environmental economics and man - scott j. callan chapter 4

C H A P T E R

4Conventional Solutions to EnvironmentalProblems: The Command-and-Control Approach

“That government is best which governs the least, because its people discipline

themselves.”

—Thomas Jefferson (1743–1826)

In Chapter 3, the public goods model and the theory of externalities were used toillustrate how pollution is the result of market failures—failures that arise becauseof the absence of property rights. Because no one owns the atmosphere or the

earth’s rivers and streams, there is no market incentive to prevent or correct contamina-tion of these resources. According to the Coase Theorem, assigning property rightswould solve the dilemma, but only under certain limiting conditions. The bottom lineis that government must act as a third-party mediator in those markets where pollutionproblems arise.

Recognizing the need for government to correct environmental market failures is animportant observation gained through economic modeling, but it is only a first step. Wecan also use these models to determine how government should respond to achieveeffective policy solutions. For example, economic theory maintains that governmentshould set objectives to achieve allocative efficiency, balancing social benefits and costsat the margin. However, government is generally not motivated by efficiency, and evenwhen it is, it is unlikely that these benefits and costs can be clearly identified. Nonethe-less, the efficiency criterion is useful in assessing whatever policy objectives are set rela-tive to their optimal level. Also, the criterion of cost-effectiveness can be used toevaluate how these objectives are being implemented, even an objective set at somethingother than its efficient level.

In this chapter, our goal is to analyze government’s use of conventional policy solu-tions to respond to environmental market failure. We begin by providing an overview ofenvironmental standards and their role in policy development. We use allocative effi-ciency to assess the level at which standards are set to define environmental objectives.Next, we provide an overview of the two broadly defined approaches to implementingthese standards-based objectives: the command-and-control approach and the market

approach. Finally, we investigate the cost-effectiveness of the command-and-control

80

Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

approach, the more conventional of the two, deferring an analysis of the marketapproach to Chapter 5.

USING STANDARDS IN ENVIRONMENTAL POLICY

Standards form the fundamental basis of most environmental policies. In the UnitedStates, setting standards follows a lengthy set of procedures involving scientific researchand a series of formal reviews. The Environmental Protection Agency (EPA) is chargedwith oversight of these tasks and for making a formal recommendation about how thesestandards are to be defined. Ultimately, the standards are legislated by Congress and subse-quently monitored for compliance and enforced by the EPA. Information on environmen-tal regulations and rulings is available online at www.epa.gov/lawsregs/index.html.

Types of Environmental StandardsWhen environmental standards are defined in the law, they can be specified as ambient

standards, technology-based standards, or performance-based standards. Ambient

standards designate the desired quality level of some element of the environment, suchas the outdoor air or a body of water. These typically are expressed as a maximumallowable concentration of some pollutant in the ambient environment. For example,the United States and most major industrialized countries use ambient standards todefine air quality and water quality. In each case, the ambient standard is not directlyenforceable but serves as a target to be achieved through a pollution limit, which inturn is implemented through one of the other types of standards.

As its name implies, a technology-based standard stipulates the type of abate-ment control that must be used by all regulated polluting sources. In the United States,the EPA is responsible for researching available technologies and evaluating their rela-tive effectiveness in accordance with certain criteria outlined in the law. It then selectsthe “best” technology, which subsequently must be adopted by all regulated polluters.1

The motivation is straightforward—to ensure a specific limit on pollution releases bycontrolling how that limit is to be achieved. For example, to reduce sulfur dioxideemissions, the EPA might require all coal-burning power plants to use a scrubbersystem, forcing each one to achieve the same level of abatement in precisely thesame way.

An alternative type of environmental standard is performance-based. A performance-

based standard specifies an emissions limit to be achieved by every regulated polluterbut does not stipulate the technology to be used to achieve that limit. By definition,performance-based standards are more flexible than their technology-based counterparts.They implicitly allow polluting sources to choose how they will reduce pollution releases,as long as they meet the statutory emissions limit.

ambient standardA standard thatdesignates the qualityof the environment tobe achieved, typicallyexpressed as amaximum allowablepollutantconcentration.

1The meaning of “best” in this context is one that is often the subject of debate, an issue we will inves-tigate in upcoming chapters.

technology-basedstandardA standard thatdesignates theequipment or methodto be used to achievesome abatementlevel.

performance-basedstandardA standard thatspecifies a pollutionlimit to be achievedbut does not stipulatethe technology.

CHAPTER 4 Conventional Solutions to Environmental Problems: The Command-and-Control Approach 81


Economic Implications of Using StandardsAlthough the use of standards sounds straightforward enough, there are important eco-nomic implications to be considered. We can investigate these through a two-part eco-nomic evaluation that centers on the following questions:

● Are the standards being used to define environmental objectives set at a level that isallocatively efficient? That is, does the marginal social cost of pollution abatementequal the marginal social benefit?

● Given some predetermined environmental objective, is the implementation of thatobjective conducted in a cost-effective manner?

ARE ENVIRONMENTAL STANDARDS ALLOCATIVELY EFFICIENT?

Because environmental objectives are defined by standards, it is important to determinewhether they are allocatively efficient standards. This criterion is met if economicresources are allocated such that the associated benefits and costs to society are equalat the margin. Therefore, we need to develop these benefit and cost concepts specificallyfor the pollution abatement market, expanding on what we presented in Chapter 3. Thegoal is to learn precisely what is required to identify an allocatively efficient abatementlevel so that we can assess the likelihood of government achieving such an outcomeusing a standards-based environmental objective.

Marginal Social Benefit of AbatementAs pollution is abated, the social gains are all the benefits associated with a cleanerenvironment, such as improvements in health, ecosystems, aesthetics, and property. Ifwe measure how these benefits increase relative to increases in abatement, we arrive atthe marginal social benefit (MSB ) of abatement. It is equally correct to think of thisMSB as a measure of the reduction in damages or costs caused by pollution.2 In theory,if we were to add up all the marginal reductions in environmental external costs acrossevery market where pollution is reduced, we would arrive at the MSB. We have actuallymodeled damage reduction, although in a limited context, in our discussion of bargain-ing in Chapter 3. By paying refineries to pollute less, recreational users of the rivergained the reduction in the marginal external cost (MEC ) associated with refined petro-leum production. A real-world case in which damages were shown to be directly attrib-utable to industrial pollution is in the town of Catano, Puerto Rico, the subject ofApplication 4.1.

From a market perspective, the MSB of abatement is society’s demand for pollutionabatement, or, equivalently, its demand for environmental quality.3 Just as the

allocativelyefficient standardsStandards set suchthat the associatedmarginal social cost(MSC ) of abatementequals the marginalsocial benefit (MSB )of abatement.

2Technically, the MSB also includes the reduction in social costs from attempting to avoid the effectsof pollution, such as the costs of air purification systems, bottled water, or water filtration systems.

marginal socialbenefit (MSB ) ofabatementA measure of theadditional gainsaccruing to society aspollution abatementincreases.

3Although we generally model demand as the MPB, which differs from the MSB by the amount of anymarginal external benefit (MEB), in this context, there is no MEB, because the demanders are all ofsociety. Thus, there are no third parties to which any external benefits could accrue.

82 MODULE 2 Modeling Solutions to Environmental Problems


recreational users were willing to pay the refineries for a cleaner river, society is willingto pay for a cleaner environment. We expect this willingness to pay to decline withincreasing levels of abatement, just as the Law of Demand predicts. Therefore, the MSBis negatively sloped.

Marginal Social Cost of AbatementOn the supply side, we need to model the costs to society as polluters reduce theirreleases of contaminating residuals. This relationship is called the marginal social cost

(MSC ) of abatement. To gain a better sense of what the MSC represents, it’s easier tothink of it as comprising two parts: an aggregation of the marginal costs of every pollu-ter’s abatement activities, and the marginal costs government incurs to monitor andenforce those activities.

Let’s begin with the first part by considering a representative polluter and how itgoes about the task of abating pollution.

APPLICATION 4.1 Catano, Puerto Rico: Reducing the Damages ofIndustrial Pollution

For years, the people of Catano, Puerto Rico, blamed theirpersistent health problems on the town’s severe airpollution. The residents had been living with a barrage ofemissions released by a nearby oil refinery, a sewagesludge incinerator, ships in San Juan Bay, and a parade of18-wheelers transporting goods from nearby docks.According to the island dwellers, however, most of theproblem has been caused by two giant power plantsoperated by the Puerto Rico Electric Power Authority(PREPA). Together, the two facilities release an averageof 100 million pounds of sulfur dioxide emissions intoCatano’s atmosphere each year. One of the town’sresidents leading the charge against the utility says thatCatano’s air can be likened to a “toxic soup.”

Acting on the residents’ complaints, several agenciesconducted health studies. Findings by a Puerto RicoMedical Association study showed that cancer rates inCatano were nearly twice the national average. Furtherdisturbing evidence came from a U.S. Public HealthService investigation, which found an alarming rate ofrespiratory disease among the people of Catano.Because it is well known that long-term exposure tosulfur dioxide causes respiratory ailments, this reportvalidated the suspicion that the utility’s emissions werethe primary cause of health damages in the town.

Responding to these disturbing medical reports, theEPA began its own study of the area, focusing on the

power plants. What they found confirmed theaccusations of Catano’s residents. Pollutant releasesfrom the plants were in violation of air quality regulations.In an effort to bring the power authority into compliance,the United States filed suit against PREPA in 1993, citingnumerous violations. In 1999, the legal action was settled,and a consent decree was entered, which was disputed inpart by PREPA. Following a protracted period ofnegotiations, a final agreement was reached in 2004. Aspart of the judicial settlement, PREPA is required to uselow-sulfur fuel to reduce sulfur dioxide emissions. Thismandated change in fuel, together with fines and othercorrective measures, was aimed at bringing PREPA’splants into EPA compliance. More on the agreement isavailable online at www.justice.gov/opa/pr/2004/June/

04_enrd_433.htm.As an interesting side note, PREPA also was fined

$7 million in punitive damages for its violations. Originally,these funds were to be paid directly to the federalgovernment. However, at the urging of a localenvironmental group and its leading activist, Rosa HildaRamos, the EPA agreed to use $3.4 million of the$7 million fine to purchase and protect a significant areaof marshland that borders the San Juan Bay Estuary.Taken together, these decisions should provide theresidents of Catano with cleaner air to breathe andprotection of an important water body for years to come.

Sources: The Goldman Environmental Prize (2008); U.S. Department of Justice (June 23, 2004); Ross (January 7, 1993).

marginal socialcost (MSC ) ofabatementThe sum of allpolluters’ marginalabatement costs plusgovernment’smarginal cost ofmonitoring andenforcing theseactivities.



Firm-Level Marginal Abatement CostReferring again to our discussion of bargaining under the Coase Theorem, recall thatrefineries reduced their toxic releases by decreasing output. In that case, the marginalcost to refineries of abating pollution was forgone profit, modeled as a movement fromright to left along the marginal profit (Mπ) curve. Therefore, if the decision variable isoutput, each polluting firm faces a marginal abatement cost equal to its forgone Mπ.However, such a model implicitly assumes that polluters can meet an environmentalstandard only by reducing output, a very limiting assumption. Because other methodsare available, we need to expand this output-based specification to something moregeneral.

Remember that as a profit maximizer, the polluting firm is implicitly a cost mini-mizer. To meet an environmental standard, the firm will consider all available abate-ment options and select the least-cost method. While it certainly could reduceproduction to meet the standard, it has other options, such as installing new abatementtechnology or changing a production process. To further understand this issue, readApplication 4.2, which discusses a relatively low-cost abatement technology used toclean up oil spills and hazardous wastes. To allow for the fact that polluters choosefrom a menu of available abatement methods, we model what is conventionally called amarginal abatement cost (MAC ) function. The MAC measures the change in economiccosts associated with increasing pollution abatement (A), using the least-cost method.

Each polluting source likely faces a unique MAC curve. Among the factors thataffect the shape and position of the MAC curve are the firm’s location, the type of con-taminants it releases, the nature of its production, and the availability of technology.However, a typical MAC curve is positively sloped and increases at an increasing rate,as shown in Figure 4.1 (page 86). Think about what this means. When pollution levelsare high, the addition of virtually any type of abatement technology will likely be quiteeffective. So, although costs are rising, they do so at a fairly slow rate relative to theabatement being accomplished. As this process continues and the environment becomescleaner, however, it becomes difficult to remove more pollution. Thus, the added costsrelative to the abatement achieved increase at a much faster rate.

Should a firm’s abatement options change, the position of its MAC curve would beaffected. For example, the introduction of a cost-saving abatement technology wouldpivot the MAC curve downward, as shown in Figure 4.2 (page 86).4 Likewise, a pollu-ter’s MAC for one pollutant might be lower than that of another. Consequently, anMAC function generally is defined for a particular contaminant at a given level oftechnology.

Market-Level Marginal Abatement CostThe aggregation of all polluters’ MACs represents the market-level marginal abatement

cost (MACmkt ) defined as the horizontal sum of each polluter’s MAC, or MACmkt =

ΣMACi for all i firms. This is exactly the same procedure used to derive market supply

marginalabatement cost(MAC )The change in costsassociated withincreasing abatement,using the least-costmethod.

4A firm’s total abatement costs are represented as the area under the MAC curve up to theabatement level required by the standard, assuming no fixed costs. Thus, the effect of the cost-savingtechnology on total abatement costs is implicitly shown as the reduction in the area under thefirm’s MAC curve.

market-levelmarginalabatement cost(MACmkt)The horizontal sum ofall polluters’ MACfunctions.



in Chapter 2. In this context, the horizontal summing ensures that the MACmkt repre-sents least-cost decisions, because it effectively sets each MAC equal at every abatementlevel.

Marginal Cost of EnforcementNow, consider the second element of the marginal social cost (MSC) of abatement. Tothe MACmkt function we need to add the marginal costs incurred by government forenforcing and monitoring abatement activities. This component is commonly referredto as the marginal cost of enforcement (MCE ). Figure 4.3 (page 87) illustrates howthe MCE is added vertically to the MACmkt to derive the MSC function. (For simplicity,all functions are assumed to be linear.) At any abatement level (A), the MCE is the ver-tical distance between MACmkt and MSC. Notice that this distance is increasing with

APPLICATION 4.2 Costs of Remediating Hazardous Waste and Oil Spills

Environmental damage linked to hazardous waste disposalor accidents is a problem that has captured world attentionin large part because of the contamination caused by majoroil spills. The 1989 Valdez incident, for example, despoiledAlaskan shorelines with 11 million gallons of oil. Morerecently, the 2010 British Petroleum (BP) oil well blowout,which released over 200 million gallons of crude oil into theGulf of Mexico, renewed public awareness of and concernabout such accidents. These disasters are internationalnews both because the environmental implications aresevere and because the abatement costs are sostaggering. Adding to these concerns is the well-publicized problem of deliberate hazardous wastedumping. Many landfill sites have become contaminatedwith cancer-causing substances, ranging frompolychlorinated biphenyls (PCBs) to heavy metals.

Based on a recent report released by the EPA, thereare currently more than 22,000 contaminated sitesneeding attention and over 62,000 known and suspectedsites throughout the United States. Associated abatementcosts are about $6 billion to $8 billion annually. Oil spillabatement expenses are no less disturbing. Exxonincurred over $3 billion to clean up the damage linked tothe Valdez oil spill, not counting fines and legalsettlements. And at the end of 2010, BP publiclyestimated that the costs to clean up the Gulf oil spill,along with such cost as fines and legal fees, would runto $40 billion, an amount disputed by some to be tooconservative. Some analysts argue the costs could becloser to $200 billion. These and other cleanupexpenditures have prompted new and ongoing researchto find lower-cost abatement technologies.

Recently, scientists have made important strides inabating contaminated soil and oil spills using a

technology called bioremediation. Bioremediation is arelatively low-cost technique that relies on microbes toconsume waste materials. In some contexts, fertilizersprays are used to stimulate the feeding of thesemicroorganisms, which accelerates the usually lengthyprocess of returning soil to its original state. Used forsome 50 years to clean wastewater treatment plants, theprocess is now being used to abate toxic contaminants. Inone of its most successful applications to date,bioremediation helped to clean up the oily mess left bythe Valdez on Alaskan beaches. Within three weeks, thesoil was restored down to a foot below the surface.

In 2010, scientists reported similar success in thecleanup of the BP oil spill. Naturally occurring bacteriaand fungi that live in the ocean consume thehydrocarbons present in the released oil. Dispersantsused to break down the oil into smaller droplets shouldaid in the process, although scientists are studyingwhether the toxicity of some dispersants deployed inthat accident may actually have run counter to theirintended effect. Remediation of oil from the deep oceanwaters is totally dependent on these microorganismsdespite the fact that the colder temperature of thosewaters inhibits their growth. At the shoreline, fertilizerscan be added to stimulate microbial activity, as was doneto abate the oil from the Valdez.

Although there is much more to study and learn,many believe that bioremediation holds great promisefor the environment. Such treatment processes providedecision makers with a wider range of alternatives toabate pollution and greater opportunities to findcost-effective solutions. For more information onbioremediation and other remediation technologies, visitwww.epa.gov/superfund/remedytech/remed.htm.

Sources: Biello (2010); U.S. EPA, Office of Solid Waste and Emergency Response (September 2004); Environmental Law Institute(2002); Hof (June 4, 1990).

marginal cost ofenforcement (MCE )Added costs incurredby governmentassociated withmonitoring andenforcing abatementactivities.



FIGURE 4.1 Single Polluter’s Marginal Abatement Cost (MAC )

A typical MAC curve is positively sloped and increases at an increasing rate. Notice that as the firmcontinues to abate from A1 to A2, the MAC increases by a proportionately greater amount fromMAC1 to MAC2. This reflects the fact that as the abatement process continues and the environmentbecomes cleaner, it becomes increasingly difficult and therefore more costly to remove each addi-tional unit of pollution.

MAC($)

MAC2

MAC

MAC1

0 Abatement (A ) A1 A2

FIGURE 4.2 Effect of Cost-Saving Technology on the MAC Curve

Changes in a firm’s abatement options change the position of the MAC curve. For example, thismodel shows how the introduction of cost-saving abatement technology would pivot the MACdownward to MAC 0.

MAC($)

MAC

MAC 9

0 Abatement (A )

©CengageLearning

2013.

©CengageLearning

2013.



higher abatement levels. As pollution standards become more stringent, polluters have agreater tendency to evade the law, which in turn calls for more sophisticated, and thusmore costly, monitoring and enforcement programs. To learn more about enforcementin the United States, visit the EPA’s Office of Enforcement and Compliance Assuranceat www.epa.gov/compliance/index-e.html.

Are Abatement Standards Set Efficiently?From our discussion in Chapter 3, we know that MSB and MSC simultaneously deter-mine the efficient level of abatement (AE), which occurs at the intersection of the twofunctions. Whether or not the government sets environmental standards to achieve thislevel depends on various considerations. Four factors in particular suggest that thisoutcome is highly unlikely: (1) legislative constraints, (2) imperfect information,(3) regional differences, and (4) nonuniformity of pollutants.

Legislative ConstraintsThe reality of a standards-based approach is that it does not necessarily set pollutionlimits to account for the associated benefits and costs. In fact, under U.S. law, manystandards are said to be benefit-based, meaning that they are set to improve society’swell-being with no allowance for balancing the associated costs. For example, under theU.S. Clean Air Act, air quality standards are motivated solely by the expected benefits ofimproved health and welfare. If costs are not accounted for in the standard-setting pro-cess, resources likely will be overallocated to abatement.

FIGURE 4.3 Deriving the Marginal Social Cost (MSC) of Abatement

To derive the MSC, the MCE is vertically added to the MACmkt. At any abatement level A, the MCEis the vertical distance between MACmkt and MSC. Notice that this distance increases with higherabatement levels. As pollution standards become more stringent, polluters have a greater tendencyto evade the law, which calls for more sophisticated, and thus more costly, monitoring and enforce-ment programs.

($) MSC 5 MACmkt 1 MCE

MACmktMCE

0 Abatement (A ) A1

benefit-basedstandardA standard set toimprove society’swell-being with noconsideration for theassociated costs.

©CengageLearning

2013.



Imperfect InformationEven when a cost-benefit balancing is called for by law, the absence of full information wouldlikely prevent the government from identifying the MSB and MSC of abatement. Let’s con-sider the MSB relationship first. Recall from our discussion of market failure in Chapter 3that pollution abatement is a public good. As such, its demand, which is the MSB curve, isnot readily identified because of nonrevelation of preferences. In practice, there are meth-ods to estimate the value society places on damage reductions associated with abatement.However, given the difficulty of trying to monetize such intangibles as health improvementsand longevity of life, the probability of accurately modelingMSB is low.

There are similar problems in identifying the MSC. In addition to estimating theMCE, the government also would have to know the MAC for every polluter. Obtainingthis firm-level information would be virtually impossible, given the diversity of produc-tion and abatement techniques across polluting sources. Furthermore, the MAC mustalso account for the implicit costs of abatement, which are difficult to quantify. In thiscontext, implicit costs would include any unemployment associated with productiondeclines, the potential loss of consumer choice if products were eliminated or altered,and any price and income effects arising from abatement requirements.5

In the absence of perfect information, it is highly probable that the government willunknowingly establish the abatement standard at some level other than the allocativelyefficient one, even if that was the legislated intent. Figure 4.4 illustrates the market for

FIGURE 4.4 Setting an Environmental Quality Standard:

Is It Allocatively Efficient?

If the government set an abatement standard at A0,MSBwould be higher thanMSC, meaning that soci-ety places a higher value on the gain from reducing pollution than the resources needed to achieve it.Hence, the A0 standard would be too lenient. On the other hand, if the standard were set at A1, it wouldbe considered too restrictive. Only at AE would society accept the legal limit as allocatively efficient.

MSC, MSB($)

MSB 5 MSC

MSC

MSB

0 Abatement (A ) A0 A1AE

MSB . MSCMSC . MSB

5In Chapters 7 and 8, we will investigate the methods used in practice to estimate the benefits andcosts of improving environmental quality.

©CengageLearning

2013.



abatement at equilibrium, comparing the allocatively efficient outcome (AE), with twoother possible levels (A0 and A1). If the standard is set at A0, MSB would be greaterthan MSC, meaning that society places a higher value on reducing pollution than itmust give up in resources to achieve it. Hence, the A0 standard would be consideredtoo lenient. Conversely, a standard set at A1 would be too restrictive. Only at AE wouldsociety consider the legal limit to be allocatively efficient. However, the informationneeded to find this optimal level of pollution abatement is immense.

Regional DifferencesEven if the law permits a balancing of costs and benefits and even if full informationwere available, there is a qualifier on the use of AE as a national standard across all pol-luting sources. Why? Because this optimal level is determined from MSB and MSC, bothof which assume the absence of region-specific abatement benefits and costs. The onlyway that AE would be allocatively efficient in all regions is if the respective MSB andMSC functions defined for those locations were identical.

By way of example, consider two hypothetical regions, X and Y, that have identicalMSC functions (i.e., MSCX = MSCY) but different MSB functions, such that MSBX islower than MSBY at all abatement levels. Such a disparity might be due to differences inincome, education, or population across the two locations. In any case, at most, onlyone of the two locations would consider a nationally determined AE as efficient. Lookat Figure 4.5, which superimposes the MSB and MSC for each region on the same dia-gram. The allocatively efficient level of abatement in region X (AX) is much lower thanthat for region Y (AY). So there is no way that a single national standard of abatement—even one that is efficient on a national level—would be optimal for both regions.

FIGURE 4.5 Effect of Regional Differences on Achieving Allocative Efficiency

This model shows how region-specific conditions can give rise to different optimal levels of abate-ment. Although the MSC curves are identical (i.e., MSCX = MSCY), the MSB in region X is lower thanthat in region Y, i.e., MSBX < MSBY. Therefore, the allocatively efficient abatement level for regionX (AX ) is lower than that for region Y (AY ). This means that a national abatement standard cannot beoptimal for both regions.

MSC, MSB($)

MSBY 5 MSCY

MSBX 5 MSCX

MSCX 5 MSCY

MSBY

AYAX

MSBX

0 Abatement (A ) ©CengageLearning

2013.



Nonuniformity of PollutantsAn inefficient outcome can also arise within the same region, if changes in releases frompolluting sources do not have a uniform impact on the environment. This can occur ifthe relationship between the change in pollutant releases and the change in exposure isnonlinear, or not directly proportional. The nonuniformity can also arise when pollutersare located at varying distances from an exposed population or ecosystem, even if theirpollution releases are identical.6 In general, the farther away from a source an affectedpopulation is, the lower the associated damage, because there is greater opportunity fordilution of contaminants.7 This in turn would mean that the MSB of abatement variesinversely with the distance between a source and the affected population or resource.Thus, even with equal MSC of abatement, the efficient level of abatement would not bethe same for all polluting sources. Consequently, just as for regional differences, anationally determined abatement standard would not be optimal for all sources.

What we can surmise from this assessment is that, in most real-world settings, atleast one of the factors—legislative constraints, imperfect information, regional differ-ences, or nonuniformity of pollutants—will be present. Therefore, there is a low proba-bility that abatement standards will be set at an allocatively efficient level. In acceptingthis, we must rely on a different criterion to evaluate not where the standards are setbut how they are implemented.

GENERAL APPROACHES TO IMPLEMENTINGENVIRONMENTAL POLICY

Our preceding analysis makes a strong case that a government-established environmen-tal standard will be set at something other than its allocatively efficient level. Yet, it ispossible that even a nonoptimal environmental standard can be implemented using theleast amount of resources. If so, the policy is said to meet the cost-effectiveness crite-rion. Whether or not this “second-best” criterion is met depends on the method used tobring about the desired reduction in pollution.

Most governments, including that of the United States, use a number of differentpolicy tools to achieve environmental quality. The majority of these fall into two broad-based categories or approaches. One is the command-and-control approach, whichuses pollution limits or technology-based restrictions to directly regulate pollutingsources. The second is the market approach, which uses incentive-based policy tools tomotivate abatement through market forces.

Of the two, command-and-control is the more conventional approach, and itdominates environmental policy in most countries. This nearly universal reliance ondirect regulation seems to have evolved from an attempt to gain immediate controlof what was initially an unfamiliar and urgent dilemma. Although well intentioned,the use of inflexible regulations and pollution limits, often imposed uniformly across

6National Acid Precipitation Assessment Program (NAPAP) (November 1991), Chapter 3, Sec. 3.1.7This relationship can be captured by what is called a transfer coefficient. For details, see Tietenbergand Lewis (2009), pp. 371–79.

cost-effectivenessRequires that theleast amount ofresources be used toachieve an objective.

command-and-controlapproachA policy that directlyregulates pollutersthrough the use ofrules or standards.

market approachAn incentive-basedpolicy that encouragesconservation practicesor pollution-reductionstrategies.



all polluters, has not met with consistent success. By way of example, Application 4.3discusses how EPA proposals for tougher environmental regulations have sparkedconcerns about the implications for job creation and economic recovery in the UnitedStates. This example and numerous others help to explain why, over time, policy-makers began to look for alternatives.

The United States and other industrialized countries have gradually integratedmarket-based solutions into their environmental policy programs. Combiningincentive-oriented policy instruments with more conventional methods seems to be anevolving trend. However, the relative gains of market-based solutions cannot be fullyappreciated without assessing the cost-effectiveness of the command-and-controlapproach.

APPLICATION 4.3 Command-and-Control Under Fire: Will New EnvironmentalRegulations Hurt the Economic Recovery?

Under the Obama administration, the EPA has beenactively promoting tighter environmental regulations andmore stringent emissions limits. Among the EPA’sregulatory proposals are new standards to control carbondioxide and other greenhouse gas emissions; tighterambient air quality standards on ground-level ozone,nitrogen dioxide, and sulfur dioxide; and new controls onindustrial boilers. Because these regulations are based onsetting limits on pollution or establishing rules affectingproduction, they are considered part of a command-

and-control approach to environmental policy.Notwithstanding widespread support for abating

pollution and assuring a clean environment, these rules-based EPA proposals have prompted resistance from anumber of stakeholders, particularly the private businesssector. Why? Because tougher controls on emissions,production, and industrial equipment, holding all elseconstant, add to operating costs and capital investment,which in turn reduces profits. Attention to this reality hasbeen magnified by the slow economic recovery thatfollowed the collapse of the housing and financialsectors. The opposition voiced by constituents from allsegments of the economy is linked in large part toconcerns that tougher environmental rules andregulations may deter job creation and slow the declinein the national unemployment rate.

By way of example, critics predict that the morestringent ozone standards proposed by the EPA will bringhundreds of counties into nonattainment status, which inturn could bring about plant closures and elevated fuel andenergy costs. This negative view has been adopted byUnions for Jobs and the Environment (UJAE), acollaborative of a dozen unions from around the world,

which include such major labor organizations as theTeamsters and the United Mine Workers. Others point tothe economic implications of new controls on greenhousegases, which, according to the U.S. Chamber ofCommerce, are expected to give rise to stifferregulations on more than 250,000 office buildings,150,000 warehouses, and tens of thousands of otherfacilities around the country.

Following the mid-term elections in 2010, HouseOversight and Government Reform Committee ChairmanDarrell Issa asked the business community to identifythose government regulations viewed as mostburdensome. The responses, which were made public inFebruary 2011, underscored the dilemma: EPA rules wereidentified more than those administered by any othergovernment agency. The president called for a review ofgovernment regulations early in 2011, with the goal ofeliminating any that were outdated or particularlyburdensome to firms. However, the initiative seemed tobe aimed more at older rulings than at the proposedcontrols on greenhouse gases, which have been thesource of broad-based criticism. In fact, in early 2011, theHouse Energy and Commerce Committee proposedthe Energy Tax Prevention Act of 2011, which wouldrepeal the EPA’s authority to control greenhouse gases.

It is clear that the debate both in Washington and inthe private sector about the command-and-controlapproach to new environmental policy under the Obamaadministration is expected to continue for some time. Inthe interim, to learn more about regulations and rulesproposed or administered by the EPA, visit www.epa.

gov/lawsregs/index.html.

Sources: Ackley (2011); Banerjee (2011); Radnofsky (2011); Inhofe (2010).



IS THE COMMAND-AND-CONTROL APPROACH COST-EFFECTIVE?

The practical way to assess whether the command-and-control approach is cost-effective is todetermine whether society is incurring higher costs than necessary to achieve a given level ofenvironmental quality. For discussion purposes, let’s consider some abatement standard as thesocially desirable (as opposed to efficient) outcome, perhaps motivated to protect humanhealth. In theory, to achieve cost-effectiveness, policymakers must identify the relative costsof all control instruments that can achieve this objective and then select the one that mini-mizes costs. Given this general premise, we can identify two command-and-control decisionsthat may violate the cost-effectiveness criterion. The first is the use of a technology-basedstandard, and the second is the use of uniform standards. We discuss each of these in turn.

Cost-Ineffectiveness of Technology-Based StandardsRecall from the beginning of this chapter that there are three types of standards: ambient

standards, performance-based standards, and technology-based standards. Take aminute to reread the definitions of these control instruments, and think about the costimplications of each. What should be apparent is that the technology-based standard poten-tially prevents the polluter from minimizing the costs of achieving a given abatement level.Remember that the MAC curve is defined under the assumption that the polluter selects theleast-cost available method. If the government forces polluters to use a specific technology tomeet an emissions limit, it is impeding the firm’s incentive to abate in a cost-effective man-ner. Unless the mandated technology happens to be the least-cost approach for all polluters,at least some will be forced to operate above their respective MAC curves. This in turnmeans that society is incurring costs higher than the MSC of abatement. The result is awaste of economic resources with no additional benefits to society.

If instead a performance-based standard were used, each polluter could select the meansby which it achieves that standard. Without further guidance, it would follow its self-interestand choose the least costly abatement method. Society would still gain the benefits of a cleanerenvironment, but fewer resources would be used to achieve that gain. A word of caution is inorder, however. Although using performance-based standards has potential cost advantagesover using technology-based standards, this selection does not by itself ensure a cost-effectivesolution. In fact, regardless of which type of standard is used, resources will be wasted if theyare imposed uniformly across polluters. Let’s consider this issue next.

Cost-Ineffectiveness of Uniform StandardsUnder a strict command-and-control framework, standards are often imposed uniformlyacross groups of polluting sources. The operative question is whether such a policyapproach is cost-effective. The answer? The use of uniform standards across pollutingsources will waste economic resources as long as abatement cost conditions differ amongthose sources. Of course, the reality is that there are many factors that might give rise tosuch differences. One is the age of the polluter’s physical plant. Newer facilities typicallyare designed and built with advanced pollution control equipment, making them capableof meeting an abatement standard at a much lower marginal cost than their less moderncounterparts. Another relevant factor is regional differences in input prices. There is noreason to expect firms in different locations to face the same costs of labor, land, and cap-ital. As long as input prices vary, so too will polluters’ costs to achieve a given standard.



By accepting that abatement costs will likely differ among polluters, we need toexplore why this makes the use of uniform standards cost-ineffective. The problem isthat uniform standards force high-cost abaters to reduce pollution as much as low-costabaters, so more resources than necessary are used to achieve a cleaner environment.Cost savings could be realized by having more of the abatement accomplished by pollu-ters who can do so at a lower cost. A simple model illustrates this assertion.

To begin, assume there are only two polluting sources in a given region, each ofwhich generates 10 units of pollution for a total of 20 units released into the environ-ment. The government determines that emissions must be reduced by 10 units acrossthe region to achieve the “socially desirable level of pollution.” Each firm faces differentabatement cost conditions, modeled as follows:8

Polluter 1’s Marginal Abatement Cost (MAC1): MAC1 = 2.5A1

Polluter 1’s Total Abatement Costs (TAC1): TAC1 = 1.25(A1)2

Polluter 2’s Marginal Abatement Cost (MAC2): MAC2 = 0.625A2

Polluter 2’s Total Abatement Costs (TAC2): TAC2 = 0.3125(A2)2

where A1 is the amount of pollution abated by Polluter 1, and A2 is the amount of pol-lution abated by Polluter 2.

Now, assume the government implements the 10-unit standard uniformly, requiringeach polluter to abate by 5 units (i.e., A1 = A2 = 5). At this level, the MAC for Polluter1 is $12.50 (MAC1 = 2.5[5] = $12.50), and its TAC is $31.25 (TAC1 = 1.25[5]2 =

$31.25). For Polluter 2, MAC2 is $3.13, and TAC2 is $7.81. Therefore, the total abate-ment costs for the region (absent the costs of monitoring and enforcement) equal$39.06, which represents the value of resources used to meet the standard. The questionis, could the same standard be achieved at a lower cost?

Notice that Polluter 2 has an abatement cost advantage over Polluter 1. For example,the fifth unit of abatement costs Polluter 2 $9.37 less than Polluter 1. Therefore, it wouldbe cheaper if Polluter 2 were to do more of the abating. Of course, it would need to havean incentive to do this, and the two firms would have to negotiate to arrive at some mutu-ally beneficial agreement.9 However, no such opportunity is allowed when the governmentforces every polluter to abate by the same amount. Thus, we conclude that the use of uni-form standards under a command-and-control approach does not achieve the cost-effectiveness criterion as long as MAC conditions differ across polluters.

Could the government reallocate abatement levels across the two polluters toachieve a cost-effective solution? The answer is yes, and economic theory conveysexactly how this result could be achieved. If each polluter were to abate to thepoint where the corresponding level of MAC is equal across firms, the cost-effective

abatement criterion would be achieved. This means that the environmental standardwould be met at minimum cost. This result is one application of what microeconomictheory calls the equimarginal principle of optimality.

To illustrate the cost savings of such an approach, let’s return to our two-pollutermodel. We need to find the abatement levels for each polluter at which their respective

8Assuming no fixed costs, the total abatement costs (TAC ) for a given abatement level A are found asthe aggregation of the MAC at each abatement level up to A. Graphically, this means that the TAC forabatement level A is the area under the MAC curve up to point A.9In a real-world setting, there would also be transaction costs associated with the negotiations betweenthe two firms.

cost-effectiveabatement criterionAllocation ofabatement acrosspolluting sources suchthat the MACs foreach source are equal.



MACs are equal, holding the combined abatement level at 10 units to meet the standard.Algebraically, the steps in the solution are:

Step 1: Set MAC1 = MAC2: 2.5A1 = 0.625A2

Step 2: Set A1 + A2 = abatement standard: A1 + A2 = 10

Step 3: Solve the equations simultaneously: A1 = 2; A2 = 8

This same result is shown in Figure 4.6. Both firms’ MAC curves are plotted on thesame diagram. For Polluter 1, A1 is measured horizontally left to right, whereas forPolluter 2, A2 is measured right to left. The horizontal axis measured in either directionranges from 0 units of abatement up to the 10-unit requirement imposed by the regula-tory authority. Thus, every point on this axis represents a combined abatement level thatsatisfies the standard. Notice that the intersection of the two MAC curves yields thecost-effective solution (A1 = 2 and A2 = 8). At this point, MAC1 = MAC2 = $5.00.

If each polluter were given these firm-specific abatement targets, the total costs ofachieving the environmental objective would be minimized. These costs can be calcu-lated from each firm’s TAC equation, substituting in the cost-effective abatement levels:

TAC1 = 1.25(2)2 = $5.00

TAC2 = 0.3125(8)2 = $20.00

By following the equimarginal principle of optimality, the total cost to society ofachieving the 10-unit abatement standard is $25.00, which is a $14.06 savings over theuniform standards approach. Equivalently, this $14.06 represents the unnecessary costsincurred by society when a uniform standard is imposed across nonidentical polluters.

FIGURE 4.6 Cost-Effective Solution in a Two-Polluter Model

The model shows the MAC curves for Polluter 1 and Polluter 2. Polluter 1’s abatement level (A1) ismeasured left to right on the horizontal axis, and Polluter 2’s abatement (A2), right to left. The hori-zontal axis measures from 0 up to the 10-unit abatement requirement imposed by government, soevery point represents a combined abatement level that satisfies the standard. In accordance withthe equimarginal principle of optimality, the intersection of the two MAC curves yields the cost-effective solution, where A1 ¼ 2 and A2 ¼ 8. At this point, notice that MAC1 ¼ MAC2 ¼ $5.00.

MAC1($)

MAC2($)

6.25

25.00

5.005.00

MAC2

MAC1

0 2Polluter 1: Abatement (A1)

10

10 8Polluter 2: Abatement (A2)

0

©CengageLearning

2013.



As a final point, it’s reasonable to ask how in practice the government could arriveat these firm-specific abatement standards within a command-and-control framework.The answer is that it would have to know the abatement cost conditions for every firmit was regulating. Of course, this kind of information would be virtually impossible todetermine, particularly when thousands of individual sources are being controlled. Butthere is a way around the problem, although not within the command-and-controlapproach. As we will discover in Chapter 5, the market approach can arrive at this samecost-effective solution without specific knowledge of polluters’ costs. How? By usingmarket incentives and the price mechanism in place of inflexible rules.

CONCLUSIONS

In this chapter, we have begun to evaluate solutions to environmental problems byfocusing on the more conventional policy tools used in practice—the use of standardsto define environmental objectives and the use of a command-and-control approach toimplement those objectives. Even at this introductory level, we were able to reachimportant conclusions. It is apparent, for example, that government-mandated environ-mental standards are not likely to be set at an efficient level. Beyond those instanceswhen the law does not allow for the requisite balancing of benefits and costs, there isstill an information problem. Policymakers would need extensive data to measure themarginal costs and benefits of abatement. Hence, in all likelihood, the level at whichenvironmental objectives are set will not be allocatively efficient.

Accepting this realization, we find that cost-effectiveness becomes the relevant criterion bywhich to assess the command-and-control approach and compare it to the market approach.Thus far, we have shown that using uniform standards under a command-and-control frame-work likely wastes resources. Cost savings can be realized if polluters reduce emissions up tothe point where their marginal costs of doing so are equal. But how can such a result beachieved in practice? The answer requires an investigation of alternative control instruments,in particular those that are part of the market approach to environmental policy.

In sum, although our findings in this chapter are important, they are incomplete.We still must learn how market-based initiatives are designed and how they compareto their command-and-control counterparts—precisely the agenda of Chapter 5.This part of our analysis is particularly relevant, given the recent trend in the UnitedStates and other nations to integrate market-based instruments into what had been anexclusively command-and-control approach to environmental policy. To appreciate thistrend and what it means for society, we must understand how market instruments oper-ate and evaluate their effectiveness in achieving environmental goals.



Summary● There are three basic types of standards used in envi-

ronmental control policy: ambient standards, whichdesignate the level of environmental quality as a max-imum allowable pollutant concentration; technology-based standards, which indicate the abatementmethod to be used; and performance-based standards,which specify an emissions limit to be achieved.

● An environmental standard achieves allocative effi-ciency if resources are allocated such that the mar-ginal social benefit (MSB) of abatement equals themarginal social cost (MSC) of abatement.

● TheMSBmeasures the additional gains to society associ-ated with the reduction in damages caused by pollution.

● The MSC is the horizontal sum of the market-levelMAC (MACmkt) and the government’s marginalcost of enforcement (MCE).

● Four factors suggest that a government-mandatedabatement standard is not likely to meet the allocativeefficiency criterion: (1) the existence of legislative

constraints, (2) imperfect information, (3) regionaldifferences, and (4) nonuniformity of pollutants.

● Governments generally use one of two approachesto implement environmental policy: the command-and-control approach or the market approach.

● Two aspects of the command-and-controlapproach may violate the cost-effectiveness crite-rion: the use of technology-based standards andthe use of uniform standards.

● Because technology-based standards dictate a spe-cific abatement method to polluting sources, theyprevent the polluter from minimizing costs.

● Uniform standards force high-cost abaters toreduce pollution as much as low-cost abaters, somore resources than necessary are used to achievethe benefits of a cleaner environment.

● To achieve a cost-effective outcome, abatement respon-sibilities across polluting sources must be allocated suchthat the level ofMAC is equal across polluters.

Review Questions1. One of the major problems in applying the

Coase Theorem in practice is the existence ofhigh transaction costs. Propose an approach thata third party could use that would reducethese costs sufficiently so that bargaining couldproceed. How likely is the solution to be efficient,and why?

2. Using a graph of the pollution abatement market,model a situation in which the allocatively effi-cient level of abatement occurs at 100 percent,or equivalently, where pollution is zero. Referringto the relative position of the MSC and MSBcurves, explain this outcome intuitively.

3. Suppose that the state of Connecticut is attempt-ing to set a water quality standard, where waterquality is measured as the percent of mercuryabated (A), and the marginal social benefit(MSB) and marginal social cost (MSC) of abate-ment have been estimated as follows:

MSB ¼ 40� 0:1A MSC ¼ 36þ 0:25A

The state’s department of environmental protec-tion sets the standard at 20 percent. Is thisstandard set efficiently, too stringently, or tooleniently? Explain briefly.

4. a. Under a strict command-and-control framework,suppose abatement standards are set equally acrosspolluters. Assume the total abatement target is 30units. Show the cost implications using three graphs,eachof adifferentpolluterwith auniqueMAC curvedrawn to depict a low-cost abater, a moderate-costabater, and a high-cost abater. On each graph, iden-tify the abatement level corresponding to a uniformstandards approach, and show the level ofMAC atthat point and the area corresponding to TAC.

b. Now, refer directly to your model, and summa-rize what would happen qualitatively to theabatement levels of each firm if the equimarginalprinciple of optimality were used. Explain intui-tively why this method would be cost-effective.

5. It is well documented that the carbon monoxide(CO) emissions from combustible engines increasein colder climates. This implies that the associateddamages are expected to be less severe in summermonths than in winter. Nonetheless, air qualitycontrol authorities use a standard for CO that isuniform throughout the year with no allowancefor seasonal effects. Use this information and thefollowing model to answer the questions:



MSB of CO abatement in winter = 350 − 0.5A

MSB of CO abatement in summer = 140 − 0.2A

MSC of CO abatement = 0.2A

where A is the level of CO abatement.a. Graph the MSB and MSC functions on the

same diagram.b. Assume the government sets a uniform stan-

dard for winter and summer at A = 500.Support or refute this policy based on the cri-terion of allocative efficiency, using your modelto explain your response.

c. If you were in charge of setting policy for COemissions, what action would you recommend

to ensure an allocatively efficient outcomeacross the two seasons?

6. Assume that two power plants, Firm 1 and Firm 2,release sulfur dioxide (SO2) in a small urban commu-nity that exceeds the emissions standard. Tomeet thestandard, 30 units of SO2must be abated in total. Thetwo firms face the following abatement costs:

MAC1 ¼ 16þ 0:5A1 MAC2 ¼ 10þ 2:5A2

where costs are measured in thousands of dollars.a. Prove that a uniform standard will not meet

the cost-effectiveness criterion.b. Determine how the abatement levels should be

reallocated across the two firms to minimize costs.

Additional ReadingsCoglianese, Cary, and Laurie K. Allen. “Does Consen-

sus Make Common Sense? An Analysis of EPA’sCommon Sense Initiative.” Environment 46(1)(January/February 2004), pp. 10–25.

Farzin, Y. H. “The Effects of Emission Standards onIndustry.” Journal of Regulatory Economics 24(3)(November 2003), pp. 315–27.

Gray, Wayne B., and Ronald J. Shadbegian. “‘Optimal’Pollution Abatement—Whose Benefits Matter, andHow Much?” Journal of Environmental Economicsand Management 47(3) (May 2004), pp. 510–34.

Harrington, Winston, and Richard D. Morgenstern.Choosing Environmental Policy: Comparing Instru-ments and Outcomes in the United States and Europe.Baltimore,MD: JohnsHopkinsUniversityPress, 2004.

———. “Economic Incentives versus Command andControl: What’s the Best Approach for SolvingEnvironmental Problems?” Resources 152 (Fall/Winter 2004), pp. 13–17.

Helfand, Gloria E., and Peter Berck. The Theory andPractice of Command and Control in EnvironmentalPolicy. Burlington, VT: Ashgate, November 2003.

Hutchinson, Emma, and Peter W. Kennedy. “StateEnforcement of Federal Standards: Implicationsfor Interstate Pollution.” Resource and EnergyEconomics 30(3) (August 2008), pp. 316–44.

Karp, Larry, and Jiangfeng Zhang. “Regulation withAnticipated Learning about EnvironmentalDamages.” Journal of Environmental Economicsand Management 51(3) (May 2006), pp. 259–79.

Keohane, Nathaniel O., Richard L. Revesz, and RobertN. Stavins. “The Choice of Regulatory Instru-ments in Environmental Policy.” Harvard Envi-ronmental Law Review 22 (1998), pp. 313–67.

Koontz, Tomas M., Toddi A. Steelman, JoAnn Carmin,Katrina Smith Korfmacher, Cassandra Moseley,and Craig W. Thomas. Collaborative Environmen-tal Management: What Roles for Government?Washington, DC: Resources for the Future, 2004.

Portney, Paul R. “EPA and the Evolution of FederalRegulation.” In Paul R. Portney, ed. Public Policiesfor Environmental Protection. Washington, DC:Resources for the Future, 2000, pp. 11–30.

Van Rooji, Benjamin. “Greening Industry WithoutEnforcement? An Assessment of the WorldBank’s Pollution Regulation Model for Develop-ing Countries.” Law & Policy 23(1) (January2010), pp. 127–52.

Westmoreland, Joshua K. “Global Warming and Ori-ginalism: The Role of the EPA in the ObamaAdministration.” Boston College EnvironmentalAffairs Law Review 37(1) (2010), pp. 225–56.

To access additional course materials, visit www.cengagebrain.com.At the home page, search for the ISBN of this title (shown on theback cover). This will take you to the product page where theseresources can be found.



environmental economics and man - scott j. callan chapter 4

Documents

environmental objectives

policy objectives

environmental market

environmental policystandards

environmental policies

objective set

market incentive

policy development