2.1 Economic efficiency
Why should society be concerned about externalities? In the New Zealand economy, the market is the principal mechanism that we use to guide production and consumption decisions. If the market is working “well” then all goods and services are priced at marginal cost and it would not be possible to improve the welfare of one individual without reducing the welfare of another individual. This outcome is Pareto efficient. Externalities drive a wedge between price and cost. To pick up on the above example involving pollution from the paper industry, in the absence of intervention the price of paper will not equal the full cost of production because the opportunity cost of lower water quality (as measured by the community’s welfare loss) is not included alongside the cost of labour, capital and other inputs used in the manufacture of paper products. If the externality is significant, then it would be possible for those that gained from an improvement in water quality to potentially compensate polluters for incurring higher treatment costs and be better off. This is described as a potential Pareto improvement.
Economic efficiency is illustrated in Figure 1 using a simple “upstream polluter downstream community” model. The polluter derives marginal benefits (MB) from being able to use the river as a sink for waste; the community faces damages (MD) associated with the waste. Assuming that all costs and benefits are expressed in the dollar metric, the efficient level of pollution is Q* where MB = MD. There are a number of points that should be noted about this equilibrium. Time is not a factor in the model and would need to be explicitly considered given the intertemporal focus of sustainable development. Hartwick (1990) shows how adjustments would have to be made to the model if the pollutants accumulated over time.
The equilibrium is determined by a balancing of costs and benefits at the margin. The shape and position of MD and MB is an empirical issue. It should be noted that techniques are available to estimate MD (Freeman, 1993). It is assumed that both functions can be expressed in the dollar metric. Industry’s MB function can be thought of as profit or the difference between revenue and (private) costs valued at competitive market prices. Use of the river’s assimilative capacity is not explicitly priced because it is not traded in the market. The opportunity cost (price) of the discharge is the impact it has on the welfare of the community down stream as measured by MD.
The price generating mechanisms embedded in Figure 1 are significant. Clearly, firms seeking to maximise profit will respond to market prices and in the absence of a price on pollution the equilibrium will be at B where marginal profit is zero. At B, MD > MB and the community could potentially compensate the polluting industry and both would be better off at a lower level of pollution. The efficient level of pollution Q* is where MD = MB.
In a nutshell, the policy problem is that there is no mechanism (eg, polluter pays charge, price of a tradable right) signalling the cost of pollution so that the adverse impacts are internalised into the polluting industry’s decision-making calculus. The policy instrument for signalling MD is an object of choice within the context of environmental policy.
Many environmental services are characterised by a degree of publicness. For example, the services provided by the earth’s atmosphere, and the attributes of endangered species, are close to the definition of a pure public good. Since a public good is non-exclusive, the price people are willing to pay for a given quantity is the sum of each individual’s willingness to pay. Two attributes of a public good are emphasised viz nonexclusivity and nonrivalry. A pure public good is characterised by:
nonexclusivity, where no one can be excluded from enjoying the benefits; and
nonrivalry, where additional consumers may use the service at no additional cost.
Application of the “private good” “public good” dichotomy to problems associated with sustainable development has limited usefulness. For example, Nicholson (2000) defines fishing grounds and public grazing land as being non-exclusive yet consumption being rival. Better defining property rights can often solve the problem of non-exclusivity. Nonrival goods that permit imposition of an exclusion mechanism are referred to as club goods. Technology will continue to lower the relative cost of excluding those not entitled to consume the services available.
In the meantime let us assume that environmental services are public goods and cannot be efficiently traded in competitive markets. The efficient quantity of a public good is determined by balancing the sum total of individual willingness to pay with the marginal cost of service supply. If water quality is a public good, then MD in Figure 1 represents the community’s willingness to pay for cleaner water and MB measures the opportunity cost (foregone profit) of cleaner water. The efficient level of clean water (or pollution level) can, in principle, be described. But in practice how might this equilibrium be achieved?
With public goods the underlying problem is to get members of the community to “truthfully” reveal their willingness to pay (WTP). Returning to Figure 1, it is possible to show that Q* is a Lindahl equilibrium where the tax share of each individual, is correctly assessed at the marginal value to each person (ie, each person’s share is WTPi ) and precisely pays to the cost. Thus, if ex ante pollution was OB then the total tax bill is P(B-Q*) and this would be shared across the community in proportion to each person’s willingness to pay. Although the equilibrium is efficient – tax shares mimicking the competitive pricing mechanism – it is not very realistic because of the free rider problem. The Lindahl solution requires knowledge of the optimal tax share for each person. Since no one can be excluded then it is possible for individuals to free ride on the supply of clean water. Voting might deliver an optimal outcome but in general a degree of compulsion is required to solve the free-rider problem.
