Selftest Problems And Solutions

ST13.1 During each 24-hour period, coal-fired electricity-generating plants emit substantial amounts of sulfur dioxide and particulate pollution into the atmosphere. Concerned citizens are appalled at the aesthetic and environmental implications of such pollution, as well as the potential health hazard to the local population.

In analyzing remedies to the current situation, three general methods used to control pollution are generally considered:

• Regulations—licenses, permits, compulsory standards, and so on.

• Payments—various types of government aid to help companies install pollution-control equipment. Aid can take the form of forgiven local property taxes, income tax credits, special accelerated depreciation allowances for pollution-control equipment, low-cost government loans, and so on.

• Charges—excise taxes on polluting fuels (e.g., coal or oil), pollution discharge taxes, and other taxes.

Answer the following questions in light of these alternative methods of pollution control.

A. Pollution is a negative production externality and an example of market failure. Why do markets fail?

B. What is the incentive provided to polluters under each method of pollution control?

C. Who pays for a clean environment under each form of control?

D. On the basis of both efficiency and equity considerations, which form of pollution control is most attractive?

ST13.1 Solution

A. Market failure sometimes occurs because the number of buyers and sellers is too small to ensure vigorous competition. Small numbers of sellers are sometimes caused by economies of scale in production, distribution, or marketing; barriers to entry caused by high capital, skilled labor, or other input requirement; or government-imposed barriers due to franchise grants, rules, or regulations.

Market failure can also occur if some of the costs or benefits of production or consumption are not reflected in market prices. Air, water, and noise pollution that emits from an industrial facility represent a cost of production that is imposed on society in general. Without appropriate charges for such pollution, producers, suppliers, and customers receive an implicit subsidy from the public at large. By failing to pay such environmental costs, they avoid paying the full cost of production and consumption. In general, if some product benefit (cost) is not reflected in firm revenues (costs), then suboptimal production quantities and output prices will result and provide both firms and their customers improper economic incentives.

B. Each alternative method of pollution control provides producers with a different set of incentives. With rules and regulations, producers often have an incentive to litigate or otherwise petition to be made a "special case" and thereby avoid regulatory costs. Rules and regulations are also sometimes difficult to monitor and enforce given the problems of determining legislative intent and regulated firm compliance. With a scheme of payments to reduce the flow of pollution, polluters have positive incentives to reduce emissions and improve economic performance. A benefit of this approach is that firms often respond better to the "carrot" of promised rewards than to the "stick" of threatened penalties. Under a pollution control method of fines or dollar penalties for noncompliance, firms have an economic incentive to reduce pollution in order to avoid charges. However, this method of forcing compliance is sometimes regarded as coercive and met with resistance.

C. When polluters are forced to respond to rules and regulations, the company, customers, employees, and stockholders are all faced with the prospect of paying the costs of pollution reduction. The incidence of pollution cleanup costs depends on the elasticity of demand for the firm's products and on the elasticity of supply. When product demand is highly inelastic, customers have no good substitutes for the products of the polluting firm and therefore must ultimately pay the costs of cleanup. When product demand is highly elastic, customers are able to avoid the costs of pollution reduction by transferring their business to other providers who need not charge for such expenses. In such circumstances, the firm, suppliers, employees, and stockholders bear the costs of pollution reduction. This situation is very similar to that faced by firms subject to pollution charges. In both instances, society's right to a clean environment is implied.

A system of payments to encourage pollution reduction contrasts in fundamental ways with rules and regulations and pollution charges and taxes. This method of pollution reduction is obviously attractive to polluters in that it is free and voluntary, rather than compulsory. It even provides a profit-making opportunity in pollution reduction that increases according to the scope of pollution. Moreover, when society pays a firm to reduce the level of its own pollution, the company's right to pollute is implicitly recognized.

D. Efficiency considerations typically favor payments and charges over rules and regulations as the more efficient methods of pollution control. From an efficiency standpoint, pollution charges are especially attractive in that they recognize pollution as a sometimes necessary cost of doing business, and they force cleanup costs to be borne by those who benefit most directly.

However, equity considerations make the choice among pollution control methods less certain. The regulatory process is attractive from an equity standpoint in that it ensures due process (a day in court) for the polluter. All parties are also treated equitably in the sense that all polluters are equal before the law. Payments for pollution reduction are sometimes favored on an equity basis in that it avoids penalizing polluters with "sunk" investment costs and employees that work in older production facilities that face new domestic and foreign competitors. Pollution charges are often favored on an equity basis in that it forces a close link between prices and full economic costs. Pollution charges, like payments for pollution reduction, are sometimes criticized as favoring large companies versus their smaller competitors.

Therefore, there is no single "best" method of pollution regulation. All are employed because each has the ability to meet efficiency and equity criteria in specific circumstances.

ST13.2 Pollution Control Costs. Anthony Soprano is head of Satriale Pork Producers, Inc., a family-run pork producer with a hog-processing facility in Musconetcong, New Jersey. Each hog processed yields both pork and a render by-product in a fixed 1:1 ratio. Although the by-product is unfit for human consumption, some can be sold to a local pet food company for further processing. Relevant annual demand and cost relations are as follows:

PP

= $110 - $0.00005QP

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