3.0 Introduction

Any economy depends on the ecological system in which it is embedded in two fundamental ways, as illustrated in Figure 3.1. First, human production and consumption processes rely on the environment as a source of raw materials; second, they also exploit the environment as a sink (or repository) for waste materials. Both sources and sinks form what economists call natural capital. Natural capital is the input that nature provides for our production and consumption processes. Pollution is the overuse of sinks; resource degradation is the overharvesting of sources. In this sense, pollution and resource degradation are flip sides of the same process, the excessive exploitation of natural capital.

What exactly do we mean by pollution? Consider three examples:

1. Tyler is eating in a smoky kitchen. Is he exposed to pollution?
2. Karen routinely comes in contact with low-level radioactive waste while working at a nuclear power plant. Is she exposed to pollution?
3. Myles is trying to get some sleep while his neighbor’s sound system blares. Is he exposed to pollution?

For the purposes of this book, the correct answers are maybe, maybe, and yes. Economists define pollution as a negative externality: a cost of a transaction not borne by the buyer or seller. Pollution is termed as an externality because it imposes costs on people who are “external” to the producer and consumer of the polluting product.

In the first case, what if Tyler is the one smoking? While the smoke is undeniably doing damage to Tyler’s lungs, he may be aware of the damage and yet, balancing pleasure against risk, does not consider himself worse off. The second “maybe” is more difficult. Exposure to radioactive waste increases Karen’s risk of cancer, which is clearly a by-product of human activity. However, if she fully understands the risk to her health when performing the job, and yet, shoulders it in exchange for a salary, then exposure to the waste is part of the bargain. That is, the exposure is not external to the transaction between her and her employer. Under these circumstances, Karen would face a serious occupational hazard, which needs regulation on its own terms, but not a pollutant, as we have defined it.¹ Finally, poor Myles is a clear-cut victim of pollution. He is involuntarily being exposed to a negative by-product of his neighbor’s listening experience.

From an economist’s point of view, market systems generate pollution because many natural inputs into the production of goods and services—such as air and water—are “underpriced.” Because no one owns these resources, in the absence of government regulation or legal protection for pollution victims, businesses will use them up freely, neglecting the external costs imposed on others. For example, coal-fired electric power production in the United States emits a variety of pollutants into the atmosphere, which, in combination, lead to tens of thousands of premature deaths, asthma and other illnesses, and millions of lost work days. Economists have recently estimated that this cost to society runs around $0.04 per KWh of electric power produced by power plants or more.² If power companies were forced to provide compensation to the families of the victims for the damages they imposed (thereby, internalizing the externalities), the firms would, in effect, be paying for the air quality they “used up.” This, in turn, would raise the production costs of the firm. Air would no longer be underpriced. As a result, consumers would conserve on their use of electricity and firms would seek out ways to clean up their discharge.

Figure 3.2 provides a simple supply-and-demand analysis of the situation. Average electricity prices in the United States today, not including the external costs, are $0.08 per KWh. Note that the supply curve in the industry shifts up vertically by the $0.04 per KWh damage to internalize the costs. This leads to a final increase in price to P′. The diagram yields an immediate prediction. If all firms are forced to pay their full social costs of production, the competitive supply curve will shift up. The market price for electricity will be higher, and the quantity sold will be lower. The diagram indicates a general principle: it is difficult to reduce pollution without also reducing the supply of the polluting product.

Because the atmosphere is commonly owned and is thus a “free” good, electricity companies overexploit it, and many people downwind are exposed to a negative externality of the electricity production process. From an economic point of view, many pollution problems arise because environmental resources such as air, rivers, and groundwater are, by their nature, the heritage of humankind as a whole. The rest of this chapter takes a closer look at the implications of this common ownership.

3.1 The Open Access Problem

Many forms of natural capital, both sources and sinks, are not (and cannot be) privately owned. Because of this, pure free-market systems will generate too much pollution (or cause too much resource degradation) by any of the standards considered in this book—efficiency, safety, or sustainability. There are two related reasons for this: The first is the open access problem, which often arises when natural capital is commonly held. The second, addressed in the next section, is the public goods problem. The open access problem can be stated simply: if people weigh private benefits against private costs—as opposed to private plus external or “social” costs—they will overexploit the common resources when given open access.

This idea was popularized in the late 1960s by Garrett Hardin, who called it the “tragedy of the commons.” He poses the problem facing a herder whose cattle forage on common land. Introducing one more cow onto the common grazing land would lead to a large private gain for this herder in the form of an additional animal available for sale or consumption. It would also lead to a small private loss, in that the degraded resource would provide less robust forage for the herder’s existing animals. Of course, the social cost would be much larger, given that most of the loss from the degraded rangeland is externalized and borne by other herders. But if the herder seeks to maximize his or her personal gain,

The only sensible course for him to pursue is to add another animal to his herd. And another, and another…. Therein is the tragedy. Each man is locked in to a system that compels him to increase his herd without limit—in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons.³

Hardin suggests a stark and inescapable connection between common ownership of resources and their ultimate exhaustion. But, in fact, grazing and fishing grounds in most traditional societies have often been commonly held and managed quite sustainably for centuries. This was achieved by informal social constraints and traditions that prevented overexploitation. However, when such restraints break down as a result of “modernization” or population pressures, the open access problem emerges, and a tragedy of the commons is likely to result.⁴

The open access problem explains not only why sources of natural capital such as grazing land are degraded but also why environmental sinks such as the air are polluted. For example, a factory owner might install a low-cost technology that generates substantial air pollution, even though he and his family live nearby and will be exposed to the toxic materials. The owner captures the full benefits of the pollution (the profit from “low-cost” production), while his family bears only a small portion of the total risk.

In combination with vastly more efficient technology, open access also explains the dramatic decline in the populations of commercial fish species over the last few decades. Close to half of America’s fisheries and more than 70 percent of global fisheries are overfished; the North Atlantic is estimated to contain only one-third of the biomass of edible fish that were present in 1950. Modern technology in the form of bottom trawling is also damaging the habitat, essentially clear-cutting, and not replanting, the ocean floor.

Fisheries off the New England Coast have been particularly hard-hit. Landings of cod peaked at 18,000 tons in 1990, and over the next 8 years, that figure plummeted to only 1,000 tons as the fishery collapsed. Recovery has been very slow, and the government continues to reduce the limits on the fisheries. But even as the overall catch declined sharply, fishers were still opposing catch limits. Strapped with mortgages on expensive boats, fisherpeople said they could not afford the luxury of cutting back on their fishing effort. Indeed, perversely, the incentive for each boat was to employ more and more sophisticated technology to increase the owner’s share of the dwindling stock.⁵

We can explore this overfishing issue further with the help of a hypothetical example. Suppose that fish cost a dollar a pound, and the marginal cost of running a vessel—including the fuel and salaries for crew and owner—is $250 per day. Then the rational response for fishing boats is to continue to fish as long as, on average, the catch equals or exceeds 250 pounds. Suppose that the long-run relationship between the number of vessels and the total catch per day in a New England bay is as illustrated in Figure 3.3. The catch level peaks at six boats, and after seven boats actually it drops off, reflecting fishing beyond a sustained yield level. If eight boats go out on a regular basis, then the breeding stock is harvested, and over time, the population of fish declines.⁶

Given this information, consider the following:

Note that, in addition to overfishing the resource, there is a second externality here. After four boats, some of the catch of the new entrants is diverted from other boats. When there is open access to the bay, however, individual fisherpeople don’t recognize (but more importantly don’t care) about these negative externalities imposed on the other boats; each bears only a small portion of the reduction in the total stock. Thus, boats continue to go out even when the total catch, and total revenue in the industry, declines. As a result of open access, in New England and globally, a human and ecological tragedy is indeed unfolding.

Figure 3.4 illustrates a graphical analysis of the open access problem. Marginal revenue first stays constant and then falls, reflecting eventual declining marginal productivity as additional boats go out. Notice that the average and marginal revenue curves coincide for up to four boats, but once declining marginal productivity kicks in, the marginal revenue curve lies below the average revenue curve. (This decline is due to the mathematical relationship between marginal and average values: as long as the addition to revenue equals the average revenue, the average stays constant and equal to the marginal value. However, when additions to revenue fall below the average, the average is pulled down.) Finally, the constant marginal cost of sending out additional boats is represented by the straight line at $250.

Again, the figure tells us that private boats will go out as long as the average revenue covers costs, even though the total profits earned in the industry are declining. Open access leads eight boats into the fishery. By contrast, the profit-maximizing catch level occurs where the marginal revenue just exceeds the marginal costs at five boats.

The profit earned in the industry is displayed visually as the sum total of the difference between marginal revenue and marginal cost for each boat that goes out—the light-shaded area in the diagram.⁷ The dark-shaded area in the picture shows the reduction in profit for the industry as a result of overfishing. For the sixth through eighth boats, the marginal revenue is less than the marginal cost, leading to a drop in industry-wide profits. Clearly, the total industry-wide profit is the largest at five boats.

In Chapter 2, we learned that an efficient outcome is one in which the net benefits produced by the economy are maximized. Here, the efficient number of boats is five. This is true because, in this example, where the price of fish (and thus the consumer) is unaffected by the small changes in supply, net social benefits are just equal to profits.

The picture also illustrates a key feature of markets that rely on scarce natural capital either as sources or sinks. When natural capital is used efficiently, long-run economic profits will be earned by those who retain access to the resource. It is precisely those profits that attract entry into the market and lead to overexploitation of the source or the sink. These long-run profits, generated by restricted access to natural capital, are called resource rents. Comparable to rents earned by landlords at choice properties, these are rents due to ownership of (or limited access to) scarce natural resources.

In our example, open access into the fishery leads to an outcome in which profits in the industry are competed entirely away. With eight boats, average revenue equals average cost, and all the boats just break even. But, at the efficient level, where marginal revenue equals marginal cost, a substantial resource rent is earned. When we add up the difference between marginal revenue and marginal cost (marginal profit) for the first five boats, the resource rent turns out to be $650 per day.

In the case of New England, economist Steven Edwards and biologist Steven Murawski estimated that fishing efforts off the New England coast would have to be reduced by about 70 percent to eliminate overfishing and achieve an efficient harvest. This in turn would generate a resource rent of about $130 million in the industry.⁸ The rent might go to the government in the form of fees for fishing rights or to the remaining fishermen and women in the form of profits. Edwards calculated that government revenues from a fee system would be sufficient to compensate those boats put out of business due to restrictions, thus suggesting a politically feasible way out of this tough problem. Fisherpeople often resent governmental restrictions placed on access to fishing grounds; it is, after all, their livelihood and lifestyle at stake. However, without some kind of restraint on open access to common property resources, overuse to the point of exhaustion is the predictable consequence.

This section has illustrated three main points. First, when there is open access to common property, overexploitation will generally result as users will not take the externality costs of their actions into account. Second, government-imposed restraints on access to common property such as fisheries, clean air, and clean water will generate a resource rent, or long-run economic profit, for those who maintain access. Finally, this rent can sometimes be collected through taxes or fees and be used to reimburse those who lose out in the process of regulating and reducing access.

3.2 The Public Goods Problem

The open access problem may explain why there is a tendency for commonly held resources such as clean air and water or fisheries to be overexploited. But, why does the government have to decide what to do about it? Instead, why don’t the victims of negative externalities simply band together on their own to prevent pollution or overexploitation of resources? As we just noted, this was the response to environmental degradation of common grazing and fishing grounds in traditional societies. Informal social pressure and tradition were relied on to prevent overexploitation. The modern American equivalent would be to sue an offending company or individual for damages. Indeed, a few so-called free-market environmentalists have advocated eliminating many environmental regulations and then relying on lawsuits by injured parties to “internalize” externalities.⁹

However, such private remedies to environmental degradation run into what economists call the public goods problem. Public goods are goods enjoyed in common; a classic example, though a little dated, is the warning service provided by a lighthouse. Technically, economists describe public goods as “nonexcludable.” Once the lighthouse is in operation, it is impossible to exclude any passing boat from utilizing the warning beacon provided by the lighthouse.¹⁰

The provision of public goods is a problem for the free market due to the existence of two factors: transaction costs and free riding. To illustrate this, consider a good that is enjoyed in common—for example, the noise level after 11 p.m. in Myles’ neighborhood. Now suppose that neighbor Tipper cranks her sound system. Myles could go to the considerable trouble of obtaining signatures from all of their neighbors, getting money from them to hire a lawyer, filing a lawsuit, and possibly obtaining a legal injunction requiring Tipper to turn it down. The costs of undertaking this action are known as transaction costs, and they are particularly high because of the public nature of the injury.

If Myles does undertake the effort, he will benefit not only himself but also the entire neighborhood. Some of the neighbors might refuse to help out and instead free ride on Myles’ provision of the public good. Instead, Myles decides that it’s not really worth organizing a lawsuit and tosses and turns in bed, hoping that someone else will make the effort. The result is that the demand for a quiet evening in the neighborhood, although it may be considerable, doesn’t get expressed. It is not possible for any one individual to overcome the transaction costs and the possibility of free riding to provide the public good of the lawsuit, although if Myles did, the social benefits might far outweigh the cost.

In most towns, the response to noise pollution is a government regulation called a nuisance law. With such a regulation in place, Myles can just call the cops, thus greatly reducing the costs associated with stopping the noise. More generally, if victims of pollution were to try to band together to protect themselves or seek compensation in the courts, they would face very high transaction costs. For most pollution problems, for example, it is difficult even for government officials to obtain good information about health risks, exposure routes, and emission sources. Given the mounting costs of a successful court case, the problems of free riding would be compounded. The general principle is that, without government intervention in the form of pollution regulations, the public good of a safe environment will be undersupplied. This is not to say that no public goods will be supplied. Some will be supplied, but less than the amount that society collectively is willing to pay for.

To see this, consider another example: private contributions to purchase and preserve wetlands and other valuable ecosystems in the United States. The Nature Conservancy is an organization that currently solicits funds to do this. Suppose that such an organization sends a mailing to Mr. Peabody and Mr. Massey saying it needs $50 per foot to preserve the last 100 feet of a prime Appalachian trout stream. Now, Peabody would be willing to pay $30 per foot and Massey $40 per foot toward the effort, for a total of $70 per foot. Thus, the monetary benefits of preservation exceed the costs by $20 per foot.

We can approach this problem graphically, by examining the difference between the demand curve for a public good and a more conventional private good. In Figure 3.5A, let us assume that the trout stream is for sale to private individuals. Note that, for 100 feet of land, as discussed earlier, Peabody would pay $30 per foot and Massey $40, but now, they do not have to share it. As you may recall from a previous course, the demand curve for a private good is the horizontal sum of the individual demand curves. At a price of $30 per foot, Peabody demands 100 feet while Massey demands 120 feet, so total demand equals $100+120$ or 220 feet. In a market for private goods, consumers face a single price, and each person consumes as much as he or she wants to buy. Thus, the total demand is met.

By contrast, when goods are public, all consumers face a given public quantity and must decide how much to pay. As shown in Figure 3.5B, the trout stream has become a public good; Massey and Peabody must share whatever is purchased. For 100 feet of land, we know that their collective value is $70 per foot; following this logic, we can see that their total willingness to pay (WTP) (or their demand) for any given amount of preservation is the vertical sum of the individual demand curves.

The true total demand for public goods is seldom expressed in the market, for two reasons. First, unlike in the case of private goods, some third party must organize the collection of funds to pay for the public good or to initiate a lawsuit against a polluter. Myles would have to drag himself out of bed and go collect signatures on a petition from the neighbors to convince a judge to tell Tipper to be quiet. More generally, there may be large costs associated with proving highly contestable environmental damages in a court of law. As noted, the need to support such efforts raises the transaction costs—the costs associated with making a market deal—for public goods.

Second, in the case of public goods, individuals also have an incentive to free ride on the efforts of others. Although Massey and Peabody collectively value the land at more than its asking price, they may be unwilling to reveal their true preferences to a private agency or government collecting revenues to pay for the public good. Incentives to free ride are often dampened in small groups, where an individual can see his or her individual effort as “pivotal” to the success of the public effort, and/or the members carry a sense of group responsibility. However, such conditions are unlikely to hold for most pollution-control efforts, thus making free riding a serious obstacle for nongovernmental attempts to provide such goods.

To summarize this section, in contrast to private goods, public goods are consumed in common. The true demand for public goods will not be satisfied in pure market economies due to high transaction costs and free riding. Free-market environmentalists advocate relying solely on the court system to internalize environmental externalities. Most economists, however, argue that, as a result of transaction costs and free riding, public goods such as clean air or water, rain forests, wilderness parks, and other environmental amenities will be undersupplied in a laissez-faire market system.¹¹ Thus, there is a need for the government to ensure provision of these goods by protecting the environment through regulation.

3.3 Is Sustainable Business a Solution?

In recent years, a new paradigm around economics and the environment has begun to emerge, the sustainable business movement. Instead of viewing environmental and social problems as unwanted costs to be externalized, can business firms look at them as potential profit opportunities? And within the confines of existing policies, laws, and regulations, can business effectively, dramatically, and profitably reduce pollution and resource degradation?

One example: In Troy, NY, two entrepreneurs have set out to eliminate Styrofoam from the face of the earth. Their company, Ecovative grows big blocks of tightly intertwined fungus, the kind that grows on logs in a forest, dries them, and then carves them up to make sculpted shipping sleeves, shipping peanuts, and even the equivalent of a foam insulation wallboard. Instead of a petroleum-based product that requires intensive mining and processing to produce, and on disposal, persists for tens of thousands of years, Ecovative’s product grows in dark rooms at room temperature. And when it has served its purpose, the consumer can break it up and put it in their garden as compost.

Across the lifecycle of Styrofoam—from oil drilling to refining and manufacture, to transport and disposal—pollution problems (externalities) abound. A regulatory strategy to separately deal with each of these problems—typically end-of-pipe controls or end-of-life mandates—undoubtedly raises the business costs for producing Styrofoam and the price to the consumer for shipping and home insulation. What Ecovative, and hundreds of other green companies, seek to do is to innovate around those costs, developing inherently cheaper and cleaner solutions.

Pioneering business leaders began pursuing this strategy in the 1990s, and the sustainable business wave began to build in the 2000s. Three levels of cost-savings have been identified:

• Risk Reduction. Firms that proactively reduce pollution reduce risk—risk of regulations, legal liability, and consumer backlash.
• Resource Savings. Pollution is often a sign of waste. Firms that use water, energy, and raw materials more efficiently also reduce emissions and will often save money.
• Culture of Innovation. Firms that see it as part of their business to profitably solve their environmental problems create cultures that breed innovation.

Sustainable business has been widely hailed, and both start-ups and Fortune 500 companies have made progress in pursuing this strategy. An emerging body of empirical evidence shows that environmentally leading firms are as profitable, if not more profitable than, as less-green competitors.¹² At the same time, however, many corporate efforts amount to little more than greenwash. At the end of the day, it is not clear how far the sustainable business movement can push. What is the scale of profitable reduction in ecological footprint that can be achieved without major changes in government regulations and policy?

We will look more closely at the opportunities for clean technology development in Chapters 18 and 19, and in Chapter 9, we will also explore the extent to which firms pursuing sustainable business strategies can simultaneously reduce ecological footprint, cut costs, and increase profits—the so-called Porter hypothesis. But, even if truly green companies can innovate and prosper, the vast majority of firms who are less focused on sustainable innovation can and do still raise profits the old-fashioned way, by overexploiting the commons and externalizing costs. This leads us back to the need for government policy to internalize externalities and create price signals that “tell the truth” about the real costs of production.

3.4 Summary

In this chapter, we have analyzed two different aspects of communal property that contribute to the degradation of the environment. First, the open access problem explains why individuals would knowingly damage a resource they depend upon; the benefits of exploitation are private while the costs are largely externalized. Second, the public goods problem explains, in part, why people cannot “buy” a clean environment, by either suing the polluters or purchasing wilderness. Transaction costs are high, and people tend to free ride on the efforts of others.

The recent rise of the sustainable business movement provides hope that, through innovation, business firms can find profitable solutions to some, and perhaps many, environmental and social challenges, particularly in conjunction with regulations that externalize internalities in the so-called dirty industries. The central point is that, generally, free-market forces do not provide the right incentives to ensure that adequate care is taken to protect our environment. Given this, what should our response be? As we have noted, a few have argued that externalities can be adequately internalized by means of private lawsuits. A second, more common, response, which we examine in Chapters 17 and 18, is the call for development of more environmentally benign “clean” technologies that reduce pollution problems in the first place. However, the conventional response has been government regulation of pollution, which brings us back to our principal topic: How much is too much?

1. 3.0 Natural capital is the input that nature provides for our production and consumption processes. Pollution is the overuse of sinks; resource degradation is the overharvesting of sources. A negative externality is a cost of a transaction not borne by the buyer or seller. Internalizing an externality means forcing the source of the externality to bear the external costs imposed on others.
2. 3.1 Negative externalities arise when there is open access to common property sources and sinks, such as air, water, or land. Traditional societies regulated access to common environmental resources using informal laws and restraints, but many of these have broken down. When access to natural capital is restricted, by either government action or private ownership, a resource rent is earned by those who retain access.
3. 3.2 Is government regulation of the environment necessary to solve the open access problem? Free-market environmentalists believe that polluters should be left unregulated and victims should sue to ensure environmental quality. However, most economists argue that because a clean environment is a public good, the obstacles of high transaction costs and free riding mean that private negotiation in the courts would be inefficient (and also unsafe and unsustainable). Thus, government regulation is needed to internalize environmental externalities.
4. 3.3 Sustainable businesses focus on profitably reducing pollution and resource degradation within the structure of existing policies, laws, and regulations. Profits arise from three sources: risk reduction, resource efficiency, and continuous innovation. Beyond the problem of greenwashing, the larger question is how widespread are opportunities to achieve major improvements in environmental quality and earn profits in doing so? And regardless, other firms currently still earn profits by externalizing the environmental costs.

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