Economics of Pollution

By Saakshi Agrawal

Almost all economic activities use environmental resources in one way or the other. Land, water, and
stock of other resources are used as inputs for production. However, in addition to the desired ‘product’,
often an unwanted waste product is also produced. For example, use of coal in thermal power plants, also
releases pollutants that have a detrimental effect on the environment. The environment is also used as a
‘waste sink’ in which the industries release their wastes and pollutants. Developing countries lack both
the technology as also funds to develop infrastructure for efficient waste management systems, leading
to their industries generating uncontrolled waste and pollution. Pollution, an unintentional effect of
economic activity, is an example of a negative externality on the environment and human health.

Externality refers to a cost or benefit caused by an economic agent that is not financially incurred or
received by the economic agent. An externality can be both positive and negative and can stem from
either consumers or producers. A positive externality is one which is a source of benefit to an individual
or the society, whereas the negative externality is a source of harm to an individual or society. A perfect
example of positive externality in today’s time would be people wearing masks. If a person leaves the
house with a mask on, he is not only benefitting himself but also the people around him and the society
as well.

Environment, clean air, and clean water are all public goods (non-rival) and no one enjoys private property
rights over these; thus no one is penalized for polluting, depleting or overusing them and neither is anyone
incentivized for their preservation, conservation or ensuring its cleanliness. The allocation at the
competitive equilibrium in the presence of an externality is not socially optimum, as it does not take into
consideration the social cost, i.e. the damage to the environment, which is a market failure. Thus, negative
externalities not only cause inefficiency and reduce social welfare but also lead to market failure.
Economists became aware that, for economic growth to be indefinitely sustainable, the economic system
needs to take into account the controlled use of the environment, so that natural resources are not
depleted and the environment is not overused as a waste sink.1

To curb the effects caused by an externality, we need to ‘internalize’ the externality. When two different
firms are considered, for example, a fishery and coal industrial unit, the coal industry lets out its untreated
waste in the nearby water body. Since it is a profit maximizing-cost minimizing industry, it will overuse the
free resource and would not want to waste money on treating the waste or looking for alternatives. This
action of the coal industry affects the fishery nearby, as a result of which their profits are reduced, or costs
are increased. This can be solved if the two units, coal industry and fishery, merge and share profits in
some ratio. Therefore, the waste released by the firm would also affect the firm now and would thus
reduce its waste. However, this arrangement is not feasible, with the coal industry and clean air. Since
clean air doesn’t have a market, property rights, or even a price to begin with.
To solve the issues of externalities, economists have come up with different policies. There are three
broad classifications of the policies – Command and Control, Pigouvian Taxes, and Coasian Permit Trading.

1
Mulhearn C, Vane HR (2012) Economics for Business, 2nd edition. Palgrave Macmillan
Tietenberg T, Lewis L (2014) Environmental & Natural Resource Economics, 9th edition. Pearson

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Command and Control policies, as the name suggests, involve the Governments issuing restrictions to
control the levels of pollution. Under this, the firms are required to adopt emission control technology or
equipment. If the emitters fail to comply with the rules and regulations, they are penalized accordingly or
their licenses are ceased. To ensure the control of such laws the Governments often install emission
monitoring devices and/or conducts regular audits. In India, the Air (Prevention and Control of Pollution)
Act 1981 is an act for the prevention, control, and abatement of air pollution.2 There are similar pollution
prevention acts implemented across the globe. All Parties that are a part of the Paris Agreement have to
report regularly on their emissions and their implementation efforts. However, this method requires lots
of checks and balances, forces firms to invest in costly equipment, can impose an unequal burden on
different firms and can also be used to push different political agendas.

To overcome the shortcomings of the Command and Control Policy, Arthur Pigou, a British Economist
came up with the concept of taxes on pollution; hence the name Pigouvian taxes. The Pigouvian tax shifts
the costs from the society to the producer of the externality. The Pigouvian taxes increase the private
marginal costs of the producers of the negative externality. Thus, the new competitive equilibrium, which
includes the cost of environmental damage, is an efficient one and maximizes social welfare. In addition
to market efficiency, Pigouvian tax ensures lesser production of the negative externality and increases
government revenue. However, these taxes require perfect information, as the quantum of tax must be
equal to the cost generated by the negative externality.
Declining salmon stocks in Ireland led the government to double the price of the existing recreational and
commercial salmon fishing licenses in 2007. The license scheme helped ease the fishing pressure on
salmon stocks, while the revenue was used to fund projects relating to conservation and habitat
restoration3. Similarly, a landfill tax was introduced in the UK in 1996 to reflect the environmental cost of
landfilling (e.g., greenhouse gas emissions), and to reduce waste generation and boost recycling.4

A further step forward in managing the externalities was the introduction of the concept of Coasian Permit
Trading. It is a system whereby the Governments set the maximum permissible level of pollution. Every
firm needs a permit from the Government for producing a certain level of pollutants. Within this specified
level of pollution, the various polluting industries can mutually “trade” their respective quota of pollution
by buying or selling it. The revenue so generated by this “trade” can be used to offset the impact of certain
developments. Therefore, there will be the same levels of pollution as in command and control but at a
lower cost to the society. By creating a market for the externality, the problem of ‘missing markets’ has
been solved and hence the externality is no longer external to the market.
In 2005, the European Union set up the first international Emissions Trading System (ETS). The EU ETS has
proved that putting a price on carbon and trading in it can help reduce the carbon levels.5 Similarly, the
US has set a cap on the aggregate level of SO2 emissions and created a market for firms to buy and sell
government-issued allowances to emit SO26. The Paris Agreement also realized the importance of

2
Vinay Vaish, Partner, Vaish Associates Advocates and Hitender Mehta, ‘Environmental Laws in India’
3
Marianne Kettunen, Institute for European Environmental Policy, ‘Conservation and sustainable management of
salmon through fishing licenses in Ireland’
4
Tim Elliott, Eunomia, ‘Landfill Tax in the United Kingdom’
5
International Carbon Markets, European Union official website, https://ec.europa.eu/clima/policies/ets_en
6
Stavins, Robert N. "The U.S. Sulphur Dioxide Cap and Trade Programme and Lessons for Climate
Policy." Vox. August 12, 2012.

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international carbon markets and allows Parties to use international trading of emission allowances to
help achieve emission reduction targets.

By adopting any of the aforementioned economic policies, we can correct the market failure and ensure
socially optimum allocation of resources. The need for environmental conservation and prioritization of
sustainable goals is the need of the hour. The Government subsidies which encourage activities that
contribute towards increased emissions or depleting forest covers should be withdrawn. Government
policies that involve people as stakeholders of the environment should be adopted. It is thus important
to understand that these economic policies must be complemented with good governance in order to
achieve the desired preservation of environment.

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 References:
1. The Effect of Allowance Allocations on Cap-and-Trade System Performance, Robert W. Hahn and
Robert N. Stavins
URL: http://www.jstor.org/stable/10.1086/661942 .
2. Optimal’ Pollution Abatement – Whose Benefits Matter, and How Much?, Wayne B. Gray Ronald
J. Shadbegian
3. Do Community Characteristics Influence Environmental Outcomes? Evidence from the Toxic
Release Inventory, S. Arora and T. N.Cason, Southern Economic Journal 65, 691-716 (1999).
4. Environmental Taxes and Policies for Developing Countries, Neil Bruce and Gregory M. Ellis,
Policy Research Department The World Bank September 1993
5. The Scale and Scope of Environmental Taxation, Agnar Sandmo Norwegian School of Economics
and Business Administration (NHH)