Tackling the Problem

The market fails to contribute towards environmental protection because of a pricing problem. The function of price, and hence the market, is to allocate resources efficiently. However, when it comes to many environmental resources and externalities no prices exist and so the market has no way of allocating these resources. Traditionally the role of government in relation to the market has been to distribute resources i.e., define and enforce property rights. Prices are a consequence of the distribution of property rights that underlie market exchange. Theoretically, if the government were to define property rights in such a way that would allow for correct pricing of environmental resources, then their actual scarcity and cost would be reflected. Further environmental degradation resulting from economic activity should be halted.

This suggests a role for governments in implementing environmental protection. Three options are available to government for this purpose: educate consumers; place quotas on the use of certain resources or ban producers from using them altogether; or create market-based incentives to induce both consumers and producers to adjust their behaviour.

In general, governments have adopted what has been referred to as a command-and-control strategy. In other words, they regulate activities that degrade the environment in accordance with some legislated or agreed standard. This involves the use of quotas or bans for restricting the use of renewable resources (like fish, etc.,), restrictions on air pollution emissions, controls on hazardous waste transport and dumping, zoning laws and ambient water quality standards. These controls are usually mandatory and enforced through litigation, licensing and fines or penalties for non-compliance (Barbier, 1992 p3; Plackett, 1994 p42).

There are certain disadvantages to the command-and-control approach, however. Regulations can be difficult to enforce and costly to administer. Rising costs and budget constraints have made regulation less attractive than economic instruments with their promise of efficiency and built-in compliance. Regulations offer no incentive for exploiters of the environment to attain standards higher than those imposed by the law either. They are also inflexible. Those subject to regulations may have no choice in how they reach these environmental and social goals. Logistics pose an additional problem. Pollution, for instance, is caused by a large number of individuals making it difficult to enforce standards. Finally, consumers have little financial incentive to purchase "environmentally friendly" goods. "Green" products are often more expensive than conventional products (Plackett, 1994 p43; OECD, 1994 p39).

With the realization that regulation is not as effective and efficient as it could be, the focus has swung towards the use of economic instruments. Economic instruments are policy measures which explicitly affect private cost and benefits. The motivation used is that rational decision makers will base their decisions on a comparison of various options. Their rational choice will be the option which has the least cost for the number of benefits received. Economic instruments seek to make environmentally more appropriate behaviour more rewarding to the decision maker. In this way individuals will be induced to change their behaviour and freely choose a more socially desirable alternative (Barbier, 1988 p2; OECD, 1994 p15).

This rationale is based on the arguments of A.C. Pigou in The Economics of Welfare dealing with the divergence between private and social costs (which is the result of externalities). Pigou is of the opinion that the party causing damages (pollution for example) should be forced to compensate the victim (Coase, 1960 pp28-31; Pearce, 1988 p2). Since it is not always so easy to compensate every individual affected by pollution, the polluting parties should have to pay the state who will then decide how to allocate and distribute the resulting funds. This is what led to the adoption of the polluter pays principle by the Organisation for Economic Co-operation and Development (OECD) countries in 1972 (Pearce, 1988 p1).

The most common theoretical instrument used under this regime is the Pigouvian tax. This tax should be set equal to the pecuniary value of the marginal damage caused by pollution at the point of "optimal" pollution. Optimal pollution is not a point of zero pollution but rather a point at which the cost of reducing pollution any further outweighs the environmental, social and economic benefit received. At this point the net benefits to society will be their greatest. Implementing such a tax is not without its problems, however. Firstly, it is next to impossible to determine the optimal level of pollution (due to difficulty in measuring the value of the damage and the cost of clean-up). Secondly, it is also difficult to calculate the level of tax required to achieve it. In practice, environmental taxes are often set at one level and then iterated up or down depending on their effect. In some cases repair of environmental damage is impossible (species extinction, for example) (Pearce, 1988 p3; von Weizäcker, 1992 pp23-24)

Policy makers, having been confronted by this problem with Pigouvian taxes, have found other ways of approaching the result. They have resorted to charges, fees, tradable and marketable permits. However, they have also recognized that similar results can be achieved by providing compensation for not using polluting substances or technologies. Subsidies, tax allowances, and grants have been used in this manner. Other policy makers have opted for a combination of the two approaches utilizing deposit/refund systems, distributive credits and feebates (Barbier, 1992 p2; Gale and Barg, 1995 p5; von Weizäcker, 1992 pp14-21). In some cases policy makers have even adopted a victim pays stance whereby similar methods are used to get victims to compensate polluting parties for not being able to pollute. Coase (1960 pp1-15), in The Problem of Social Cost, shows that this solution would achieve exactly the same results.