All Commentary
Monday, October 1, 2001

Getting the Most Out of Pollution

How about a Market for Pollution Rights?

The Environmental Protection Agency’s attempt to reduce pollution with command and control suffers from the same problem as attempting to direct the economy with socialism—central authorities dictate outcomes without knowing what the outcomes should be or how they are best achieved. The EPA isn’t any better at socialism than the former Soviet Union (or anyone else for that matter). Reducing pollution efficiently requires information from many firms and coordination of their activities. This is clearly a task for markets, since market prices excel at communicating widely dispersed information to those who can respond to it most effectively by coordinating their actions with the actions of others.

But markets require private ownership, and pollution problems exist because our waterways and atmosphere aren’t privately owned. If they were privately owned, there would be no pollution problems because prices for discharging our waste in these resources would arise that would reflect the costs imposed on others. But how can we use markets to reduce pollution if we cannot divide up, and parcel out as private property, these resources? As we shall see, we can create an imperfect market that will reduce pollution far more efficiently than the command-and-control approach.

In most markets price communication determines not only how much of a good goes to each consumer, but also how much is supplied. When consumers want more of a good, they communicate that through higher prices, and suppliers respond by increasing production as long as the marginal value to consumers (the price they are willing to pay) is greater than the marginal cost of production. If oceans, lakes, rivers, and the atmosphere could be privately owned and every owner could charge everyone whose discharges pollute his water or air, then market transactions would determine the efficient amount of pollution. If polluters wanted to pollute more, they would communicate that desire by offering to pay a higher price to do so, and owners of air and water would allow more pollution until its marginal value (the price polluters are willing to pay) is greater than its marginal cost. As I explained in my May and June columns, the bargaining needed to determine this efficient amount of pollution is not likely to take place.*

So no market we create will determine the right amount of pollution reduction. That decision will generally be made politically. But once made, we can create a market that achieves the reduction at far less cost than can command-and-control policies. The EPA would issue transferable permits for a particular type of pollutant; each permit would allow a given amount of discharge over some specified period, with the total adding up to the allowable discharge of the pollutant. Because the permits would be transferable, a market would quickly develop in which the permits are bought and sold at a price that clears the market—equates the number of pollution permits demanded with the number that exists.

Because of market incentives, it doesn’t make much difference how the permits are issued, or who receives them initially, or who ends up using them. It obviously makes a difference to individual recipients. But no matter who receives them, they will soon be sold to those who value them most—those willing to pay the most for them, who presumably can create the greatest value with the allowable pollution.

Suppose the permits were given to an environmental organization such as the Audubon Society or some consortium of such organizations (not a serious recommendation). Wouldn’t they refuse to sell any permits, thus keeping them out of the hands of polluters? Indeed, they might keep some off the market to reduce pollution. But not many. For example, if all the permits were kept off the market, their marginal value to polluters would be far higher than the marginal environmental cost. And the Audubon Society would take that marginal value to polluters fully into consideration, since it would be reflected in the revenue possible from selling the permits. Of course as more permits are sold, their marginal value to polluters declines and the marginal cost of pollution increases.

But as long as the marginal value of the permits is more for polluting than for preventing pollution, the Audubon Society would recognize that it can probably do more to further its environmental goals by selling the permits and using the money to buy wildlife preserves and promote environmental education. And this is not just idle speculation. As I discussed in my June 1999 column, although the Audubon Society opposes drilling for oil on public land, such as the Arctic National Wildlife Refuge in Alaska, it allows oil companies to drill on for oil in its own wildlife refuge in Louisiana. Whether the Audubon Society owns a wildlife refuge or pollution permits, ownership and market prices motivate it to put property into its highest-valued use, just as they do everyone else. And this is no less true when the highest-valued use is one that creates pollution.

Getting the Most Value from Pollution

The market for pollution rights will result in a price that all polluters have to pay, so everyone who wants to discharge an additional unit of a particular pollutant will have to pay the same market price to do so. Since it pays everyone discharging a pollutant to increase pollution to the point where the marginal value is equal to the marginal cost, which is the common price of the pollution permit, it follows that the marginal value of pollution will be the same for all polluters. This is another example of the advantage of “equating at the margin,” which in this case means that we are getting the greatest possible value from the allowable pollution. If, for example, the marginal value of polluting is greater for polluter A than for polluter B, the total value could be increased without increasing pollution by allowing A to increase pollution by another unit while requiring B to reduce pollution by a unit. It also demonstrates the advantage of the market approach over command and control to pollution management.

It is impossible for the EPA to collect and consolidate into usable form the information necessary to mandate the pattern of pollution that would allow the most value to be generated.

Getting the most value from a given amount of pollution is equivalent to reducing pollution to that given amount at least cost. This is immediately obvious from the fact that cost is forgone. My next column will go into further detail on the efficiency advantages of market approaches to control by focusing the discussion on the cost side of pollution control.

* I shall consider possibilities for market determination of pollution levels in two months.

  • Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.