumption decisions establishes a basis for government intervention.
Before the government sector is called to correct market failure, one crucial, but realistic, condition must be met: Government intervention must improve market outcomes. Society is not served when the costs of government intervention (e.g., increase in bureaucracy, diversion of resources, etc.) outweigh the benefits (e.g., a cleaner environment).
How can government intervention help? The government needs to, either directly or indirectly, correct miscommunication in the marketplace. When the correction is made, the divergence between private costs and social costs is eliminated.
We can sum up the options open to the government in two general strategies for environmental protection:
- Alter market incentives in such a way that they discourage pollution.
- Bypass market incentives with some form of regulatory intervention.
Both strategies involve the government correcting market miscommunication. The government does this by internalizing external costs and benefits.
Altering Market Incentives
Somehow, the government has to get the market participants to recognize all costs (private and external) before the production decision is made. This approach relies on the market participants to make their own decisions based on the revised (and more accurate) cost and benefit data. In other words, the government is allowing the market to choose the rate of output but with additional information.
Emission Fees (production-side)
An example of a market-based approach to internalize external costs on the production side of the market is for the government to charge the private firms for pollution generated from their production. Emission fees attach direct costs to the act of polluting. With this approach, the firm is allowed to operate according to its profit maximizing principles, but it will be charged for all resources used in the production process (even the clean air or drinkable water it was consuming and polluting for free). An example of an emission fee would be the government charging a power company 2 cents for every gram of noxious emission it discharges into the air.
Confronted with emission fees, the profit-maximizing firm will alter its production decision. An emission fee increases the private cost of production and encourages lower and/or cleaner output (see Figure 11).
Figure 11
Figure 11 shows how an emission fee (t) can be used to close the gap between social costs and private costs. The amount of the fee is equal to the external cost. Faced with an emission fee of size t, firms will reduce supply (because their cost of production has increased) and consumers will reduce demand (because firms pass part of the emission fee to consumers via higher prices). The emission fee causes the market equilibrium output to fall from Q0 to Q1 and the equilibrium price to rise from P0 to P1. Reduced output leads to reduced pollution.
User Fees (consumption-side)
Another market-based approach to internalizing pollution externalities is to make consumers pay for the pollution that is generated from their consumption. An example of a user fee is a gasoline tax on fuel consumers at the point of purchase of the fuel. If drivers were charged for the damage caused by the carbon emissions from their car’s tail pipe, they would drive fewer miles in their car. A gasoline tax encourages commuters to take public transit and/or carpool. *The exception to this result is when higher fees encourage commuters to drive more fuel-efficient cars. In this case, the number of miles driven does not need to decline to reduce air pollution. Also, aside from correcting for external costs, gasoline taxes are also used to pay for the building and repair of the roads that drivers use.
Tradable Pollution Permits
Still another market-based method for solving the problem of pollution related external costs is to create a market for the right to pollute. Instead of using emission or user fees, the government could assign a permitted pollution limit.
This system of pollution control starts with the government issuing each firm a permit to emit a certain amount of pollution. Efficient (or “green”) firms that emit a relatively small amount of pollution into the environment can sell their unused permits to less efficient (or “dirty”) firms. The market for permits determines the price at which firms trade permits. It is important to keep in mind that the number of permits (and the amount of allowable pollution) is fixed by the government. Also, these pollution permits could be bought and sold by anyone including environmental groups.
An example of this market-based approach is the Environmental Protection Agency’s Acid Rain Program. The Acid Rain Program introduces an allowance trading system that harnesses the incentives of the free market to reduce pollution.
Under this system, affected power plants are allocated permits based on their historic fuel consumption and a specific emissions rate. Each permit allows a power plant to emit 1 ton of \(\mathrm{SO}_2\) during or after a specified year. For each ton of \(\mathrm{SO}_2\) emitted in a given year, one permit is retired, that is, it can no longer be used.
Permits may be bought, sold, or banked. Anyone may acquire permits and participate in the trading system. However, regardless of the number of permits a source holds, it may not emit at levels that would violate federal or state limits set under Title I of the Clean Air Act to protect public health.
During Phase II of the program (now in effect), the Act set a permanent ceiling (or cap) of 8.95 million allowances for total annual allowance allocations to utilities. This cap firmly restricts emissions and ensures that environmental benefits will be achieved and maintained.
For more information on how allowance trading works in the Acid Rain Program, see the allowances fact sheet. For more information about trading in general, see the trading section home page.
The principal advantage of tradable pollution permits is their creation of a market for pollution. Now, a firm can no longer freely pollute during its production process. It will first have to weigh the costs and benefits of its actions and then decide if it is willing to pay for a pollution permit.
Problems with Altering of Market Incentives
If simply charging the market participants (i.e., the producers and consumers of the good or service) for the damage caused by their polluting activities or establishing a market for pollution permits can effectively reduce pollution then why is market related pollution still a problem? Well, a critical assumption when using a market incentives approach is that the government knows the precise amount to charge firms and/or consumers. In other words, the government knows the cost of the externality and thereby knows the fee to be charged or the amount of permits to issue.
If the government has incomplete information regarding external costs (which is usually the case), it runs the risk of miscalculating the emission and user fees or the number of issued permits. The result of this miscalculation may result in excessive costs to firms and consumers (see Figure 12).
Figure 12
Figure 12 shows how an excessive emission fee (fee = T) can shift the supply curve(private) too far. In this example, the government did not know how to assess the costs associated with pollution and overcharged the firm for its production related pollution. So, instead of producing at the socially optimal rate of Q1, the firm reduces output to Q2.
By-Passing Market Incentives (Command-and-Control Options)
Whenever external costs exist, private firms will not allocate resources in a way that will maximize social welfare. When this happens, the government could take a command-and-control position and simply require firms to reduce pollutants by specific amounts and/or specify which pollution control technology must be used. It is important to note that this approach does not rely on tradable pollution permits or other market incentives to achieve a desired reduction in pollution levels.
The Clean Air Acts of 1970 and 1990 are examples of command-and-control strategies for dealing with pollution. These governmental regulations not only mandated fewer emissions but also specific processes, such as catalytic converters and lead-free gasoline, for attaining them.
For more information on the Clean Air Acts, go to the Environmental Protection Agency’s website.
Problems with the Command-and-Control Approach
Command-and-control regulations can be effective, but also can lead to waste. By requiring all market participants to follow specific rules, the government is not differentiating between efficient and inefficient firms. It may be the case that some firms can reduce their level of emissions at a lower cost than others. Also, there is a risk of command-and-control processes becoming entrenched long after they are obsolete. This “blanket approach” to this type of market failure can raise the costs of environmental protection.
