Before 1970, there were no rules governing the amount of sulphur dioxide power plants in North America could emit—which is why acid rain got to be such a problem. After 1970, the U.S. Clean Air Act set rules about American sulphur dioxide emissions—and the acidity of rainfall declined significantly. In 1985, Canada passed the Canadian Acid Rain Control Program that set targets to reduce sulphur dioxide emissions in eastern Canada by 50% by 1994. Economists argued, however, that a more flexible system of rules that exploited the effectiveness of markets could achieve lower pollution at less cost. This theory was put into effect with a modified version of the U.S. Clean Air Act in 1990 and the 1991 Canada–U.S. Air Quality Agreement. 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 economically advanced nations. Environment Canada is the principal enforcer of environmental policies at the national level, supported by the actions of provincial, territorial, 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 so on.

Environmental standards came into widespread use in the 1960s and 1970s, and they have had considerable success in reducing pollution. For example, since the U.S. Clean Air Act in 1970, overall emission of pollutants into the air has fallen by more than a third, even though the U.S. population has grown by a third and the size of its economy has more than doubled. Even in Los Angeles, still famous for its smog, the air has improved dramatically: ozone levels in the South Coast Air Basin exceeded U.S. federal standards on 194 days in 1976; in 2010, on only 7 days. Air pollution levels in Hamilton, Ontario, another city with a long history of smog, have also been trending downward since the mid-1990s.

Despite these successes, economists believe that when regulators can control a polluter’s emissions directly, there are more efficient ways than environmental standards to deal with pollution. By using methods grounded in economic analysis, society can achieve a cleaner environment at lower cost. Most current environmental standards are inflexible and don’t allow reductions in pollution to be achieved at minimum cost. For example, two power plants—plant A and plant B—might be ordered to reduce pollution by the same percentage, even if their costs of achieving that objective are very different.

How does economic theory suggest that pollution should be directly controlled? There are actually two approaches: taxes and tradable permits. As we’ll see, either approach can achieve the efficient outcome at the minimum feasible cost.

One 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 produces. For example, power plants might be charged $200 for every tonne of sulphur dioxide they emit.

Look again at Figure 16-2, which shows that the socially optimal quantity of pollution is Q_OPT. At that quantity of pollution, the marginal social benefit and marginal social cost of an additional tonne of emissions are equal at $200. But in the absence of government intervention, power companies have no incentive to limit pollution to the socially optimal quantity, Q_OPT; instead, they will push pollution up to the quantity Q_MKT, at which marginal social benefit is zero.

It’s now easy to see how an emissions tax can solve the problem. If power companies are required to pay a tax of $200 per tonne of emissions, they now face a marginal cost of $200 per tonne and have an incentive to reduce 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 costs to society of their actions.

Why is an emissions tax an efficient way (that is, a cost-minimizing way) to reduce pollution but environmental standards generally are not? Because an emissions tax ensures that the marginal benefit of pollution is equal for all sources of pollution, but an environmental standard does not. Figure 16-4 shows a hypothetical industry consisting of only two plants, plant A and plant B. We’ll assume that plant A uses newer technology than plant B and so has a lower cost of reducing pollution. Reflecting this difference in costs, 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 tonne 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 an additional unit of emissions is equal to zero. Recall that the marginal social benefit of pollution is the cost savings, at the margin, to polluters of an additional unit of pollution. 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 tonnes each for plants A and B—the quantity of pollution at which MB_A and MB_B are each equal to zero. So although plant A and plant B value a tonne of emissions differently, without government action they will each choose to emit the same amount of pollution.

Now suppose that the government decides that overall pollution from this industry should be cut in half, from 1200 tonnes to 600 tonnes. Panel (a) of Figure 16-4 shows how this might be achieved with an environmental standard that requires each plant to cut its emissions in half, from 600 to 300 tonnes. The standard has the desired effect of reducing overall emissions from 1200 to 600 tonnes but accomplishes it in an inefficient way. 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 is now producing 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 tonnes 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 socially 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 tonne, so that the marginal cost of an additional tonne 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 tonnes; meanwhile, plant B reduces its pollution less, going from 600 to 400 tonnes. In the end, total pollution—600 tonnes—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.

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 during rush hour or operating a noisy bar in a residential area. 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 socially 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 the tax too low, there will be too little improvement in the environment; if they set it too high, emissions will be reduced by more than is efficient. This uncertainty cannot be eliminated, but the nature of the risks can be changed by using an alternative strategy, issuing tradable emissions permits.

Rather than levy a tax directly on pollution, it is possible to impose the tax on the production of the good whose production or consumption results in the creation of the pollution. Figure 16-5 below revisits the competitive market for electricity with an optimal Pigouvian tax.

Suppose an excise tax is imposed on electricity producers. This per-unit tax raises the marginal private cost of suppliers by T, effectively shifting the supply curve up. If the tax is set equal to the size of the marginal external cost of electricity at the socially optimal level of output, then the tax results in the socially optimal point being reached. The socially optimal level of electricity (Q_OPT) will be produced, consumers will be charged the socially optimal price (P_OPT), and firms will receive a price of (P_OPT – T). Of course, as we discussed in Chapter 7, if the per-unit tax is applied to consumers the same result will occur.

After the tax is applied, the consumer surplus is equal to area A, the producer surplus is equal to the sum of areas H and I, while the government tax revenue is the rectangle made up of B, C, D, E, F, and G. Since the total external cost is the area between the MSC and supply curves it equals the sum of the areas D, G, and I. So with the tax, the total economic surplus is equal to the sum of the areas A, B, C, E, F, and H. The calculations in the table in Figure 16-5 show that this outcome is socially efficient. By charging a per-unit tax on electricity equal to the marginal external cost at the socially optimal level, the market fully internalizes the cost generated by the externality, which eliminates the deadweight loss of perfect competition.

Tradable emissions permits are licences to emit limited quantities of pollutants that can be bought and sold by polluters. They are usually issued to polluting firms according to some formula reflecting their history. For example, each power plant might be issued permits equal to 50% of its emissions before the system went into effect. The more important point, however, is that these permits are tradable. Firms with differing costs of reducing pollution can now engage in mutually beneficial transactions: those that find it easier to reduce pollution will sell some of their permits to those that find it more difficult.

In other words, firms will use transactions in permits to reallocate pollution reduction among themselves, so that in the end those with the lowest cost will reduce their pollution the most, and those with the highest cost will reduce their pollution the least. Assume that the government issues 300 licences each to plant A and plant B, where one licence allows the emission of one tonne of pollution. Under a system of tradable emissions permits, plant A will find it profitable to sell 100 of its 300 government-issued licences to plant B. The effect of a tradable permit system is to create a market in rights to pollute.

Just like emissions taxes, tradable 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 tonne of sulphur dioxide is $200. Then every plant has an incentive to limit its emissions of sulphur dioxide to the point where its marginal benefit of emitting another tonne of pollution is $200. This is obvious for plants that buy rights to pollute: if a plant must pay $200 for the right to emit an additional tonne of sulphur dioxide, it faces the same incentives as a plant facing an emissions tax of $200 per tonne.

But it’s equally true for plants that have more permits than they plan to use: by not emitting a tonne of sulphur dioxide, a plant frees up a permit that it can sell for $200, so the opportunity cost of a tonne of emissions to the plant’s owner is $200.

In short, tradable emissions permits have the same cost-minimizing advantage as Pigouvian taxes over environmental standards: either system ensures that those who can reduce pollution most cheaply are the ones who do so. The socially optimal quantity of pollution shown in Figure 16-2 could be efficiently achieved either way: by imposing an emissions tax of $200 per tonne of pollution or by issuing tradable permits to emit Q_OPT tonnes of pollution. If regulators choose to issue Q_OPT permits, where one permit allows the release of one tonne of emissions, then the equilibrium market price of a permit among polluters will indeed be $200. Why? You can see from Figure 16-2 that at Q_OPT, only polluters with a marginal benefit of pollution of $200 or more will buy a permit. And the last polluter who buys—who has a marginal benefit of exactly $200—sets the market price.

It’s important to realize that emissions taxes and tradable permits do more than induce polluting industries to reduce their output. Unlike rigid environmental standards, emissions taxes and tradable permits provide incentives to create and use technology that emits less pollution—new technology that lowers the socially optimal level of pollution. The main effect of the permit system for sulphur dioxide has been to change how electricity is produced rather than to reduce the nation’s electricity output. For example, power companies have shifted to the use of alternative fuels such as low-sulphur coal and natural gas; they have also installed scrubbers that take much of the sulphur dioxide out of a power plant’s emissions.

The main problem with tradable emissions permits is the flip-side of the problem with emissions taxes: because it is difficult to determine the optimal quantity of pollution, governments can find themselves either issuing too many permits (that is, they don’t reduce pollution enough) or issuing too few (that is, they reduce pollution too much).

Lacking any significant new federal action, in 2008 British Columbia, Manitoba, Ontario, and Quebec, committed to joining the Western Climate Initiative: a tradable permits market in Canada and the United States that seeks to reduce greenhouse gas emissions and the negative externalities they create. After first relying on environmental standards, the U.S. government has turned to a system of tradable permits to control acid rain. And in 2005 the European Union created the largest emissions-trading scheme, with the purpose of controlling emissions of carbon dioxide. The EU scheme is part of a larger global market for the trading of greenhouse gas permits. The upcoming Economics in Action describes these two systems.

It turns out that a tax on emissions of greenhouse gases, like the carbon tax in British Columbia, can have the exact same outcome as a system of tradable emissions permit. Figure 16-6 below helps to convey this point.

Suppose we have a product whose production results in the emission of greenhouse gases. Panel (a) of Figure 16-6 shows the impact of a tax on greenhouse gas emissions that is levied on the suppliers of this product. Imposing an excise tax, T, per unit shifts the supply curve up to (S + T) and moves the market equilibrium from A to B. In the new equilibrium, the quantity exchanged has declined (from Q_E to Q_T), the price paid by consumers has increased (from P_E to P_C), and the price received by producers will decline (from P_E to P_P, where P_P = P_C – T). The tax revenue is equal to the area shaded in green in Figure 16-6 (Tax revenue = T × Q_T).

Now what if the government decides to impose a system of tradable emissions permits instead? Such a system is described in panel (b) of Figure 16-6: the government creates a volume limit or “cap” on the total quantity of the product that can be supplied. In effect, this makes the supply curve perfectly vertical and shifts it to the left to the new (lower) government imposed upper bound on production. This new supply curve is labelled S₂ in the diagram. In the new equilibrium at B, the quantity exchanged has declined (from Q_E to Q_Cap) and the price paid by consumers has increased (from P_E to P_C). If the government issues permits freely, the firms receiving them capture the shaded area as profit since the price earned by firms (P_C) exceeds their cost of production (P_P). Alternatively, if the government sells the permits, then the green-shaded area is equal to the governments permit revenue and firms earn zero profit.

The lesson is simple. It does not matter whether the government uses an emissions tax or a tradable emissions system; if properly designed both can result in exactly the same outcome for society.