(1) Economy & Environment

Economy and the Environment

EI1

The economy and the environment

Londoners woke on the morning of Friday, 5 December 1952, to find the city blanketed by dense, yellowish, acidic fog smog’ - that reduced visibility to barely a few yards and caught in the back of people’s throats. The weather had been cold for some weeks, and the emissions of sulphurous soot from domestic coal fires, industry, and London’s new diesel buses were trapped close to ground level by a layer of colder air – a temperature inversion that persisted for five days, until the winds changed direction. Much of the life of the city ground to a halt. Buses needed passengers with torches to walk in front of them to guide them home. Motorists followed the tail lights of the car in front, hoping that it was going in the right direction; some reportedly ended up in a stranger’s front drive. Sporting events were cancelled as spectators would be unable to see the action on the pitch; the greyhound racing at White City was abandoned when the dogs could no longer see the mechanical hare they were supposed to chase. On the Saturday, a performance of La Traviata at Sadler’s Wells was called off after the first act because the smog had seeped into the theatre and left the singers and audience coughing and choking.

London had long been known for its thick fogs – ‘pea soupers’ as the locals called them – but this was on a completely different scale, and had devastating consequences. Estimates at the time suggested that 4,000 people died as a result of the smog, though more recent estimates put the figure three times higher. Public outrage at the episode led directly to new legislation. The Clean Air Act of 1956 introduced smokeless zones in various parts of London, requiring householders to convert open coal fires to closed stoves burning smokeless fuels, or gas and electrical heaters, a measure that marked the start of the UK’s modern pollution-control legislation.

Public anger forced a rapid policy response in the United States, too, a few years later, after the publication in 1962 of Silent Spring, by the biologist and naturalist Rachel Carson. In a meticulously researched and persuasively written account, Carson highlighted the drastic ecological effects of the practice of widespread and indiscriminate aerial spraying of DDT to kill mosquitoes. She argued that the poison was entering the wildlife food chain, and had led to a drastic fall in the population of birds and mammals over a wide area.

Moreover, the effects threatened human health too, as residues entered the human food chain. The impact of the book was not simply a result of its observations on the harm to wildlife. Carson warned of the potential hazards that unregulated scientific innovations could pose for the environment, highlighting the misleading claims made by industry about the safety of their profitable new products and the uncritical acceptance of these by the public authorities. The outraged public response to the book led President Kennedy to initiate a Science Advisory Committee investigation of the book’s claims. When this endorsed the book’s message, radical policy action followed. The use of DDT was restricted and eventually banned, the powerful US Environmental Protection Agency was established in 1970, and a raft of tough new environmental legislation was introduced over the subsequent decade.

Both episodes – the 1952 London smog and the furore surrounding Silent Spring – signaled the emergence of widespread public concern about the environment as a major driver of policy action and legislation. The legislative actions that followed both events were by no means the first environmental legislation in either country. In the UK, industrial pollution had been regulated and controlled since the establishment of the Alkali Inspectorate in 1863. In the US, pollution regulation had largely been regarded as a matter for individual states rather than the federal government, but this had already begun to change, and the National Air Pollution Control Administration had been set up in 1955 in response to smog in Los Angeles and other problems. Nevertheless the two episodes were, perhaps, amongst the first signals of public recognition that issues of environmental quality are not simply technical issues of factory safety, but lie at the heart of our consumption and lifestyle, requiring changes in behavior – and sometimes uncomfortable choices – across a wide field of public and private action. Environmental economics provides a way of analyzing these tradeoffs and choices. To policy-makers at the time, no doubt, the intensity of the public pressure for action made the policy decisions rather straightforward. With the benefit of hindsight, too, the actions taken seem a well-justified response to the problem. But both issues provide a useful illustration of the way in which environmental economics can help us to think about environmental policy choices, and shed light on some aspects of the underlying issues which are rather less straightforward.

The initial measures to control the London smog focused on restricting the use of coal for domestic heating. They required tough regulation of heating choices at the level of individual households, but supplemented this with substantial financial assistance to help households convert quickly from open coal fires to cleaner forms of heating. In the longer run, however, maintaining a clean atmosphere in London and other major cities has required a much broader portfolio of measures including emission regulations for motor vehicles, power stations, and industrial facilities. The costs of this programme of pollution abatement measures have been substantial, but set against the deaths, human distress, and massive disruption caused by smog in the 1950s the abatement costs seem well justified.

London’s atmosphere is now substantially cleaner than in 1952; levels of particulate pollution are now less than one-hundredth of the level in the early 1950s. Nevertheless, despite all the abatement expenditure, it has not been possible to entirely eliminate periods of poor air quality. In December 1991, another temperature inversion led to a freezing smog, containing a peak in concentration of pollutants from road transport well above safe levels, and, again, the death rate rose, albeit not as drastically as in 1952.

What would have to be done in order to eliminate completely the risk of any repetition of such pollution episodes? Clearly, further restrictions on emissions, and more wide-ranging restrictions on road transport and other private behavior would be needed. How far should we go, in order to reduce the risk of any further period of high pollution? Would the costs involved be justified in terms of the benefits from eliminating the remaining risk? Questions of this sort lie at the heart of environmental economics, which provides a toolkit for structured thinking about this tradeoff, and for drawing a balance between the costs and benefits of further policy action.

Similarly, the policy response to Silent Spring prompts a question of how far to go in curbing the risks of environmental harm from the use of agricultural chemicals. The costs of reducing the damage caused by DDT are the costs of alternative forms of pest control, and, to the extent that the alternatives might be less effective, the loss of agricultural production and farm incomes. How far should we be willing to incur these abatement costs in order to achieve the benefits from eliminating the ecological harm to wildlife and the risks to human health? And at what point do we stop, and say that further costs are not justified in terms of reducing the remaining risks and harm?

Much environmental policy consists of legislation to prohibit environmentally damaging behavior (such as a ban on using DDT), or to compel actions which will improve the environment (such as replacing open grates with cleaner domestic stoves and heaters). Economists have argued that direct and inflexible regulation of this sort can be unduly costly, and that the same environmental improvement could be achieved at lower cost using more flexible, market-based forms of regulation.

 What is the economic case for action to limit global climate change? How can we assess the benefits of action, not just to ourselves, but also to future generations? What scale of action is then warranted, and how rapidly? Finally, what form should this action take? In particular, how far is there a role for pricing instruments such as carbon taxes and emissions trading in steering individual behavior towards lower-carbon choices?

Why an unregulated market economy damages the environment

Environmental economics is embedded in the framework of ideas and methods developed by economists more generally. To understand the arguments of environmental economics, we need to begin by briefly sketching in some of the general economic background to the particular approaches taken in environmental economics.

Markets do many things well. They also do some things badly – in some cases disastrously. Economists refer to these cases as ‘market failure’, and a lot of the economic justification for public policy action has to do with repairing the underlying causes of market failure, or mopping up the consequences. Nevertheless, to understand what economists mean by ‘market failure’ we first need to appreciate market success: what it is that markets do well when they function properly.

In principle, markets provide us with an extraordinarily efficient mechanism for allocating society’s limited productive capacity – its stock of productive resources, including labour, capital, technology, and natural resources – to their most highly valued uses. Among the things that markets do well are that, by and large, they supply goods and services that consumers want. Firms that do not, go to the wall, while those that accurately identify consumer needs and desires and meet them will be more likely to make profits and thrive.

Competitive markets also allocate productive resources – labor and capital – to activities where they will be most productive. In doing this, prices coordinate economic activity in two crucial ways: they communicate information about scarcity, and they incentivize behavior that tends to make the most productive use of the available resources. Where something is in short supply, its price will tend to be bid up. The high price communicates this scarcity throughout the economic system, without the need for detailed information about the underlying origins or reasons for the scarce supply. The high price, too, is an incentive for a range of responses which will tend to reduce the scarcity: it will make additional supply profitable, it will choke off some demand, and it encourages innovation that may in due course create alternatives or reduce demand.

But markets do not always deliver such benign outcomes, and tracing the various forms of market failure is crucial to effective management and regulation of the economic system. Market failure does not, however, simply mean that the market economy leads to outcomes that disappoint us. Rather, it means that there are systematic impediments to the normal functioning of the market system, which have the effect that in some cases markets may not exist at all, and in other cases prices provide incentives that fail to promote the common good.

One way in which market failure can arise is when a market participant has monopoly power – as the only supplier, or one of a very limited number of suppliers of a particular good. A monopolist does not sell as many goods as can be profitably produced, but instead restricts supply, creating artificial scarcity which pushes prices up, in order to profit through higher prices rather than maximum sales. Some consumer needs remain unmet, even though they could be met at a price which covers the costs of supply.

Market failure can also arise where buyers and sellers in a market have different knowledge about the characteristics of the good or service being sold. In some conditions, this can make it impossible for anyone to trade profitably, or for honest or high-quality producers to remain in the market. Market failure also arises in the supply of goods known as ‘public goods’, a technical term meaning goods which everyone benefits from as soon as one person has bought them. Public street lighting would be an example; we cannot selectively make the streets dark for those who have not paid for the lighting. In this situation, there is a danger that no-one is willing to pay, and that all hope to free-ride on their provision by others.

The economist’s normal presumption that a market economy leads to socially desirable outcomes is also overturned by the presence of ‘externalities’, the category of market failure most directly relevant to environmental policy. An externality is a situation where the actions of some firm or individual have consequences for someone else who has no say in the matter. Pollution is a negative externality, where person A’s actions cause harm to the interests of person B. City motorists cause noise and air pollution, damaging the quality of life and possibly the health of people who live near urban roads, but an unregulated market economy does not require motorists’ travel decisions to take this into account, and offers no route for the people harmed to choose the cleaner air that they want. A factory discharging toxic effluent into a lake may harm the livelihood of a fish-farmer, but the damage to the fish-farmer’s profits do not enter into the calculation of the polluting factory’s profits and its business decisions? Both are examples of negative pollution externalities, one affecting living standards, the other affecting a production activity.

Positive externalities can also arise; the classic case is the beekeeper whose hives of bees pollinate the fruit trees in a neighboring orchard. In both cases, positive and negative, externalities are a source of ‘market failure’, in the sense that the natural operation of an unregulated market economy will not tend towards the efficient level of the externality.

Without regulation, a market economy will have too few beekeepers, and it will have too much pollution.

To non-economist readers, it may seem like stating the obvious to observe that polluting firms harm people unless action is taken to stop them. But the key point about the notion of an externality as a market failure is that it pinpoints the source of the problem and at the same time suggests possible remedies.

One thing should be clear: without some form of public intervention to regulate the level of pollution, we are unlikely to achieve the socially optimal level of pollution control. The reason for this is straightforward. The costs and benefits of pollution control accrue to different people. Installing pollution filters to reduce polluting emissions from industry would add to firms’ costs (and reduce their profits), while the benefits would accrue to those harmed by pollution damage – local residents perhaps. Unless there happens to be sufficient fortuitous benefit to polluting firms from reducing their pollution (in terms of good community relations, PR, or reputation), those bearing the costs of cutting pollution will not perceive corresponding benefits – and are therefore unlikely to be willing to pay for pollution control unless they are pushed into doing this by a government regulator. 

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