Market Failures Leading to Environmental Degradation

Environmental degradation is an important sustainability issue. In order to tackle it, we must look at the root causes . Essentially the economic causes (as opposed to other causes) of environmental degradation are pricing and poverty (Munasinghe 1993 p17). However, this bibliography will concentrate on dealing with the pricing problem since this is what economic instruments seek to rectify. The issue of pricing can further be broken down into four components: externalities, underpricing, the lack of markets for environmental services and policy failure (Barbier, 1992 p1; OECD, 1994 p28).

Externalities refer to a situation where effects (harmful or beneficial) of production or consumption are imposed on others but cannot be traced or charged back to the originator. The main characteristic of an externality is the separation between the affected individual and the source of the effects. Because of this it is difficult to get the perpetrator to pay for the costs of the harmful effects or the beneficiaries to reimburse those who create benefits to society. Thus, externalities are not built into the market price of a good or service. An example of a negative externality would be pollution. A positive one may be environmental enhancement (Bishop, Aylward, & Barbier, 1991 p6; Conway 1991 p471; Pearce, 1988 p2).

Underpricing occurs when all the costs of an input or activity are not included in the price of an output. This is generally due to the fact that markets only make provision for pecuniary costs and not environmental and social costs of production. Environmental economics is making an effort to incorporate non-pecuniary costs into the price of outputs through shadow pricing or economic opportunity costs and other valuational techniques (Munasinghe, 1993 pp16-19; Pearce, Markandya and Barbier, 1989 p154).

A lack of information also leads to incorrect pricing because it gives a distorted impression of the scarcity of a resource. While insufficient information can lead to a commodity being overpriced, it is when it leads to underpricing that environmental degradation is most likely to occur.

Government policies are also guilty of causing underpricing. Through government subsidies for certain inputs, particularly in agriculture, the consumer bears less cost and thus gains a false impression of the (non)scarcity of a resource. Furthermore, a lower cost will induce an individual to use more of a resource (which is after all the point of a subsidy) with the possible consequence of negatively affecting some other resource in the process. For example, using too much fertilizer often leads to contaminated groundwater.

The final market failure has to do with situations where no property rights (and hence no market) exist for certain goods (whether resources, services, or products used by producers or consumers). These are generally referred to as open-access resources or public goods which are usable by all without payment. Since such resources are difficult to value, they tend to be overexploited due to their negligible user charges (Munasinghe, 1993 p17; Pearce, Markandya and Barbier, 1989 p5-7,154).