Policy for Negative Externalities

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Environmental Regulation

Traditionally, environmental regulations in the U.S. have taken the form of 'command-and-control regulation.'

Environmental regulations which specify allowable quantities of pollution and which also may detail which pollution-control technologies companies must use, fall under the category of command-and-control regulation.
In effect, command-and-control regulation requires that firms increase their costs by installing anti-pollution equipment. Thus, firms are required to account for the social costs of pollution in deciding how much output to produce.

When the United States started passing comprehensive environmental laws in the late 1960s and early 1970s, a typical law specified to companies how much pollution their smokestacks or drainpipes could emit and imposed penalties if companies exceeded the limit.
In 1970, the Federal government created Environmental Protection Agency (EPA) to oversee all environmental laws. In the same year, Congress enacted the Clean Air Act to address air pollution. Just two years later, in 1972, Congress passed and the president signed the far-reaching Clean Water Act. These command-and-control environmental laws have been largely responsible for America’s cleaner air and water in recent decades.

Command-and-control regulation offers no incentive to improve the quality of the environment beyond the standard set by a particular law. Once firms meet the standard, polluters have zero incentive to do better.

Second, command-and-control regulation is inflexible. It usually requires the same standard for all polluters, and often the same pollution-control technology as well.
This means that command-and-control regulation draws no distinctions between firms that would find it easy and inexpensive to meet the pollution standard—or to reduce pollution even further—and firms that might find it difficult and costly to meet the standard.
Firms have no reason to rethink their production methods in fundamental ways that might reduce pollution even more and at lower cost.

Legislators write the command-and-control regulations, and so they are subject to compromises in the political process.
Existing firms often argue (and lobby) that stricter environmental standards should not apply to them, only to new firms that wish to start production. Consequently, real-world environmental laws are full of fine print, loopholes, and exceptions.

Market-oriented environmental policies create incentives to allow firms some flexibility in reducing pollution.

The three main categories of market-oriented approaches to pollution control are:
- pollution charges;
- marketable permits; and
- better-defined property rights.
All of these policy tools which we discuss, below, address the shortcomings of command-and-control regulation - albeit in different ways.

A pollution charge is a tax imposed on the quantity of pollution that a firm emits.
A pollution charge gives a profit-maximizing firm an incentive to determine ways to reduce its emissions—as long as the marginal cost of reducing the emissions is less than the tax.

When a city or state government sets up a marketable permit program (e.g. cap-and-trade), it must start by determining the overall quantity of pollution it will allow as it tries to meet national pollution standards.
Then, it divides a number of permits allowing only this quantity of pollution among the firms that emit that pollutant. The government can sell or provide these permits to pollute free to firms.

Now, add two more conditions. Imagine that these permits are designed to reduce total emissions over time. For example, a permit may allow emission of 10 units of pollution one year, but only nine units the next year, then eight units the year after that, and so on down to some lower level. In addition, imagine that these are marketable permits, meaning that firms can buy and sell them.
The total quantity of pollution will decline. However, buying and selling the marketable permits will determine exactly which firms reduce pollution and by how much.
With a system of marketable permits, the firms that find it least expensive to do so will reduce pollution the most.

A clarified and strengthened idea of property rights can also strike a balance between economic activity and pollution.
Ronald Coase (1910–2013), who won the 1991 Nobel Prize in economics, offered a vivid illustration of an externality: a railroad track running beside a farmer’s field where the railroad locomotive sometimes emits sparks and sets the field ablaze. Coase asked whose responsibility it was to address this spillover.

Coase pointed out that one cannot resolve this issue until one clearly defines property rights—that is, the legal rights of ownership on which others are not allowed to infringe without paying compensation.
if either the farmer or the railroad has a well-defined legal responsibility, then that party will seek out and pay for the least costly method of reducing the risk that sparks will hit the field. The property right determines whether the farmer or the railroad pays the bills.