Chapter Five

Economics of Environmental Pollution

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 Topic outline
1) pollutant taxonomy/ classification
2) The efficient allocation of pollution
– Efficient allocation of Stock Pollutants
– Efficient allocation of Fund Pollutants
3) Defining of Cost Effective Allocation
4) Environmental Policy - economic instruments
– Cost Effective Pollution Control Policies
i. Emission Standards (Command- and–control)
ii. Emission Charges
iii. Transferable Emission Permits
iv. Liability Rules
5) Trans-boundary Environmental Problems
i. Ozone Layer Depletion
ii. Global Warming
iii. Biological Diversity 2
 Pollutant Taxonomy
• In Economics of pollution the natural starting point is
classifying or giving taxonomy of pollutants.
• This is very important because the way the efficient
level of waste flow to the environment is determined
highly depends on the type of pollutants one is
concerned about.
• Moreover, the policy instrument of pollution control
that a society must choose also depends on the type of
pollutant at hand.
• Pollutants can generally be classified based on the
basis of absorptive capacity and on their zone of
influence.
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 Pollutant Classification
• Based On Absorptive Capacity
• Stock Pollutants are pollutants for which the environment
has little or no absorptive capacity. Stock pollutants
accumulate over time as emissions enter the environment.
Examples of stock pollutants include non-biodegradable
bottles and heavy metals.
• Fund Pollutants are pollutants for which the environment
has some absorptive capacity. As long as the emission rate
doesn’t exceed the absorptive capacity of the environment
these pollutants do not accumulate. Examples of fund
pollutants are not hard to find. These include Organic
matters like animal or human waste.
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• Based On Their Zone of Influence
• Pollutants can also be classified by their zone of influence;
vertical or horizontal.
–The horizontal dimensions
• The horizontal dimension deals with the domain over which
damage from an emitted pollutant is experienced. With this
regard we can have two types of pollutants.
• Local Pollutants The damage caused by local pollutants is
experienced near the source of emission.
• Regional Pollutants These are pollutants whose damage is
experienced at greater distances from the source of
emission.

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 –The Vertical Zone of Influence
• The vertical dimension or zone of influence describes
whether damage is caused mainly by ground level
concentration of an air pollutant or by concentrations in the
upper atmosphere.
• Surface Pollutants When the damage caused by a
pollutant is determined mainly by concentrations of the
pollutant near the earth’s surface, it is called a surface
pollutant.
• Global Pollutants When the damage from a pollutant is
related to its concentration in the upper atmosphere, the
substance is called a global pollutant.
• Water pollutants are obviously surface pollutants while air
pollutants can be surface, global or both. One common
global pollutant, Carbon dioxide 6
 5.2. The efficient allocation of pollution
• It is conceivable for someone to get confused by the
term ‘efficient level of pollution’ as pollution is
something that is not needed and needs to be totally
avoided.
• But zero level of pollution is not efficient as it can
be achieved only when there is zero level of
production and consumption.
• As long as there is a positive amount of production
and/or consumption, the efficient level of pollution
that will maximize societal net benefit should
certainly be positive. 7
 5.2.1. Defining the efficient allocation of
pollution
• Pollutants are the residuals of production and
consumption.
• These residuals must eventually be returned to the
environment in one form or another. Since their
presence in the environment may depreciate the
service flows received, an efficient allocation of
resources must take this cost into account.
• As we have said what is meant by the efficient
allocation of pollution depends on the nature of the
pollutant and hence there is a need to define for
each type of pollutant independently.
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 5.2.1.1 Efficient allocation of Stock Pollutants
• The efficient allocation of a stock pollutant must
take into account the fact that the pollutant
accumulates in the environment over time and that
the damage caused by its presence increases and
persists as the pollutant accumulates.
• By their very nature, stock pollutants create
interdependency between the present and the
future, since the damage imposed in the future
depends on current actions.

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• Let us now try to establish what is meant by an
efficient allocation for such pollutants together.
Suppose, for example, that we consider the allocation
of a commodity which we refer to as X.
• Suppose further that the production of X involves the
generation of a proportional amount of a stock
pollutant.
• The amount of this pollution can be reduced, but that
takes resources away from the production of X.
• The damage caused by the presence of this pollutant in
the environment is further assumed to be proportional
to the size of the accumulated stock.
• As long as the stock of pollutants remains in the
environment, the damage persists.
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• The efficient allocation, by definition, is the one
which maximizes the present value of the net benefit.
• In this case the net benefit at any point in time t is
equal to the benefit received from the consumption of
X minus the cost of the damage caused by the stock
pollutant in the environment.
• This damage is a cost that society must bear, and in
terms of its effect on the efficient allocation, this cost
is not unlike that of extracting minerals or fuels.
• While for minerals the extraction cost rises with
cumulative amount of the deplorable resource
extracted, the damage cost associated with a stock
pollutant rises with the cumulative amount deposited
in the environment. 11
• The accretion of the stock pollutant is proportional to the
production of X, which creates the same kind of linkage
between the production of X and this pollution cost as
exists between the extraction cost and the production of
mineral.
• They both rise over time with the cumulative amount
produced.
• The one major difference is that the extraction cost is
borne only at the time of extraction, while damage is
borne as long as the stock pollutant exists in the
environment.
• When extraction cost rises, the efficient quantity of a
depletable resource extracted and consumed declines over
time. 12
• Exactly the same pattern would emerge for a
commodity which is produced jointly with a stock
pollutant.
• The efficient quantity of X (and therefore, the addition
to the accumulation of this pollutant) would decline
overtime as the marginal cost of the damage rises.
• The price of X would rise over time, reflecting the
rising social cost of production.
• To cope with the increasing marginal damage, the
amount of resources committed to controlling the
pollutant would increase over time.
– Ultimately, a steady state would be reached where additions
to the amount of the pollutant in the environment would cease
and the size of the stock would stabilize. 13
• At this point, all further emission of the pollutant
created by the production of X would be controlled
(through recycling for example).
• The price of X and the quantity consumed would
remain constant.
• The damage caused by the stock pollutant would
persist.
• The efficient level of a stock pollutant is therefore
achieved when the present value of the marginal
benefit from the consumption of commodity X is
equated with the present value of the marginal cost
of damage from its associated pollution.
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• It is dynamic efficiency. (related to its effect among generations)
• This is basically because the accumulating nature
of stock pollutants will create interdependency
between the current period and the future.
• A stock pollutant created in the current period will
cause not only current damage but also pose
future damage as it will accumulate and persist in
the environment.
• As a result, we should involve the concepts of
discount rates and present values in our analysis of
the determination of the efficient level of stock
pollutants.
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 5.2.1.2 Efficient allocation of Fund Pollutants

• Before discussing the determination of the efficient

allocation of fund pollutants, let us clear an area where
confusion might arise.
• The fact that the environment has some absorptive
capacity for fund pollutants does not mean that these
pollutants won’t accumulate in space and time.
• Accumulation of a waste load depends on both on the
assimilative capacity of the environment and the emission
load (the rate at which waste is being discharged).

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• Therefore, to the extent that the emission of fund
pollutants exceeds the assimilative capacity of the
environment, they accumulate and share some of the
characteristics of Stock pollutants.
• In such a situation the efficient level of the fund
pollutant is determined in the manner in which we
discussed for Stock pollutants and there is no need to
repeat that scenario here.
• We will, therefore, concern ourselves in the
determination of the efficient level of fund pollutants
where the emission load doesn’t exceed the absorptive
capacity of the environment.
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• When the emission rate of fund pollutants is low enough
the discharges can be assimilated by the environment.
• In this case, present emissions cause present damage and
future emission brings future damage.
• That is, the link between present emissions and further
damage may be broken.
• Static efficiency is appropriate to be used in such a
situation because the independence of allocations among
time periods allows us to use static, rather than dynamic
efficiency.
 The normal starting point for the analysis would start from
maximizing the net benefits from the waste flows.
• There are two kinds of costs associated with fund pollutants.
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1. Damage costs are costs caused by the fund pollutant
on the environment while
2. Control or Avoidance costs are costs incurred in a bid
to reduce the impact of the pollutant.
– The later are also usually referred to as Abatement
Costs.
– The efficient level of the fund pollutant (the one that
maximizes net benefit) can equivalently be modelled as
the one that minimizes the sum of these two costs
(Damage costs and Controls costs).
– The efficient level of the fund pollutant will be the one
that minimizes the sum of the two costs.

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• Generally, the marginal damage caused by a unit
of pollution increases with the amount emitted.
• When small amounts of the pollutant are emitted,
the marginal damage is quite small.
• However, when large amounts are emitted, the
marginal unit can cause significantly more
damage.
• Because, small amounts of pollution are easily
diluted in the environment and the body can
tolerate small quantities of substances.

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• However, as the amount in the atmosphere increases,
dilution is less effective and the body is less tolerant.
• As a result, the additional or marginal damage
caused by an additional unit of the pollutant is higher
than the previous unit of pollutant emitted.
• Marginal control costs commonly increase with the
amount controlled.
• Obviously, the marginal or per unit cost of avoiding
the pollution will be less costly when the level of
pollution is too much.

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• As you avoid or control more and more of the
pollution ( as the level of pollution becomes too
small), avoiding the same level of pollution as before
will take you too much time and money and hence
becomes more costly.
• Remember this thing could be confusing if you mix
marginal analysis with total analysis.
• We are not saying that the total cost of avoiding too
much pollution is less costly than the total cost
avoiding small amount of pollution.

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• This is a total analysis. But we are into marginal
analysis.
• What is being said is that avoiding one unit of
pollution costs less when the pollution is too much
than when the pollution is too small.
• The relationship between marginal damage cost and
marginal control cost can easily be exploited to
determine the efficient level of a fund pollutant.
• Remember that as you control more pollution, the
marginal control cost increases but the marginal
damage cost decreases as the level of pollution
reduces with greater control or avoidance
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• At any given level of pollution, if the marginal
control cost is greater than the marginal damage
cost, it means that marginal benefit in terms of
avoided damage is less than the marginal cost of
achieving it.
• Microeconomic theory tells us that if the marginal
cost is greater than the marginal benefit, we should
reduce our activity.
• Likewise, if the marginal cost of control is greater
than the marginal damage cost, we should reduce
our pollution control effort and allow more
pollution.
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• On the other hand, if the marginal damage cost is
greater than the marginal control cost, then a unit of
pollution controlled will give us more benefit in terms
of avoided damage than the cost of achieving it.

• As a result, the efficient level of pollution is

determined at the level of pollution in which marginal
control cost equals marginal damage cost.

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• Figure 5.1 uses marginal damage cost and marginal
control cost to derive the efficient level of pollution.
• On the horizontal axis the level of pollution emitted
is measured from left to right while a movement
from right to left refers to greater control and less
pollution emitted.
• The efficient level of pollution is represented by Q*,
the point at which the damage caused by the
marginal unit of pollution is exactly equal to the
marginal cost of avoiding it.

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Efficient level of fund pollutant

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• The area below the marginal damage cost and to the
left of the level of pollution represents total damage
cost.
• The area below the marginal control cost and to the
right of the level of pollution controlled represents
total control cost.
• remember that the level of pollution controlled is
measured from right to left.
• Total cost of pollution which is the sum of total
damage cost and total control cost is minimized at
Q*.
• Greater degree of control (points to the left of Q*)
are inefficient because the further increase in control
or avoidance costs would exceed the reduction in
damages. 28
• Hence total cost would rise.
• Similarly, levels of control lower than Q* would result in a
lower cost of control but the increase in damage costs
would be even larger, yielding an increase in total cost.
• Either increasing or decreasing the amount controlled,
causes an increase in total costs.
• Hence Q* must be efficient.
• If we look back Figure 5.1 once again, there is another
lesson to be drawn from it.
• The figure suggests that the optimal level of pollution is
not zero.
• This is because zero level of pollution implies 100%
elimination of consumption or production of a product.
This is, however, costly to do.
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 5.3. Environmental Policy - economic instruments
• 5.3.1. Cost Effective Pollution Control Policies
• Now you know how to determine the efficient level
of pollution and how to allocate the total amount of
pollution reduction among the different emission
sources.
• However, as economists we want to allocate this
emission reduction responsibility using a policy that
minimizes the cost of doing it and that disturbs the
market as small as possible.
• It is so the right time to discuss the different pollution
control policies at the disposal of control authorities
and to choose from the one that is cost effective.
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• Sources have a large menu of options for controlling the
amount of pollution they inject into the environment.
• The source can choose to reduce its emissions of
residuals by using inputs more efficiently or by producing
less output so that less residual is produced.
• Alternatively, the firm can choose to recycle the residuals
or by removing the most damaging components of the
residuals and dump the rest into the natural environment.
• The cheapest method of control, however, differs not
only among industries but also among plants in the same
industry.
• The selection of the cheapest method requires detailed
information on the possible control techniques and their
associated costs.

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• To reduce pollution to the efficient level in a cost
minimizing way, we have to distribute the amount of
pollution each polluter emits in such a way that
marginal control costs are equal among each emitter.
• This implies that control authorities gives more burden
of pollution control to polluters with low cost of
control and gets relatively easy on the high cost
controlling polluters in a bid to reduce the total cost of
pollution reduction from the society’s point of view.
• This presupposes that control authorities have full
knowledge of marginal control costs of all the
polluters.

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 1. Emission Standards (Command- and–control)
• In environmental policy, the command-and-
control approach consists of relying on standards
to bring about improvements in environmental
quality.
• An emission standard is a maximum rate of
emissions that is legally allowed.
• The spirit of standards is, if you want people not to
do something, simply pass a law that makes it
illegal, and then send out the authorities to enforce
the law.
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 2. Emission Charges
• An emission charge is a fee, collected by the
government, levied on each unit of pollutant
emitted into the air or water.
• The total payment any source would make to the
government could be found by multiplying the fee
times the amount of pollution emitted.
• The whole essence of this policy is to make
pollution costly to producers and hence force the
source to seek ways to reduce its pollution.

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 5.3.2 Transferable Emission Permits
• Under this system, the regulator first sets an aggregate
permissible pollution.
• Permits to allow pollution are then created such that the
overall pollution allowed by all the permits collectively is
exactly the fixed aggregate permissible pollution.
• The regulator then issues these pollution permits to the
firms. Each permit specifies exactly how much the firm is
allowed to emit.
• The permits are freely transferable; a firm may, if it so
wishes, sell its pollution permits to another firm through
mutual agreement.
• Any firm that sells its pollution permits forfeits its right to
pollute assigned to it through those permits. 35
 5.3.3. Liability Rules
• Liability rules are set in such a way that there is an
incentive for a producer to follow some prescribed
mandate, technological restriction or acceptable
behaviour.
• Liability rules can be set so that the producer pays a
bond in advance and is reimbursed if there is no harm
committed or pays a non-compliance fee after the harm
has occurred.
• Liability rules attempted to reduce the level of shirking
on environmental pollution control by raising the costs
of misbehaviour.
• One important liability rule concerns the non-
compliance fee: a producer is fined if his actions lead to
a level of pollution that exceeds some set standard. 36
 5.3.4. Trans-boundary Environmental
Problems
• In the preceding sections, we have seen different
pollution reducing policies that are at a disposal of
control authorities.
• These policies are primarily used to solve local
environmental problems and improve immediate
surroundings.
• As you know pollution problems in particular and
environmental problems in general, are not just local
problems.
• Some of them have trans-boundary or global
characteristics. 39
• Trans-boundary Environmental Problems
Ozone Layer Depletion
Global Warming
Biological Diversity

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