The Economics of Pollution

Why is pollution an example of market failure?

Pollution is a side effect of production. Pollution is defined as the introduction of waste and harmful products in to an environment that are classed as undesirable. Let us use the example of so-called greenhouse gases. Assume that a company engages in production and in doing so it generates waste products that escape into the atmosphere. These waste products could be in the form of carbon dioxide. Carbon dioxide contributes to the build up of greenhouse gases. The chart below shows just how much carbon dioxide emissions have risen over the past two centuries.

Source: Zfacts.com.

The build-up of greenhouse gases traps ultra-violet radiation from the sun within Earth's atmosphere. This causes the average temperatures to rise and has effects such as melting polar ice caps. As these ice caps melt, sea levels rise and weather patterns can be affected. The resultant increase in extreme weather conditions can affect people in all sorts of ways. The increase in flooding, storms, tornados and drought that results might affect millions of people around the world.

It should be noted that there are those who would dispute the links between greenhouse gases and global warming. However, let us assume, for the sake of this analysis that carbon dioxide emissions do translate to global warming and the extremes of weather we hear about. One example that we are going to focus on is the tornado that struck residents in North London earlier this year. We are going to make (albeit a rather generalised) assumption that this tornado was one of the direct results of global warming.

In the UK, it seems we are hearing more and more reports of extremes of weather - is this a result of global warming? If so, who bears the cost - the polluters who have contributed to global warming? How do we apportion those costs? Copyright: Gianni T, stock.xchng.

The effects on the residents who suffered from the tornado represents a cost to them. To the business that is generating carbon dioxide, this cost is not considered as part of their private costs. It is a cost borne to people in society at large - the residents of this street!

Now, let us further assume that there were 10 residents whose houses were badly damaged. The cost to each resident was £60,000. That represents a total cost to them of £600,000. This is a cost (we are assuming) that is a direct result of Firm X's output of carbon dioxide but which they do not take into consideration. This is the social cost.

It is generally represented on a diagram such as the one below.

The supply curve is upward sloping as usual and represents the marginal cost of production. This is also the private cost of generating output. The true cost of generating each unit of output, however, ought to take into consideration the cost imposed on society. For each unit of output the true cost would be larger than the private cost. This would be represented by a supply curve positioned to the left of the MPC curve as shown. If we look at output level OQ2, the private cost of this output is shown as £250,000 but the true cost is shown as £300,000. This is reflected throughout the output range.

The demand curve represents the sum of the benefits received by consumers from production. We use money as a means of measuring the value of these benefits. The total benefit of consuming OQ2 units is shown as the area under the demand curve as shown below.

The demand curve slopes down from left to right because each additional unit consumed represents a slightly lower level of utility than the previous one (the marginal utility). As a result, consumers are willing to pay less to consume more units since they confer lower levels of utility. The total value of the benefits however does not take into consideration the fact that consumers have to pay a price to gain those benefits. We need, therefore to subtract the value of the sum paid from these benefits to get the net benefit from consumption. This is shown by the yellow area in the diagram below. This is the area of consumer surplus.

If we look at the area of consumer surplus when private costs are considered only, we can see that the consumption of OQ2 units is associated with a consumer surplus equal to the value of the triangle x,y,z. The area of producer surplus is shown by the area a,b,c.

Let us now compare this to the situation when we take into account the social costs. The consumption of OQ2 units is now associated with a higher cost. If the market price was the intersection of the demand curve and the MSC curve the price paid by consumers would be higher - reflecting the true cost of production. The area of consumer surplus, therefore, would now be less than before (shown by the triangle x1, y1,z1). The area of producer surplus would now be a1,b1,c1. What this demonstrates is that the market has failed. It has failed because price did not provide the right signals for both producers and consumers.

What this led to was overproduction of this particular good. If the market price had been a more accurate reflection of the costs and benefits of production and consumption then there would have been less produced and the price would have been higher. Going back to our scenario, if company X had factored in the social cost into their production then they would have produced less, generated less carbon dioxide and the tornado would not have been so devastating. The less devastating tornado would have had less of an impact on the homes of the residents and their costs for repair would have been lower.

Finding ways of recycling waste products, including gases, might be one way forward but there has to be an incentive for firms to do this - and it must be cost effective.

This concluding analysis does, of course, require a leap of faith to really come to terms with. However, it does illustrate the basic concept. People all over the world are being affected by the external costs of production. We are consuming items at a price lower than it should be and as a result are consuming amounts that we would not if price were higher and we were made more aware of the true costs. Equally producers would behave differently if they had to factor in the true costs of production into their decision making.

What can be done?

The solution is relatively simple in theory but more difficult to implement in practice. What needs to happen is that price needs to be more reflective of the true costs and benefits of production. Both producers and consumers need to be more aware of the relative costs and benefits of production. The main way of solving the problem of pollution is to make businesses that generate the pollution take account of it in their costs. If they do so they will produce less and also have incentives to change their behaviour to find ways of cutting the pollution or producing without generating pollution. In some cases, it could be that a business will look to find ways of recycling or using the waste product and gaining some form of competitive advantage that might generate future profit.

For consumers, it is a case of making them recognise that the price they pay is a more accurate reflection of the true benefits from consumption and that over consumption might be associated with negative externalities. We might feel we are getting a good deal out of consumption and the price is such that we are tempted to buy it. However, if we, as consumers, are not fully aware of the costs that our consumption is creating then price is not accurately reflecting the value of the benefits - because they are not, ultimately, benefits!

A higher price might make consumers think more carefully before buying the product concerned. It helps send a signal about the value of the product. The problem in many cases with market failure is that consumers want cheaper prices but are very concerned by issues like global warming. As consumers we are not always prepared to pay for production and for protecting the things we might hold dear!

The main way of trying to deal with pollution is through taxation, some form of pollution permit (carbon trading permits for example) or through some form of pricing policy that makes consumers more aware of the true costs of consumption such as road pricing. Road pricing's main target is to try and reduce congestion but if car use falls as a result there will also be reductions in the amount of pollution emitted from vehicles.