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Market Failure: Pollution, the Environment and Externalities - 271003

This Mind your business article looks at Market Failure: Pollution, the Environment and Externalities.

Mind your Business - 27 October 2003

Market Failure: Pollution, the Environment and Externalities

The News

Environment Agency:
The Environment Agency are responsible for the protection and improvement of the air, land and water in England and Wales. During the summer, they released their annual report - part of which was devoted to reporting on the performance of businesses in relation to incidents of pollution. The report suggests that overall incidents of serious pollution were 20% lower than in 2001 but cautions against any complacency and identifies well known businesses as being guilty of repeat offences. The key industries responsible for the pollution of water, land and air are not that surprising - agriculture, waste management, the water industry and the chemical industry. But repeat offenders included companies such as BP UK, Tesco, Tiles-R-Us, TotalFinaElf, Anglian Water, Thames Water, BT, Yoplait and Stationary Box. Such repeat offenders account for around a fifth of the total list and as the term repeat offenders suggests, they have been fined before for breaching environmental regulations. Fly tipping (the unauthorised dumping of waste materials) continues to rise and landfill sites are a cause for concern - 3.5% of which 'pose unacceptable risks to the environment'

The average fine per company rose by over one third to £8,744. Fines of more than £20,000 rose by nearly 42% compared to 2001 but the Environment Agency clearly feel that the size of the fines are insufficient to persuade companies to change their behaviour. They cite numerous examples of businesses who flouted the regulations including a company director who dumped soil containing arsenic, mercury and cyanide. Arsenic is a deadly poison it its pure form and can cause circulatory problems, skin damage and increases the risk of cancer. Cyanide causes nerve damage and thyroid problems and mercury causes skin disorders, internal bleeding, liver, kidney and intestinal damage. He was jailed for a year!

Part of the problem facing businesses are the increased costs associated with safely disposing of waste products. This becomes especially acute when margins are already tight as in farming. Late summer is traditionally a time of year when many farmers employ sheep dips as a way of controlling parasites on sheep. The liquid, however, is very dangerous and needs to be mixed, administered and disposed of with great care. Regulations surrounding the use of such a product includes installing underground tanks to store the dip, having enclosed areas to dip the sheep and then enclose them afterwards until the excess dip has drained off. In addition sheep must not be allowed near rivers and streams for two weeks after being dipped in case the dip washes off into rivers. This bit of detail highlights the large increase in costs that farmers who use such methods may have to cope with.

Photograph of a chemical works - Responsibility to produce, often dangerous products, safely and responsibly is a key consideration for many firms

Responsibility to produce, often dangerous products, safely and responsibly is a key consideration for many firms.

Theories

The theory here relates to market failure. Market failure occurs where resources are not allocated to their most efficient use. In the case of the environment the failure occurs because of the existence of negative externalities. Negative externalities are the effects on a third party of an economic decision. Businesses highlighted in the Environment Agency report may choose to make decisions to dispose of waste in rivers, streams, produce by-products that pollute the atmosphere as a result of the production process (e.g. through smoke from chimneys) or have an indirect effect on the environment through a lack of complete understanding of the impact of production processes they are involved in. For example, should farmers be expected to know that sheep have to be carefully monitored for two weeks after being dipped to prevent the dip from washing off into streams?

The producer may be aware of the impact of his or her decisions but feels that a. they can get away with it; b. the cost of disposing the waste is too high; c. that profits will be higher if costs are kept to a minimum and disposing of waste through a least cost method is highly efficient. The true cost to society therefore is actually much higher than the private cost to the producer.

We can use the framework of supply and demand to help explain the problem. Look at the PowerPoint presentation on the topic. The demand curve has been re-labelled the Marginal Social Benefit curve. What this means is that the demand for a particular good or service relates the price consumers are willing to pay in relation to the perceived value they gain from consumption. Price, times the utility gained from consumption, can be seen as the value of the benefits to consumers. We can therefore look at the demand curve as the sum of the benefits to society of consumption.

The supply curve represents the private costs (MPC) to the producer of producing a given amount. Increasing production would imply increased costs hence the positive relationship between price and quantity supplied. Remember that the price received by the producer must cover the costs of production and also include the element of profit needed to keep the producer in that line of business. The MPC does not, however, reflect the true cost of production given that there are costs that society will have to pick up in order to deal with the pollution. It may be the harm to wildlife, it may be the need to clean up and repair historic or civic buildings that have been attacked by the chemicals in the pollution, it may be the cost to the health service of treating people with illnesses related to pollutants in the air - for example asthma, cancers and so on. The difference between the MPC and the true cost represents the social cost of the production level concerned. The supply curve therefore is, in reality, the sum of the MPC and the marginal social cost (MSC). Where the new supply curve cuts the MSB curve is the socially efficient output. Society would, at this level, value the output produced at the the same value as the cost of producing it. Previously society valued the output of the product concerned less than the true cost of supplying it. The triangle highlighted is the sum of the welfare loss experienced by society as a result of the over production of the product concerned.

The diagram helps to highlight to us the fact that if we, as a society, wish to reduce the damage caused by pollution of this sort, we need to accept that we may have to pay more in order to gain that benefit. For example, if the producer found a way of investing in technology to safely dispose of the pollution then it will cost them more. Some of that cost will be passed on to the consumer in the form of higher prices. We might be paying more, but society benefits from reduced pollution! The last point highlights the problem that often causes market failure - the inability of price to act as an appropriate signal to both consumers and producers.

Solutions to the problem therefore tend to focus on making the price signal work more effectively. Taxing the producer, having some sort of financial incentive to invest in appropriate technology (for example through heavy fines for pollution) permits to pollute that gradually become more and more stringent and an extension of property rights are all possible methods.

Imposing taxes on those who pollute attempts to make those who do the pollution take responsibility for their actions. If they reduce pollution, they get taxed less! Permits allow producers to pollute up to a certain level. If they find methods of reducing pollution then they are able to sell the 'spare pollution' capacity to other producers who might find it more difficult to invest in such technology quickly. These are sometimes referred to as 'tradable permits'. When the permits are renewed the level will be progressively reduced thus the overall level of pollution will eventually come down.

For fines to be effective, the severity of them must be such that they act as a significant deterrent to firms. One of the complaints of the Environment Agency in their annual report is that the fines are too low to be effective. As is often the case with business, weighing up the relative costs and benefits of an action will influence their decision-making. If the benefit they gain from polluting can be estimated at £500,000 per year, a fine of £20,000 is not going to be a sufficient 'cost' to offset the benefit! Any type of ban or fine therefore must be capable of being enforced effectively. Often identifying the source of pollution can be difficult as well as identifying the extent of the pollution caused by that source as opposed to others.

Extending property rights is an important but very difficult area. The basic theory is this. If you decided to throw a brick through the window of my house I would be well within my rights to expect legal redress. The reason is that you have caused damage to my property and provided I can prove it was you who caused the damage and that I am the legal owner of the house I can expect compensation to put right the damage (replacing the window pane might be one aspect but also for any emotional trauma caused!) With things such as rivers, streams, land and air it is less easy to establish who are the legal owners. If some system could be devised whereby the ownership of property could be established then those that cause damage to that property can be brought to book! Part of this process has been developed through establishing the Environment Agency and giving them control over the nations rivers and streams but with the air it is more difficult.

Illustration showing how a house owner's air could be polluted by a neighbouring factory

Whatever solution or combination of solutions are used to help reduce the problem of negative externalities, the main aim is to try to 'internalise the externality' - what we mean by this is that the decision maker takes into consideration the impact of his or her decisions on a third party.

Questions

  1. Explain how the reference to 'repeat offenders' in the news story highlights the issue of market failure. (8 Marks)
  2. Discuss the degree of success experienced by the Environment Agency in dealing with cases of environmental damage. Cite at least two case study examples to illustrate the points you are making in your answer. (12 Marks)
  3. Consider the solutions to the problem of market failure in this context and examine the case for and against each measure. Support your answer with appropriate examples. (30 Marks)

Total: 50 Marks

Related Web sites for research

Mark Scheme

Question 1

1. The issue to consider here is that if companies are repeat offending then they have not learnt their lesson and the externality clearly has not been internalised! Questions will have to be raised about the extent of the punishment the companies face in preventing them from repeating the problem. It is always wise to begin your answer with a clear definition, in this case, 'market failure'. Use an example drawn from the evidence to help support your definition. You may have to ask the question 'why do companies continue to break environmental regulations and laws?' Part of the reason is that the price mechanism is not working effectively and as such the right information for both producers and consumers is not available on which to make informed choices. 2 marks for an appropriate definition, 2 for a supporting example. The remaining 4 marks are awarded for the ability to relate the definition to the issue of the 'repeat offenders' - the size of the firms in the example may be a clue here!

Question 2

2. The command word 'discuss' implies the use of analysis and evaluation in your answer. The analysis will come from highlighting the degree of success - find examples of successful prosecutions but then provide some balance by illustrating some of the problems that still exist - the figures in the 'News' section above might help you in this respect. The evaluation comes in the form of you making judgements about the EXTENT of the success. You will have to judge whether the laws and the powers that the Environment Agency possess are sufficient to do the job they have been entrusted with! If they are doing a wonderful job should the figures for pollution be coming down rapidly or do you think that there is still some way to go before pollution is brought under sufficient control? The use of 2 specific examples form the Environment Agency website again directs you towards linking theory and practice and encourages you to support your answers with real life examples. 4 marks for the application of appropriate case studies, 4 for the analysis and 4 for the use of supported judgements.

Question 3

3. This question is designed to encapsulate the style of the main exam boards in the way in which they frame their questions on this subject. The command word is 'examine' which implies that you need to go into a degree of detail about the subject. Take each of the four solutions given in the 'Theory' section and discuss the relative advantages (benefits) and disadvantages (costs) of each. Use examples to highlight your answer - this suggests that you need to do a little more research around the topic - see the suggested Web sites for help in this respect as well as using your textbook. 6 marks for each solution with the remaining 6 marks for the quality of the argument you present and the quality of the conclusion you draw from your study. If you do this question carefully you will have a good basis for tackling most questions about the issues arising from market failure. The solutions to the problem of pollution can just as easily be applied to congestion on the roads, the problem of over fishing in the EU and so on.

Submitted by aashwin on Mon, 20/10/2003 - 12:00