Economics of Pollution - Outside View by Nitin Gregory

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Economics of Pollution
Dec 21, 2015

'Freedom in a commons brings ruin to all' - Garrett Hardin, The Tragedy of the Commons

Environmental issues have been the focus of recent news and public debate. The Climate deal in Paris, the 'odd-even' formula of Delhi, and the Chennai floods have sharpened the focus on pollution and its consequences.

The discussions on global warming and pollution are not new; many groups have been fighting this cause. However, today we are feeling the effects of the smog we inhale and the inconvenience of unpredictable weather patterns. Recent events seem to have struck a collective nerve.

What lead to this situation? The answer seems obvious - the needs of men have resulted in emissions of waste into the environment. But even your daily habits of cooking, cleaning, etc... generate a lot of waste. Why does it not end up in your yard, smelling and creating an unsanitary situation?

We are careful about the treatment and disposal of waste in our immediate neighbourhood (private property). The air, oceans, and rivers are referred to as commons, and the incentive to maintain common property is very low. The effect has been termed as the 'tragedy of the Commons' by famous ecologist Garett Hardin.

Common property is like a common grazing ground (free to the public). A goat herd has no individual cost to add a goat (the additional goat can graze for free on this common area). All the benefits associated will accrue to the herd. It is a no-brainer for the herd to maximize the number of goats he owns. However once the ground has reached its capacity, further addition will result in "over grazing" and depletion of the common resource. At this stage, for each individual goat-herd the cost of adding another goat is very low (spread across all the goat-herds) but the benefits of the additional goat will accrue to him. Inevitably the herd continues to increase the number of goats because the individual cost-benefit analysis is in his favour (low cost of depletion spread across versus high benefit of additional goat).This leads to over-grazing and eventually destroying the grazing ground. The outcome would be vastly different if each herd was given ownership to a small patch of the grazing ground.

A related view in Austrian economics is that pollution is the result of inter-personal conflict over the use of resources. An entrepreneur who has built a factory discharging pollutants into the air is in conflict with an upcoming residential colony downwind. The factory owner and construction company have plans for the 'air' as a resource. For the factory owner, it is just a medium for waste disposal, but for the construction company it is a crucial component that can impact the price of their residential villas.

In an ideal scenario where property rights are assigned to 'air', it would result in a discussion between the two parties and a mutually acceptable compensation will be arrived at. But the reality is there are no clear demarcations or property rights regarding this resource, resulting in a conflict in their plans and no apparent 'market fix'.

This begs the question: Can we assign property rights? It is a sticky problem. It is difficult to provide clear property rights on 'air'. In case of a legal dispute, it can be very difficult to prove that the cause of the pollution was a particular source and not one of the many adjacent polluters.

Given these hurdles towards an ideal state of perfect property rights, we are seeing a more practical compromise to this problem. The two common (and arguably most effective) approaches to deal with this problem are:

  1. Emissions trading: Here there is a cap on emission, and the rights to pollute/generate emissions are allocated to all sources. For example the government will allocate "emission rights" (ER) to each industry (based on considerations like overall target for emissions, criticality of industry etc.). Each ER represents a level of permissible emissions. At the end of the year, the industry has to prove that the level of emissions is supported by an equivalent number of ER's. These rights can be bought and sold. This incentivises clean manufacturing methods. A factory with old methods of production will have to spend money buying additional emission rights to stay legal. The price of his product will ultimately reflect these expenses and make him less competitive. This is the cost of polluting air. Emissions trading creates market forces (price mechanism) that steer manufacturers and consumers towards greener choices. Emissions trading today is in effect in the European Union and for select pollutants in the USA.
  2. Pollution Tax: This is a straightforward tax based on the pollution level. The tax is intended to compensate for the social cost of pollution. There are some obvious difficulties in calculating the social cost. In the case of vehicles, a pollution tax properly enforced can help drive cost-conscious consumers towards public transport, car-pooling, and more fuel-efficient vehicles. The most recent example is the Supreme Court directive to levy a pollution tax on commercial vehicles in Delhi. This tax, however, should be linked to pollution the vehicle generates as opposed to a blanket tax on all commercial vehicles. This will create a business case for more efficient and cleaner commercial vehicles on our roads.

Both prevailing methods are an attempt to nudge the consumer choice towards a better outcome. Adam Smith's invisible hand of the market can help by letting consumers make their own choices. Most 'command and control' interventions create further distortions in the economy and also carry the additional burden of governing these new maverick regulations.

This column is authored by Nitin Gregory. Nitin, who graduated from IIM-Calcutta, is currently pursuing a finance role with an automotive major. He has a deep interest in Macroeconomics and pens a blog at Gregonomics.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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