fedgazette

The economics of environmental protection

David S. Dahl - Regional Economist

Published September 1, 1989  |  September 1989 issue

Can we preserve the environment and continue to enjoy economic growth, or does one have to come at the expense of the other?

According to the physical law of the conservation of matter, the production of goods rearranges materials, but their mass does not diminish. Wastes are part of these rearranged materials. A corollary law, the physical law of the conservation of energy, suggests that the energy the earth receives or has received from the sun can be redirected but not destroyed.

The real issue, therefore, is not prohibiting pollution, for example, but rather striking a balance between environmental quality and economic growth. In achieving this balance, economics can make an important contribution.

Although environmental concerns have captured our attention late in the 20th century, economists recognized the problem much earlier. A. C. Pigou, a noted British economist, in a groundbreaking 1912 book, WEALTH AND WELFARE, provided an economic explanation for our environmental problems.

The essence of his argument, which economists continue to espouse, is that some products' prices in a market economy fail to reflect the products' full costs to society. A firm that spews contaminants into the air in the process of producing widgets, for example, does not include the costs of that contaminated air in the price of its widgets.

The firm does not recover these costs because air is what economists call a "public good." No one has the property rights to the air, so its use does not cost the firm anything. If it is concerned about the environment and reduces the emitted contaminants, these costs must be recovered in the price of the firm's widgets, and it would be at a competitive disadvantage with other widget producers who are not concerned about the environment.

The costs that contaminated air imposes on residents of a community are what economists refer to as "externalities," that is, the costs or benefits incidental to producing or consuming a good or service that affect people other than the buyer or seller of the good or service. Because these negative externalities are not in the price of widgets, people consume more widgets than they would if the price of widgets reflected the cost that their production was imposing on the economy. Consequently, the economy ends up with more air pollution and widgets than optimal.

Economics suggests that including environmental costs in the price of widgets should bring about a better balance between air pollution and the number of widgets produced. Policymakers, however, traditionally have relied primarily upon direct controls to reduce pollution.

Both a government order directing the widget manufacturer to reduce its harmful emissions or a tax on these emissions would reduce pollution. But the tax, which is a market- or price-oriented policy, puts self-interest to work. With a mandated 10 percent reduction in harmful emissions, for example, the widget manufacturer has no incentive to reduce emissions beyond 10 percent. With a tax on emissions, the more the widget manufacturer cuts them back, the more its tax payments are reduced.

Furthermore, the proceeds from a tax can be used to clean up the environment or compensate those who are harmed.

Another policy that focuses on price incentives is emissions permits. The government sets emission limits and then lets firms bid for permits that would allow this amount of pollution. Although very similar to a tax on pollutants, it has the additional advantage of allowing the government to establish with some certainty, the amount of allowable emissions.

Compelling arguments can be advanced for using the price system to balance environmental costs and economic growth. However, implementing such policies is difficult. Economist Alan Blinder recently stated in Business Week: "Unfortunately, scientists know too little about the harm done by many pollutants, and economists know too little about the money value of better health and greater longevity. And, if you can quantify only the costs of pollution abatement and not the benefits, it is hard to estimate the 'optimal' level of pollution."

Despite incomplete knowledge, economics can still play a useful role in debates balancing environmental costs and economic growth. It can shift the discussion away from whether pollution is good or bad to identifying the best way to balance costs and benefits. In doing so, taxes and emissions permits should be considered along with direct controls. Policymakers are starting to agree, for President Bush's proposed amendments to the Clean Air Act contain marketplace incentives.

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