economic activities involve transformation of resources from their
original locations and natural forms to locations where they are
used as final products. These transformation processes also generate
wastes (pollution) at different stages and often the environment is
used as a repository for waste products. When waste deposited in the
environment exceed the assimilative capacity of the environment,
degradation of environmental resources take place. Degradation of
the environment affects public health, physical health, physical
assets and materials, plants and animals, scenic beauty, etc.
The environmental costs occur in the forms of (a) larger expenditure
on health care, provision of protected water supply and maintenance
(b) an increase in the application of resources to achieve a given
basket of output over time in order to compensate for the decline in
the quality of resources (c) abatement expenditures incurred by
producers, defensive expenditures incurred by consumers and
administrative expenses. As the potential human impact on the Planet
increases with the expanding population seeking a higher material
standard of living, the impact will become an actual impact in the
absence of regulations to prevent it.
Hence what is required is a package of regulatory measures to
identify and monitor pollutant (negative externalities), to identify
their economic, ecological and sociological effects and to
internalize their effects within levels, which are not only safe for
survival but also fully appropriate to the quality of life expected.
Efficient level of pollution
In view of the damages caused by externalities regulatory instruments should be designed so as to keep pollution at an optimal level. Hence an understanding of the efficient level of pollution is needed. For this we need an understanding of the Marginal abatement cost (MAC) and Marginal damage (MD).
As in the case of production of any other goods and services, environmental protection or pollution control involves costs and benefits. Costs are measured in terms of the various inputs that must be devoted to pollution control. Benefits are measured in terms of the reduction in damages (health damages, ecological damages, etc.) that is allowed by reducing the emissions of pollution. Costs and benefits must be traded-off, to do so, the notions of marginal abatement cost and marginal damage needs to be defined. The marginal abatement cost (MAC) is the cost of reducing pollution emissions by an additional unit. It is generally assumed that the MAC increases as abatement increases. In other words, the more one abates pollution, the more costly it becomes to reduce pollution by an additional unit.
The marginal damage (MD) is the damage caused by an additional unit of pollution. It is generally assumed that the MD increases as pollution increases. It is also generally assumed that the environment has the capacity to absorb a limited amount of pollution without adversely affecting its quality.
As shown in the diagram, facing no incentives to reduce its level of pollution, a polluter would produce the amount P of pollution, where the marginal abatement cost is zero. However, the efficient or socially optimal level of pollution is determined at the intersection of the marginal abatement cost and marginal damage functions: S is the optimal level of pollution. Left to themselves, polluters thus produce too much pollution. It is on this basis that interventions by the regulator may be justified.
First Best Approaches to Regulation
The regulatory instruments are designed to internalize the external cost of pollution, i.e., internalize externalities, making the polluter pay, and at the same time minimize the cost of a given level of abatement under given conditions with regard to tastes, production and abatement costs, etc.
In his pioneering work, The Economics of Welfare, Pigou (1920) suggested a tax on the output of an activity, which generates negative externality (pollution).
According to Pigou externalities stem from differences between private and social costs of an activity. These differences should be corrected by taxes or subsidies in such a manner that they alter the private cost until it equals the social cost.
Private Cost + Tax = Social Cost
He showed that, by choice of an appropriate tax rate, the behaviour of the polluter can be altered in such a way that his production decisions conform to that of a social welfare maximizer.
Coase (1960), in his classic article, ‘The Problem of Social Cost’, attributed the pollution problem to the absence of property rights for environmental resources and the existence of transaction costs, which impede the smooth functioning of markets. He advocated an important role for the Government in creating property rights for environmental resources as well as in formulating policies for mitigating transaction costs in exchange.
This approach focuses on the fact that goods and services can only be bought and sold and therefore brought within the orbit of the market mechanism. Ownership of a good or service means that people can have property rights. Coase sees externalities as arising from the absence of property rights: as consequence of this certain economically important goods and services cannot be bought and sold, and the market cannot ensure their provision at an efficient level. The natural policy prescription would be the introduction of property rights for goods that lacked them. This approach is applied to air pollution by the introduction of tradable emission quotas. Under this approach, before emitting pollutant into the atmosphere, a firm must own the right to effect such an emission: such a right is conveyed by the purchase of a tradable emission quota. The creation of these quotas establishes property rights in the atmosphere and thus ensures that the atmosphere is brought under the purview of the market.
Both approaches are consistent with the “polluter pays” concept. The works of Pigou and Coase form the first best solutions and provide theoretical bases for designing economic instruments for pollution control.