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Environmental Economics: Basic Concepts and Debates
(Released April 2007)

 
  by Ethan Goffman  

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Environmental economics applies the insights of economics to environmental issues, using supply and demand to minimize the impact of the human economy on ecosystems. An older paradigm of environmental regulation placed strict mandates on how much individuals and businesses could pollute, an approach that violated basic economic logic, failing to understand the differing capabilities of different companies:

Where relative costs of performing an activity differ among individuals, business firms, or regions, there are almost always potential gains from trade. In today's jargon, trade can always be win-win. Traditional approaches to addressing environmental problems have generally not taken advantage of this potential. Rather, command and control regulatory policy instruments have been the tools of choice. (Edmonds et al. iii)
However, as the Economist explains it, the old environmentalist habits of regulation and litigation are changing: "Yesterday's failed hopes, today's heavy costs and tomorrow's demanding ambitions have been driving public policy quietly towards market-based approaches." For some companies regulation can be extremely burdensome, while others need only slight changes and could easily surpass mandates. Inflexible caps are not economically efficient.

environmental compliance manuals
Source: BLR: Business and Legal Reports
One way to increase flexibility is emissions charges, a straightforward tax on the release of pollutants. "By leaving polluters free to determine how best to reduce emissions" such charges harness individual companies' "energy and creativity and their desire to minimize costs, to find the least-cost way of reducing emissions" (Field & Field 235). There is some flexibility, in that those for whom regulation is most onerous can pay their way out of it, while others will reduce the amount they pollute. Still, this approach cannot meet specific targets. A more sophisticated approach is Cap and Trade, in which "individual sources of pollutants are issued emission permits, which may be bought and sold in transactions with other sources, or with other market permits. A cap on the total number of permits ensures that total air or water pollution will be reduced" (Field & Field 8). Cap and Trade sets an overall limit on the emission of a certain pollutant, but allows companies that can easily reduce emission to sell credits to other companies, essentially selling the right to pollute. Depending on the situation and the way it is implemented, Cap and Trade can offer the flexibility allow an optimum balance between economic output and pollution control.

Marginal Abatement Costs

The basic reason why this approach works is that it's easier for some businesses to reduce pollution than others. Pollution reduction depends on many factors, such as the equipment used by a given business, the item being produced, the availability of new technology, and so on. The graph below shows the Marginal Abatement Cost in which, as the money spent to reduce pollution goes up the amount of emissions goes down, although not necessarily in a straight line. This graph can be quite different for different companies.

graph of emissions against cost

Let's assume that there are two companies with very different circumstances that have very different Marginal Abatement Cost functions when it comes to reducing emissions. The first can easily decrease pollution (say through a basic technological investment) but then has difficulty decreasing it further. The second has a more regular Marginal Abatement Cost graph.
graphs comparing two companies graphs comparing two companies
Company A Company B
To optimize efficiency, that is, to reduce emissions the most for the least cost, Company A should make the investment that allows the initial plunge in emissions, but further investments are fairly futile. The regulating agency may determine that this emission level is sufficient, but if further decrease is desired it is Company 2 that should investment in emissions control for maximum economic efficiency.

Note that regulations requiring a set amount of emissions reduction will usually lead to greater cost than necessary. To illustrate this let's look at the two companies in chart form:
Pollutants
Emitted
Company A
8
10
12
14
15
Company B
4
8
12
16
20
$ Spent
(in thousands)
10
20
30
40
50

The numbers in the grey row represent money spent and the numbers above represent units of pollutants emitted. Assume that studies have shown that emissions need to be reduced by 24 units to allow healthy ambient air quality in the local area. If regulators require each company to reduce emissions by 12 units, the total cost would be $60,000. However if Company A were to reduce emissions by 8 units and Company B were to reduce by 16 units the cost would be only $50,000 for the same amount of reduction, saving $10,000. For a much smaller target reduction of 8 units, it is most efficient for Company A to spend $10,000 and Company B to spend nothing at all. For a larger emissions reduction target of 28 it would make sense to increase company B's share to 20 and leave Company A at 8, for a total cost of $60,000. Only for extremely large reductions (off of this chart) does it make sense to start increasing company A's load, as each reduction by company B becomes increasingly expensive. Much of environmental economics deals with such situations, figuring out the most economically efficient way to lower environmental impact. The above is a greatly simplified version of events. Normally there are numerous companies with a great variety of Marginal Abatement Costs (and numerous kinds of environmental impacts) to worry about. Still, by fusing the different companies in an aggregate graph, it is always theoretically possible to find the most efficient-that is the least costly-means of reducing emissions. Figuring out how "to reduce aggregate emissions at the least possible cost" from multiple sources with differing marginal abatement costs is known as the equimarginal principle (Field & Field 104). The math may become far more complicated than in the above example, but the underlying principles are the same.

The Real World

The preceding graphs assume a perfect knowledge of facts that is exceedingly rare in the real world, where "there are very few actual instances of environmental pollution where the marginal damage and marginal abatement functions are known with certainty" (Field & Field 107). The science might not be advanced enough to calculate how much each kind of technology reduces a given kind of pollution. On top of this, companies have an interest in estimating costs of lowering pollution on the high end so that each can argue that it is receiving an unfair burden. In practice, it is not realistic for regulators to name the specific amount of reduction necessary for each company.

Fortunately there is a solution to the problem: the market. The government sets an external regulation in such a way that the market can most efficiently adjust: "most important is that prices must be set correctly. The best way to do this is through liquid markets, as in the case of emissions trading. Here, politics merely sets the goal. How that goal is achieved is up to the traders" (economist). One such regulation mechanism, as mentioned above, is taxes. In the above example, if a tax is levied on each unit of pollution, Company A will invest in emissions reduction where it's most effective, early in their Marginal Abatement curve, then pay taxes where it would be cheaper than making additional investments. While taxes are the easiest mechanism to implement, they are also the least precise-it's difficult to predict just how much a given tax will lower pollution.

Where a definite target is sought, one common method is Cap and Trade. Companies may sell, on an open market, their right to pollute. Under a Cap and Trade system, the above mentioned Company A would be likely to buy emissions from Company B once it rose above its inexpensive, high-impact initial investment of $10,000. In the far more complicated real world, companies buy and sell the right to emit until the most efficient price level is found. There's no need for regulators to attempt to calculate the best level for each company and no need for companies to obfuscate.

Under either tax or Cap and Trade systems, essentially each company is paying for its right to harm the environmental commons. While some might regard this as intrinsically bad, it is far better than the previous situation, not paying to pollute the environmental commons. All economic activity involves some environmental cost, without which human life as we know it would come to an end. However, the environmental commons is an enormous system capable of self-repair, and the idea is to collectively keep this system from approaching any dangerous thresholds while maximizing economic growth. This, at least, is the theory derived from classical economics; ecological economists operate from different assumptions.

Go To Ecological Economics: Altering Assumptions

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