Chapter 3

Government Intervention in
Market Failure
Introduction
The issue is not whether the government
should intervene, but what form government
intervention should take.
While economic incentives have not had
dramatic success, this chapter will explore
the potential for correctly structured
economic incentives to achieve an
improvement in environmental quality at the
lowest possible cost.

2
Pigouvian Taxes
A.C. Pigou (1938) argued that an externality
cannot be mitigated by contractual
negotiation between the affected parties.
Pigou argued that direct coercion by the
government or judicious use of taxes should
be used against the offending party.
These taxes are referred to as Pigouvian
taxes.

3
Pigouvian Taxes
 The basic principle behind the use of externality
taxes is that the tax eliminates the divergence
between the Marginal Private Cost (MPC) and the
Marginal Social Cost (MSC).

 Consider Figure 3.1.

 Q1 represents the market equilibrium (where
MPC=MPB), and
 Q* represents the optimal level of output (where
MSC=MSB).

4
Figure 3.1 – An Externality Tax on Output

5
Pigouvian Taxes
 An externalities tax equal to the divergence between
MPC and MSC would raise the steel firms’ private
costs.
 The tax would shift the MPC curve by an amount
equal to the distance from a to b in Figure 3.1.
 The market would arrive at an optimal equilibrium of
Q*.
 This is known as internalizing an externality.
 Subsequent work has shown the tax should be
placed on the externality (such as pollution
emissions) rather than on output.
6
Coase Theorem
Ronald Coase (1960) argued that not only is
a tax unnecessary, it is often undesirable.
Coase argued:
The market will automatically generate the
optimal level of the externality.
This optimal level of the externality will be
generated regardless of the initial allocation
of property rights.

7
Coase Theorem
 Coase’s example to illustrate his theory is based on
the interaction of a cattle rancher and a crop farmer.
 Cattle occasionally leave rancher’s property and
damage farmer’s crop.
 Coase argued that the farmer and rancher will reach
an agreement that will make them both better off.
 Either the rancher will accept payment to reduce the
size of the herd or farmer will accept payment to
cover cost of crops lost.
 And this will happen without government
intervention.
8
Coase Theorem
One critical assumption that Coase makes is
that transactions costs are insignificant.
Transactions costs are costs associated with
arriving at an agreement (the costs of
negotiation).
These may be small for a 2 party agreement
but would be very large for an externality
such as sulfur dioxide emissions across
North America.

9
Coase Theorem
The number of participants makes
transactions costs important.
One way to reduce transactions costs is to
appoint an agent who acts in behalf of a
large number of people.
The use of agents is associated with its own
problems:
 Free riders – don’t share in cost, but share benefits.
 Often it is difficult for individuals to identify the
agent that will best represent their view point.
10
Coase Theorem
Another problem associated with the Coase
Theorem is the need for asymmetric pricing.
Maximizing social welfare requires that the
generator of a negative externality be
charged a price, while the victim remains
uncompensated.
This means that an efficient market cannot
develop, as a market requires the same price
for the buyer and the seller.

11
Coase Theorem
Another problem associated with the Coase
example is that there is only one victim.
In a multiple victim/generator model, the
allocation of property rights would signal
entry and exit in response to those rights.
If ranchers have the right to let their cattle
roam without worrying about paying
damages, then there will be an increase in
the number of ranchers, and more damage.

12
Coase Theorem
A final problem associated with the Coase
Theorem is the existence of income effects.
Income effects imply that the higher an
individual’s standard of living, the greater his
or her marginal valuation of a normal good or
service.
Being free from a detrimental externality
raises an individual’s standard of living, the
marginal valuation of the damages depends
on the definition of property rights.

13
Types of Government Intervention
There are five broad classes of government
intervention:
 Moral suasion
 Direct prohibition of environmental quality
 Pollution prevention
 Command and control regulations
 Economic incentives
Each of these represents a different
philosophy toward the role of government in
society.
14
Moral Suasion
This term is used to describe government
attempts to influence behavior without
actually stipulating any rules.
Effectiveness depends upon the extent to
which individuals believe it is in their
collective interest to do so.
Successful programs include Woodsy Owl’s
“Give a hoot, don’t pollute” and Smokey
Bear’s “Only you can prevent forest fires.”

15
Direct Production of Environmental
Quality
Includes
 reforestation,
 breaching of dams,
 stocking of fish,
 creation of wetlands,
 treatment of sewage, and
 toxic waste site cleanup.

These are largely ameliorative actions.

16
Pollution Prevention
Not designed to control the externality, but to
address a related market failure of imperfect
information.
Basic premise is that combined efforts of
government agencies, national laboratories,
university and private firms can lead to
development of innovative and beneficial
technologies.
These programs emphasize being proactive
in reducing pollution.

17
Command and Control Regulation
These place constraints on the behavior of
households and firms.
Constraints generally take the form of limits
on inputs or outputs in the consumption or
production process.
Examples include:
 Requiring sulfur-removing scrubbers on the
smokestacks of coal-burning utilities.
 Prohibitions against dumping of toxic substances.

18
Economic Incentives
Economic incentives simply make self
interest coincide with social interest.
Examples include:
 Pollution taxes
 Pollution subsidies
 Marketable pollution permits
 Deposit-refund systems
 Performance bonds
 Liability systems

19
Choosing the Correct Level of
Environmental Quality
Zero pollution is not possible for two
reasons:
 The reduction of pollution will have opportunity
costs.
 The Law of Mass Balance makes a choice of zero
physically impossible.
The Law of Mass Balance states that the
mass of outputs of any activity are equal to
the mass of inputs.
Any consumption or production activity must
produce waste.
20
Choosing the Correct Level of
Environmental Quality
The desired level of pollution will be a
function of the social costs associated with
pollution.
The first of these is the damage that pollution
creates by degrading the physical, natural,
and social environment.
The second is the cost of reducing pollution
and includes the opportunity costs of
resources used to reduce pollution and the
value of foregone outputs.

21
The Marginal Damage Function
The marginal damage function represents
the damages that pollution generates by
degrading the environment.

Even if these impacts are not quantifiable,

the marginal damage function is useful for
thinking about the relationship between
environmental change and social welfare.

22
Figure 3.3 Marginal Damage Function

23
Marginal Damage Function
The marginal damage function in Figure 3.3
specifies the damages associated with an
additional unit of pollution.

The total damages generated by a particular

level of pollution is represented by the area
under the marginal damage function.

24
Marginal Damage Function
The increasing slope of the marginal damage
function indicates how damage changes with
each additional unit of pollution.

An upward sloping marginal damage

function indicates that as the level of
pollution becomes larger, the damages
associated with the marginal unit of pollution
become larger.

25
Marginal Abatement Cost Function
Abatement Costs are those costs associated
with reducing pollution to a lower level so
that there are fewer damages.
Abatement costs include:
 Labor
 Capital
 Energy needed to lessen emissions
 Opportunity costs from reducing levels of
production or consumption.

26
Marginal Abatement Cost Function
The marginal abatement cost function
represents the costs of reducing pollution by
one more unit.
In the following figure, Eu represents the
level of pollution that would be generated in
absence of any government intervention.
As pollution is reduced below Eu, the
marginal abatement cost increases.

27
Marginal Abatement Cost Function

28
Marginal Abatement Cost Function
Marginal abatement costs rise as cheaper
options for reducing pollution are exhausted
and more expensive steps must be taken.
The decreasing slope indicates that the costs
of reducing pollution increases at an
increasing rate.
A high vertical intercept indicates that the
cost of eliminating the last few units of
pollutants would be extremely high.

29
The Optimal Level of Pollution
Optimal level of pollution minimizes the total
social costs of pollution (the sum of total
abatement costs and total damages).

This level occurs at the point where marginal

abatement costs are equal to marginal
damages.

30
The Optimal Level of Pollution

31
The Optimal Level of Pollution
 If the level of emissions is less than E1, then the
marginal abatement costs are greater than the
marginal damages that the unit of pollution would
have caused.
 It doesn’t make sense to reduce pollution.

 If the level of emissions are greater than E1, then the

marginal damages are greater than the marginal
abatement costs associated with reducing pollution
by one unit.
 Society is better off eliminating that unit of pollution.
32
Social Costs When Pollution Level is
Greater than Optimal

33
Social Costs When Pollution Level is
Greater than Optimal
The optimal level of pollution is E1.
The actual level of pollution is E2.

Total costs associated with pollution have

been increased by the area of triangle abc.
This represents marginal damages greater
than marginal abatement costs for the range
of pollution emissions between E1 and E2.

34
Social Costs When Pollution Level is
Less Than the Optimal

35
Social Costs When Pollution Level is
Less than Optimal
The optimal level of pollution is E1.
The actual level of pollution is E3.

Total costs associated with pollution have

been increased by the area of triangle ade.
This represents marginal abatement costs
greater than marginal damage for the range
of pollution emissions between E1 and E3.

36
Pursuing Environmental Quality with
Command and Control Policies
One way to achieve an optimal level of
pollution is to mandate action to achieve the
desired level of pollution.
Critics have argued that command and
control regulations generate more abatement
costs than necessary.
Consider Figure 3.9 where both polluters are
required to reduce pollution by 50 percent.

37
Pursuing Environmental Quality with
Command and Control Policies

38
Pursuing Environmental Quality with
Command and Control Policies
The aggregate marginal abatement cost
function (societal marginal abatement cost
function) is the horizontal summation of the
individual marginal abatement cost
functions.
With no environmental regulation, polluter 1
would emit 10 units and polluter 2 would emit
6.
A requirement to reduce emissions by 50%,
regardless of cost, would reduce polluter 1 to
5 units and polluter 2 to 3 units.
39
Pursuing Environmental Quality by
Equating Marginal Abatement Costs
When both polluters are required to reduce
emissions by 50%, regardless of marginal
abatement costs, polluter 2 incurs a higher
cost ($3) than polluter 1 ($2).
Society’s total abatement costs can be
lowered by keeping total emissions constant,
but reallocating level of emissions by
marginal abatement costs.
The optimal level of emissions will be where
marginal abatement costs are equal, for a
given level of emission.
40
Pursuing Environmental Quality by
Equating Marginal Abatement Costs

41
Pursuing Environmental Quality by
Equating Marginal Abatement Costs
 Since polluter 2 has higher marginal abatement
costs, polluter 2 should be allowed to emit more, and
polluter 1 will be required to pollute less.
 Polluter 1 reduces pollution by one half unit (to 4 ½)
and polluter 2 increases pollution by one half unit (to
3 ½).
 Polluter 1’s marginal abatement costs increase and
polluter 2’s marginal abatement costs decrease.

 Total abatement costs are minimized.

42
The Role of Command and Control
Policies

 Despite their inability to equate marginal abatement

costs across polluters, command and control
policies may still be the most desirable policy
instrument under the following circumstances:
 When monitoring costs are high.
 When the optimal level of emissions is at or near
zero.
 During random events or emergencies that can
change the relationship between emissions and
damages.

43
The Role of Command and Control
Policies
While it might be possible to achieve an
optimal amount of litter through the use of a
tax or per person allocation, this would
require the “litter police”.
It is easier to make ALL littering illegal and
establish a punitive fine for those caught
littering.
The fine multiplied by the probability of being
caught would be factored into the choice to
litter.

44
The Role of Command and Control
Policies
 When the optimal level of pollution is zero or at zero,
direct controls make sense.
 This is the case for extremely dangerous pollutants,
such as heavy metals and radioactive waste.
 Damages associated with these pollutants are quite
severe.
 Direct controls also make sense in other cases
where initial damages are quite high compared to
initial marginal abatement costs.
 An example is CFC’s, where accumulated amounts are
dangerous but there are low cost alternatives.

45
The Role of Command and Control
Policies
Emergency situations may make direct
controls the preferable policy instrument.
These events occur in random and
unpredictable fashion.
Examples include smog alerts and droughts.

46
Pursuing Environmental Quality with
Economic Incentives
Economists advocate policies based on
economic incentives for two primary
reasons:
 Economic incentives minimize total abatement
costs by equating marginal abatement costs across
polluters and encouraging a broader array of
abatement options.
 Economic incentives encourage more research and
development into abatement technologies and
alternatives to the activities that generate the
pollution.

47
Economic Incentives and Minimized Total
Abatement Costs
 Consider the following graph.
 A polluter is polluting at an unregulated level of 10
units.
 The government imposes a tax equal to t dollars per
unit of pollution.
 The polluter compares the tax of t dollars to the
marginal abatement cost (MAC) of reducing
pollution.
 As long as the MAC is less than the tax, polluter will
reduce level of emissions.
 Each polluter will chose an emission level which
equates MAC and the tax.
48
Economic Incentives and Minimized Total
Abatement Costs

49
Economic Incentives and the Certainty of
Attaining a Target Level of Pollution
If the aggregate marginal abatement cost
function is know, then achieving a targeted
level of pollution is easily accomplished.
If the aggregate marginal abatement cost
function is not known, the appropriate tax
level is much harder to determine.
Consider Figure 3.16, where evidence
suggests that the true MAC function lies
between an upper and lower bound set of
MAC’s.

50
Economic Incentives and the Certainty of
Attaining a Target Level of Pollution

51
Economic Incentives and the Certainty of
Attaining a Target Level of Pollution
 Suppose policymakers believe MAC1b is the true
MAC. In an effort to achieve an emissions level of
E1, they impose a tax of t1.
 However, if MACt describes how polluters will
respond, the emissions level will be E2.
 E2 is higher than the desired level of pollution.

 Because the choice of pollution abatement and

production technologies is sensitive to specific tax
structures, it may not be easy to change the tax to
achieve the desired level of pollution emissions.
52
In summary:
Pollution taxes are preferable to command
and control techniques since pollution taxes
minimize abatement costs and provide other
desirable incentives.

Under certain conditions, pollution taxes are

less proficient than command and control
techniques in achieving a desired level of
pollution.

53
Marketable Pollution Permits
Marketable pollution permits are permits
which give a firm the right to emit a specific
number of units of pollution.
Polluters are free to buy and sell these rights
to pollute.
A marketable pollution permit system can
both minimize total abatement costs, provide
flexibility in the choice of mechanisms used
to meet pollution goals, and achieve the
desired level of pollution emissions.

54
Marketable Pollution Permits
A system of marketable pollution permits
begins with the determination of the target
level of pollution.
The next step is to allocate pollution across
polluters.
This allocation can be based on historic
pollution levels, auctions, a lottery, or some
other allocation scheme.
The buying and selling of pollution permits
will reallocate the emission rights.

55
Marketable Pollution Permits
 Marketable pollution permits equate marginal
abatement costs across polluters.
 Each polluter compares his/her marginal abatement
costs with the price of a permit.
 If the marginal abatement costs are higher than the
price, they have an incentive to buy.
 If the marginal abatement costs are lower, they have
an incentive to sell.
 Buying and selling will continue until the equilibrium
price is reached which equates marginal abatement
costs across all firms.
56
Marketable Pollution Permits and
Geographic Considerations
Geographic location of emissions can have a
profound impact on the damages the
pollution generates for some categories of
pollution.
Central to the importance of location of
emissions is the manner in which the
pollution disperses when it enters the
environment.
Pollution controls must take into
consideration the geographic variation in the
effect of pollution on society.
57
Marketable Pollution Permits and
Geographic Considerations
A pollution control system based on taxes
could take variation into account by charging
higher taxes in areas where emissions are
more damaging.
A marketable pollution permit system must
divide the overall region into subregions.
These subregions can account for
geographic variability in one of two ways:
development of a receptor-based system or
development of separate markets for
subregions.
58
Marketable Pollution Permits and
Geographic Considerations:
Ambient-based Permit System
 A receptor-based or ambient-based system allocates
pollution receptors across the subregion.
 Locations relatively close to, and downwind from,
the polluter may require more permits.
 Dispersion coefficients are used to help define the
terms of trade in this type of marketable pollution
permit market.
 In the following figure, the location of a particular
polluter is denoted by a star and receptors are
designed by letters. This polluter may have to buy
some combination of 15 different types of permits.

59
Marketable Pollution Permits and
Geographic Considerations:
Ambient-based Permit System

60
Marketable Pollution Permits and
Geographic Considerations:
Emissions-based Permit System
 An alternative to the ambient-based system is to
divide the subregions into separate markets.
 Polluters need only purchase permits for the
subregion in which they are located.
 The inability to trade across subregions may mean
that firms with lower abatement costs will not be
able to trade permits with higher abatement cost
firms in another subregion.
 A compromise would be to have one type of permit
and allow trade across all regions, as long as the
trade does not result in ambient quality standards
being violated at any receptor point.

61
Marketable Pollution Permits and
Geographic Considerations:
Emissions-based Permit System

62
Other Types of Economic Incentives
 Deposit-refund systems are a good way of
employing economic incentives when monitoring
costs are high.
 This system is based on requiring a payment up
front for undesirable acts and then building in a
refund when a desirable action occurs.
 The most common example of this is the deposit-
refund system in place for beverage containers.
 This system has also been used for cars and
batteries in other countries.

63
Other Types of Economic Incentives
 Bonding systems are closely related to deposit-
refund systems.
 A bonding system requires a potential degrader of
the environment to place a large sum of money in an
escrow account.
 This money is returned if the environment is
undamaged (or returned to its original condition)
and will be forfeit otherwise.
 Bonds need to be large enough to provide an
incentive to use appropriate safeguards and/or cover
the cost of clean up if damage occurs.

64
Other Types of Economic Incentives
 Liability systems are based on defining legal liability
for the damages caused by certain types of pollution
discharges and facilitating collection of these
damages.
 The Comprehensive Environmental Response,
Compensation and Liability Act of 1980 (CERCLA)
defines legal rights to natural resources for local,
state and federal governments and defines how
damages can be recovered.
 A related system defines legal liability and then
requires potential polluters to obtain full insurance
against any damages. There is a potential moral
hazard problem with this option.
65
Other Types of Economic Incentives
 A system of pollution subsidies would pay each
polluter a fixed amount of money for each unit of
pollution reduced.
 The polluter would reduce pollution to the point
where the subsidy is equal to the marginal cost of
abatement.
 While the outcome is the same as a tax on polluters,
there are distributional effects, problems with
political acceptability and the possibility that
strategic behavior would lead to higher initial levels
of pollution in order to obtain the subsidy. In
addition, the subsidy could potentially attract more
polluters into the industry.
66
Conclusion
 Market failures associated with environmental
externalities generate losses in welfare.
 Command and control policies are the basis of
current policy but do not equate marginal abatement
costs across polluters.
 Economic incentives, such as taxes or marketable
pollution permits do equate marginal abatement
costs.
 While there are some problems with economic
incentives, they do create additional motivation for
technological innovation to reduce pollution.

67