The Myth of Simple Market Solutions

I introduced my previous post by noting that there are several prevalent myths regarding how economists think about the environment, and I addressed the “myth of the universal market” ­– the notion that economists believe that the market solves all problems.  In response, I noted that economists recognize that in the environmental domain, perfectly functioning markets are the exception, not the rule.  Governments can try to correct such market failures, for example by restricting pollutant emissions.  It is to these government interventions that I turn this time.

A second common myth is that economists always recommend simple market solutions for market problems.  Indeed, in a variety of contexts, economists tend to search for instruments of public policy that can fix one market by introducing another.  If pollution imposes large external costs, the government can establish a market for rights to emit a limited amount of that pollutant under a so-called cap-and-trade system.  Such a market for tradable allowances can be expected to work well if there are many buyers and sellers, all are well informed, and the other conditions I discussed in my last posting are met.

The government’s role is then to enforce the rights and responsibilities of permit ownership, so that each unit of emissions is matched by the ownership of one permit.  Equivalently, producers can be required to pay a tax on their emissions.  Either way, the result — in theory — will be cost-effective pollution abatement, that is, overall abatement achieved at minimum aggregate cost.

The cap-and-trade approach has much to recommend it, and can be just the right solution in some cases, but it is still a market.  Therefore the outcome will be efficient only if certain conditions are met.  Sometimes these conditions are met, and sometimes they are not.  Could the sale of permits be monopolized by a small number of buyers or sellers?  Do problems arise from inadequate information or significant transactions costs?  Will the government find it too costly to measure emissions?  If the answer to any of these questions is yes, then the permit market may work less than optimally.  The environmental goal may still be met, but at more than minimum cost.  In other words, cost effectiveness will not be achieved.

To reduce acid rain in the United States, the Clean Air Act Amendments of 1990 require electricity generators to hold a permit for each ton of sulfur dioxide (SO2) they emit.  A robust permit market exists, in which well-defined prices are broadly known to many potential buyers and sellers.  Through continuous emissions monitoring, the government tracks emissions from each plant.  Equally important, penalties are significantly greater than incremental abatement costs, and hence are sufficient to ensure compliance.  Overall, this market works very well; acid rain is being cut by 50 percent, and at a savings of about $1 billion per year in abatement costs, compared with a conventional approach.

A permit market achieves this cost effectiveness through trades because any company with high abatement costs can buy permits from another with low abatement costs, thus reducing the total cost of reducing pollution.  These trades also switch the source of the pollution from one company to another, which is not important when any emissions equally affect the whole trading area.  This “uniform mixing” assumption is certainly valid for global problems such as greenhouse gases or the effect of chlorofluorocarbons on the stratospheric ozone layer.  It may also work reasonably well for a regional problem such as acid rain, because acid deposition in downwind states of New England is about equally affected by sulfur dioxide emissions traded among upwind sources in Ohio, Indiana, and Illinois.  But it does not work perfectly, since acid rain in New England may increase if a plant there sells permits to a plant in the mid-west, for example.

At the other extreme, some environmental problems might not be addressed appropriately by a simple, unconstrained cap-and-trade system.  A hazardous air pollutant such as benzene that does not mix in the airshed can cause localized “hot spots.”  Because a company can buy permits and increase local emissions, permit trading does not ensure that each location will meet a specific standard.  Moreover, the damages caused by local concentrations may increase nonlinearly.  If so, then even a permit system that reduces total emissions might allow trades that move those emissions to a high-impact location and thus increase total damages.  An appropriately constrained permit trading system can address the hot-spot problem, for example by combining emissions trading with a parallel system of non-tradable ambient standards.

The bottom line is that no particular form of government intervention, no individual policy instrument – whether market-based or conventional – is appropriate for all environmental problems.  There is no simple policy panacea.  The simplest market instruments do not always provide the best solutions, and sometimes not even satisfactory ones.  If a cost-effective policy instrument is used to achieve an inefficient environmental target — one that does not make the world better off, that is, one which fails a benefit-cost test – then we have succeeded only in “designing a fast train to the wrong station.”  Nevertheless, market-based instruments are now part of the available environmental policy portfolio, and ultimately that is good news both for environmental protection and economic well-being.

About Robert Stavins

Robert N. Stavins is the Albert Pratt Professor of Business and Government at the Harvard Kennedy School, Director of the Harvard Environmental Economics Program, Chairman of the Environment and Natural Resources Faculty Group at the Kennedy School, Director of Graduate Studies for the Doctoral Programs in Public Policy and Political Economy and Government, Co Chair of the Harvard Business School Kennedy School Joint Degree Programs, and Director of the Harvard Project on International Climate Agreements. He is a University Fellow of Resources for the Future, a Research Associate of the National Bureau of Economic Research, the Editor of the Review of Environmental Economics and Policy, and a Member of: the Board of Directors of Resources for the Future, the Board of Academic Advisors of the AEI Brookings Joint Center for Regulatory Studies, the Editorial Boards of Resource and Energy Economics, Environmental Economics Abstracts, B.E. Journals of Economic Analysis & Policy, and Economic Issues. He is also an editor of the Journal of Wine Economics. He was formerly a member of the Editorial Board of Land Economics, The Journal of Environmental Economics and Management, the Board of Directors of the Association of Environmental and Resource Economists, a member and Chairman of the Environmental Economics Advisory Committee of the U.S. Environmental Protection Agency's (EPA) Science Advisory Board, the Chair of the Scientific Advisory Board of the Massachusetts Executive Office of Environmental Affairs, a Lead Author of the Second and Third Assessment Reports of the Intergovernmental Panel on Climate Change, and a contributing editor of Environment. He holds a B.A. in philosophy from Northwestern University, an M.S. in agricultural economics from Cornell, and a Ph.D. in economics from Harvard. Professor Stavins' research has focused on diverse areas of environmental economics and policy, including examinations of: market based policy instruments; regulatory impact analysis; innovation and diffusion of pollution control technologies; environmental benefit valuation; policy instrument choice under uncertainty; competitiveness effects of regulation; depletion of forested wetlands; political economy of policy instrument choice; and costs of carbon sequestration. His research has appeared in the American Economic Review, Journal of Economic Perspectives, Quarterly Journal of Economics, Journal of Economic Literature, Science, Nature, Journal of Environmental Economics and Management, Ecology Law Quarterly, Journal of Regulatory Economics, Journal of Urban Economics, Journal of Risk and Uncertainty, Resource and Energy Economics, The Energy Journal, Energy Policy, Annual Review of Energy and the Environment, Explorations in Economic History, Brookings Papers on Economic Activity, other scholarly and popular periodicals, and several books. He is the co-editor of Architectures for Agreement: Addressing Global Climate Change in the Post-Kyoto World (Cambridge University Press, 2007), editor of the fifth edition of Economics of the Environment (W. W. Norton, 2005), co editor of Environmental Protection and the Social Responsibility of Firms (Resources for the Future, 2005), editor of The Political Economy of Environmental Regulation (Edward Elgar, 2004), co editor of the second edition of Public Policies for Environmental Protection (Resources for the Future, 2000), and the author of Environmental Economics and Public Policy: Selected Papers of Robert N. Stavins, 1988 1999 (Edward Elgar, 2000). Professor Stavins directed Project 88, a bi partisan effort co chaired by former Senator Timothy Wirth and the late Senator John Heinz, to develop innovative approaches to environmental and resource problems. He continues to work closely with public officials on matters of national and international environmental policy. He has been a consultant to the National Academy of Sciences, several Administrations, Members of Congress, environmental advocacy groups, the World Bank, the United Nations, the U.S. Agency for International Development, state and national governments, and private foundations and firms. Prior to coming to Harvard, Stavins was a staff economist at the Environmental Defense Fund; and before that, he managed irrigation development in the middle east, and spent four years working in agricultural extension in West Africa as a Peace Corps volunteer.
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6 Responses to The Myth of Simple Market Solutions

  1. MattYoung says:

    “no particular form of government intervention,”

    An environmentalist is often stereotyped as a regulator when intervention often means deregulation. For example, my current favorite, is the Clinton era deregulation of telecom which removed several energy consuming bottlenecks in the economy. If the environmentalist continues to reinforce the view that intervention is regulation then opportunities for energy efficiency pass by the wayside, and much worse happens.

  2. Torben says:

    If I understand you correctly,Robert, one implication one can draw from the current post could be that it is most likely that market based instruments could be inefficient unless they are supplanted with non-market instruments such as information disclosure and awareness, re-framing the nature of competition in the newer market to counteract an environment of market imperfections for economic-instruments, design of market institutions[ for eg.”Trading for the Future: Signaling in Permit Markets” @ http://tinyurl.com/alkz9e%5D,etc. Then are we sure that market based instruments ALWAYS Pareto dominate command and control? If not, is there any study that analyzes alternative conditions under which either of the instruments are socially efficient?

  3. Torben, there is a large literature in environmental economics that compares various market-based instruments with command-and-control regulations — both theoretically and empirically — and compares the conditions under which one or the other approach is preferable under criteria of cost-effectiveness, dynamic efficiency, distributional equity, etc. As one example, here’s an article I wrote with Richard Newell of Duke University. It originally appeared in the Journal of Environmental Economics and Management.

  4. Torben says:

    Sorry the link I meant is http://tinyurl.com/alkz9e

  5. Torben, thanks for the link to Bard Harstad’s paper. I’m particularly pleased because Professor Harstad is a participant in the research initiatives of the Harvard Project on International Climate Agreements. You and others can find his work on negotiating and updating climate agreements at the Project web site.

  6. Torben says:

    Thanks for the link to the project. It seems quite rich. 😉

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