Before 1970, there were no rules governing the amount of sulfur dioxide that coal-burning power plants in the United States could emit. When sulfur dioxide is emitted into the air, it mixes with water and produces sulfuric acid, which falls to earth as acid rain. Acid rain is as acidic as lemon juice and has killed fish in lakes over a wide swath of the northeastern United States, damaged trees and crops, and in time even began to dissolve limestone buildings.

In 1970, Congress adopted the Clean Air Act, which set rules forcing power plants to reduce their emissions. And it worked—the acidity of rainfall declined significantly. Economists, however, argued that a more flexible system of rules that exploits the effectiveness of markets could reduce pollution at a lower cost. In 1990 this theory was put into effect with a modified version of the Clean Air Act. And guess what? The economists were right!

In this section we’ll look at the policies governments use to deal with pollution and at how economic analysis has been used to improve those policies.

The most serious external costs in the modern world are surely those associated with actions that damage the environment—air pollution, water pollution, habitat destruction, and so on. Protection of the environment has become a major role of government in all advanced nations. In the United States, the Environmental Protection Agency is the principal enforcer of environmental policies at the national level, supported by the actions of state and local governments.

How does a country protect its environment? At present the main policy tools are environmental standards, rules that protect the environment by specifying actions by producers and consumers. A familiar example is the law that requires almost all vehicles to have catalytic converters, which reduce the emission of chemicals that can cause smog and lead to health problems. Other rules require communities to treat their sewage or factories to avoid or limit certain kinds of pollution. And as we just saw in the Economics in Action, environmental standards were put in place in 2014, compelling new coal- and gas-fired power plants to adopt cleaner-burning technologies.

Environmental standards came into widespread use in the 1960s and 1970s, and they have had considerable success in reducing pollution. For example, since the United States passed the Clean Air Act in 1970, overall emission of pollutants into the air has fallen by more than a third, even though the population has grown by a third and the size of the economy has more than doubled. Even in Los Angeles, still famous for its smog, the air has improved dramatically: in 1976 ozone levels in the South Coast Air Basin exceeded federal standards on 194 days; in 2013, on only 5 days.

Another way to deal with pollution directly is to charge polluters an emissions tax. Emissions taxes are taxes that depend on the amount of pollution a firm emits. As we learned in Chapter 7, a tax imposed on an activity will reduce the level of that activity. Looking again at Figure 16-2, we can find the amount of tax on emissions that moves the market to the socially optiimal point. At Q_OPT, the socially optimal quantity of pollution, the marginal social benefit and marginal social cost of an additional unit of pollution is equal at $200. But in the absence of government intervention, polluters will push pollution up to the quantity Q_MKI, at which marginal social benefit is zero.

It’s now easy to see how an emissions tax can solve the problem. If polluters are required to pay a tax of $200 per unit of pollution, they now face a marginal cost of $200 per unit and have an incentive to reduce their emissions to Q_OPT, the socially optimal quantity. This illustrates a general result: an emissions tax equal to the marginal social cost at the socially optimal quantity of pollution induces polluters to internalize the externality—to take into account the true cost to society of their actions.

The term emissions tax may convey the misleading impression that taxes are a solution to only one kind of external cost, pollution. In fact, taxes can be used to discourage any activity that generates negative externalities, such as driving (which inflicts environmental damage greater than the cost of producing gasoline) or smoking (which inflicts health costs on society far greater than the cost of making a cigarette). In general, taxes designed to reduce external costs are known as Pigouvian taxes, after the economist A. C. Pigou, who emphasized their usefulness in his classic 1920 book, The Economics of Welfare. In our example, the optimal Pigouvian tax is $200. As you can see from Figure 16-2, this corresponds to the marginal social cost of pollution at the optimal output quantity Q_OPT.

Are there any problems with emissions taxes? The main concern is that in practice government officials usually aren’t sure how high the tax should be set. If they set it too low, there won’t be sufficient reduction in pollution; if they set it too high, emissions will be reduced by more than is efficient. This uncertainty around the optimal level of the emissions tax can’t be eliminated, but the nature of the risks can be changed by using an alternative policy, issuing tradable emissions permits.

Tradable emissions permits are licenses to emit limited quantities of pollutants that can be bought and sold by polluters. Tradable emissions permits work in practice much like the tradable quotas discussed in a Chapter 5 Economics in Action in which regulators created a system of tradable licenses to fish for crabs. The tradable licenses resulted in an efficient way to allocate the right to fish as boat-owners with the safest and lowest cost of operation purchase the rights of owners with less safe, higher cost boats. Although tradable emissions permits involve trading a “bad” like pollution instead of a “good” like crab, both systems work to allocate an activity efficiently because the permits, like licenses, are tradable.

Here’s why this system works in the case of pollution. Firms that pollute typically have different costs of reducing pollution—for example, it will be more costly for plants using older technology to reduce pollution than plants using newer technology. Regulators begin the system by issuing polluters with permits to pollute based on some formula—say, for example, equal to 50% of a given firm’s historical level of emissions. Firms then have the right to trade permits among themselves. Under this system, a market in permits to pollute will emerge. Polluters who place a higher value on the right to pollute—those with older technology—will purchase permits from polluters who place a lower value on the right to pollute—those with newer technology. As a result, a polluter with a higher value for a unit of emissions will pollute more than a polluter with a lower value.

In the end, those with the lowest cost of reducing pollution will reduce their pollution the most, while those with the highest cost of reducing pollution will reduce their pollution the least. The total effect is to allocate pollution reduction efficiently—that is, in the least costly way.

Just like emissions taxes, tradable emissions permits provide polluters with an incentive to take the marginal social cost of pollution into account. To see why, suppose that the market price of a permit to emit one unit of pollution is $200. Every polluter now has an incentive to limit its emissions to the point where its marginal benefit of one unit of pollution is $200. Why?

If the marginal benefit of one more unit of pollution is greater than $200 then it is cheaper to pollute more than to pollute less. In that case the polluter will buy a permit and emit another unit. And if the marginal benefit of one more unit of pollution is less than $200, then it is cheaper to reduce pollution than to pollute more. In that scenario the polluter will reduce pollution rather than buy the $200 permit.

From this example we can see how an emissions permit leads to the same outcome as an emissions tax when they are the same amount: a polluter who pays $200 for the right to emit one unit faces the same incentives as a polluter who faces an emissions tax of $200 per unit. And it’s equally true for polluters that have received more permits from regulators than they plan to use: by not emitting one unit of pollution, a polluter frees up a permit that it can sell for $200. In other words, the opportunity cost of a unit of pollution to this firm is $200, regardless of whether it is used.

Recall that when using emissions taxes to arrive at the optimal level of pollution, the problem arises of finding the right amount of the tax: if the tax is too low, too much pollution is emitted; if the tax is too high, too little pollution is emitted (in other words, too many resources are spent reducing pollution). A similar problem with tradable emissions permits is getting the quantity of permits right, which is much like the flip-side of getting the level of the tax right.

Because it is difficult to determine the optimal quantity of pollution, regulators can find themselves either issuing too many permits, so that there is insufficient pollution reduction, or issuing too few, so that there is too much pollution reduction.

In the case of sulfur dioxide pollution, the U.S. government first relied on environmental standards, but then turned to a system of tradable emissions permits. Currently the largest emissions permit trading system is the European Union system for controlling emissions of carbon dioxide.

Figure 16-3 shows a hypothetical industry consisting of only two plants, plant A and plant B. We’ll assume that plant A uses newer technology, giving it a lower cost of pollution reduction, while plant B uses older technology and has a higher cost of pollution reduction. Reflecting this difference, plant A’s marginal benefit of pollution curve, MB_A, lies below plant B’s marginal benefit of pollution curve, MB_B. Because it is more costly for plant B to reduce its pollution at any output quantity, an additional unit of pollution is worth more to plant B than to plant A.

In the absence of government action, we know that polluters will pollute until the marginal social benefit of a unit of pollution is equal to zero. As a result, without government intervention each plant will pollute until its own marginal benefit of pollution is equal to zero. This corresponds to an emissions quantity of 600 units for each plant—the quantities of pollution at which MB_A and MB_B are equal to zero. So although plant A and plant B have different costs of pollution reduction, they will each choose to emit the same amount of pollution.

Now suppose that regulators decide that the overall pollution from this industry should be cut in half, from 1,200 units to 600 units. Panel (a) of Figure 16-3 shows this might be achieved with an environmental standard that requires each plant to cut its emissions in half, from 600 to 300 units. The standard has the desired effect of reducing overall emissions from 1,200 to 600 units but accomplishes it inefficiently.

As you can see from panel (a), the environmental standard leads plant A to produce at point S_A, where its marginal benefit of pollution is $150, but plant B produces at point S_B, where its marginal benefit of pollution is twice as high, $300.

This difference in marginal benefits between the two plants tells us that the same quantity of pollution can be achieved at lower total cost by allowing plant B to pollute more than 300 units but inducing plant A to pollute less. In fact, the efficient way to reduce pollution is to ensure that at the industry-wide outcome, the marginal benefit of pollution is the same for all plants. When each plant values a unit of pollution equally, there is no way to rearrange pollution reduction among the various plants that achieves the optimal quantity of pollution at a lower total cost.

We can see from panel (b) how an emissions tax achieves exactly that result. Suppose both plant A and plant B pay an emissions tax of $200 per unit, so that the marginal cost of an additional unit of emissions to each plant is now $200 rather than zero. As a result, plant A produces at T_A and plant B produces at T_B. So plant A reduces its pollution more than it would under an inflexible environmental standard, cutting its emissions from 600 to 200 units; meanwhile, plant B reduces its pollution less, going from 600 to 400 units.

In the end, total pollution—600 units—is the same as under the environmental standard, but total surplus is higher. That’s because the reduction in pollution has been achieved efficiently, allocating most of the reduction to plant A, the plant that can reduce emissions at lower cost. (Remember that producer surplus is the area below the supply curve and above the price line. So there is more total producer surplus in Panel (b) than in Panel (a).)

Panel (b) also illustrates why a system of tradable emissions permits also achieves an efficient allocation of pollution among the two plants. Assume that in the market for permits, the market price of a permit is $200 and each plant has 300 permits to start the system. Plant B, with the higher cost of pollution reduction, will buy 200 permits from Plant A, enough to allow it to emit 400 units. Correspondingly, Plant A, with the lower cost, will sell 200 of its permits to Plant B and emit only 200 units. Provided that the market price of a permit is the same as the optimal emissions tax, the two systems arrive at the same outcome.