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Marina Souyioultzis                                                                                                             For Dr. Ryan

Peterhouse Part II

Lent 1999


“Taxing pollution is invariably superior to regulating it.” Discuss with reference to the former Greater London Council’s policy of banning truck movements in inner London at night in order to reduce noise pollution in residential areas.

The basic source of environmental problems is the fact that the price system is simply not applied to many resources. In the Pigouvian tradition, economists have frequently proposed the adoption of a system of unit taxes (or subsidies) to control externalities, where the tax on a particular activity is equal to the marginal social damage it generates. A reorientation of the tax system would change relative prices so as to provide incentives for the conservation of scarce resources. In practice, however, such an approach has rarely proved feasible because of our inability to measure marginal social damage, and regulation has become the most common form of controlling pollution. However,  a system of direct controls involves inefficiencies, including the high real enforcement costs that generally accompany it. In the end, each of the available policy instruments has its particular merits and shortcomings, and each is best adapted to deal with particular circumstances.

An externality if an indirect effect that either a production or a consumption activity has on a utility function, a consumption set or a production set. By “indirect” is meant both that the effect is created by an economic agent other than the one who is affected, and that the effect is not transmitted through prices. The noise from truck movements in residential areas is an example of a consumption externality. This definition indicates that the basic notion of externality depends on the definition of economic agents and the existence of markets to coordinate transactions among these agents.

Should governmental control of externalities take the form of prohibitions and of direct quantitative regulations of certain activities, or the form of taxes to discourage activities which create external diseconomies? Consider a factory that is polluting the atmosphere by emitting smoke. It is not necessarily in the social interest to prohibit all the pollution. The cost of complete abatement of pollution might be exceedingly high. There is an optimal level of pollution which is illustrated below. Suppose that in the absence of any control an industry would find it convenient to emit OO units of pollution. The curve OC measures the increasing marginal damage done to society as the amount of pollution increases. But pollution abatement is costly, and the stricter the abatement the higher probably the marginal cost. The rising marginal cost of pollution abatement is shown by the curve OD. OA, determined by the point of intersection of these two curves, is the optimum amount of pollution. Note that while the cost of pollution abatement is a reasonably definite one, the marginal social damage curve, which must also be estimated in pounds by the government authority concerned, presents difficulties of a different order altogether. The present value of the social damage done by pollution is a matter of considerable doubt and uncertainty. Indeed, the value of the social damage done will have in many cases to be set at a figure determined in a rather arbitrary manner.





The economic case for intervening in the transport sector is that “transport involves large costs, some incurred directly or indirectly by users, and some as a result of its environmental effects. Hitherto, most of the latter costs have fallen on the community rather than on the users or the builders of the transport system. Seriously misleading price signals have resulted, leading to decisions in all areas of transport which have harmed the community”. (Report on Transport and the Environment, 1994). To an economist, the problem is one of market failure – the markets are failing to allocate resources efficiently because users face misleading price signals. If these were corrected to reflect external costs, or externalities, and if transport users responded efficiently to the corrected price signals, the result should be an efficient use of transport. This view suggests that the problem is how best to move to a situation in which the marginal social benefit of transport is equated to the marginal social cost incurred by the community and the environment. How far can this be achieved by market means, using corrective taxes and proper charges for road use, and how much reliance needs to be placed on non-market controls over the supply of and access to road space (such as the banning of truck movements in inner London at night)?

Baumol and Oates have listed a number of criteria for evaluating environmental policies. One of the fundamental differences between pricing techniques and the direct-controls approach to environmental protection is that the latter characteristically treats environmentally damaging activities as illegal acts, while the former considers them normal consequences of economic activity which should certainly be curtailed, but without the use of the police powers of the state. In this respect, the use of pricing incentives, at least in principle, differs markedly from the reality of outright prohibition. The effectiveness of prohibition clearly depends on the vigour and clout of the enforcement mechanism. Violators of a regulation must first be caught in the act. They must then be prosecuted, found guilty, and given a substantial penalty. If any of these steps fails, the violators get away (virtually) free despite their disregard for the law. At the same time, however, the levying of a tax may involve the installation of some sophisticated metering device in every truck and its policing by the tax authority. 

The regulatory approach is often thought to be superior to the use of pricing incentives in terms of fairness. Yet the appearance of fairness is largely illusory, because pollution abatement is generally more costly for some producers than for others. In the case of trucks, a charge for using inner London roads would affect some firms more. If our objective is to distribute noise quotas fairly, we might do better to require reduction quotas such as the unit of the cutbacks were the same for all polluters. A unit tax, leaving each firm free to decide how much noise it will cause, will produce a given reduction in noise pollution at a minimal cost. Those firms which find it cheap to restrict their movements in inner London at night will reduce their pollution much more than those firms which find it costly to use a different route or travel at a different time. From this perspective, a charge for using the roads at night may arguably be more equitable than a uniform percentage reduction in noise.

The potential revenue contribution of pollution taxes is by no means negligible. Thus, taxes levied to close the existing divergences between marginal costs and marginal revenues associated with certain activities, kill two birds with one stone: they directly reduce the particular externalities which they are directly designed to counteract, and at the same time they raise revenue for other necessary government expenditures, thus reducing the need to impose revenue-raising taxes which would themselves introduce or intensify certain other externalities, e.g. by distorting incentives.  

A tax imposed per unit of pollution emitted is not the only way of using the price mechanism to regulate pollution. If it is possible and desirable to control the quantity of pollution emitted by each polluter, the following procedure might be adopted. The authority concerned determines the total amount of pollution which shall be permitted. Licenses to pollute up to his amount are then put up to auction, so that the total permitted amount of pollution is distributed over all producers in such a manner that at the closing auction price per unit of licensed pollution each producer has in fact decided how much pollution it is profitable for him to emit. This auctioning of licenses to pollute has many of the same basic features as a system of a tax levied per unit of pollutant. Both raise revenue by charging for an external diseconomy, and both enable the price mechanism to be used to determine the cheapest and most efficient way of obtaining a reduction in pollution. The basic difference is that in the case of the straightforward tax the authority first guesses what the optimum tax is, and can then judge whether some revision of the tax is desirable in the light of the resulting quantity of pollution, whereas with the auctioning of licenses the authority first guesses what is the desirable quantity of pollution to permit and can then judge whether, in the light of the price which polluters will offer for licenses to pollute, it should increase or decrease the licenses which in future it puts up for auction.

There is an administrative aspect which will tilt the balance in favour of direct quantitative regulation. To prohibit entirely some activity may be very much easier to monitor and enforce than to restrict the activity to some positive level or to charge a tax per unit of that activity. Whether or not trucks use inner London roads at night at all may be much easier to determine than whether in using the roads they have exceeded the creation of a certain restricted number of decibels of noise. The loss of welfare caused by prohibition of truck movements will be zero or at the worst very little. Where this is so, and where at the same time prohibition is administratively much easier than other forms of control, complete prohibition is obviously the sensible policy.   

The potential for averting activities has important implications for the choice of policy to control externalities. Averting behaviour involves individual efforts to reduce the level of disturbance, given any particular level of externality. Averting behaviour is an important way of dealing with unwanted noise, and efficient procedures for regulating noise must take averting possibilities into account. If a cost-benefit analysis is used to formulate policy and averting possibilities are not considered, the valuations attached to any changed positions will be too low; the chosen policy will usually aim for externality levels that are too close to the status quo.

Coase (1960) was the first economist to explore the broad implications of the importance of averting behaviour. He was interested in showing that, where externalities are involved, private contractual arrangements can lead to efficient outcomes. The difficulties in applying the Coase theorem to many-receiver diseconomies are well-known. There is a prisoners’ dilemma problem, whether the producers have rights, in which case the receivers will have little incentive to provide each other a public good, or whether the receivers have rights, in which case they will strategically overstate their damages, leading to a suboptimal level of externality. The possibility of taking averting actions, even if paid by the polluter, does not change matters. Receivers will still be locked in a situation of strategic interaction. With producer liability, there will be too little of the diseconomy; with receiver liability, there will be too much. Competitive behaviour in this artificial market is thus unlikely and strategic behaviour may lead to an allocation that is less desirable than the laissez-faire equilibrium. Hence, the private bargaining solution will not work in the many-receiver case, making government intervention desirable. This can take a variety of forms that include taxes, subsidies and direct regulation or standard-setting. Unlike private bargaining, these forms are not likely to be upset by the self-interested or strategic behaviour of free riders. And unlike an artificial market, they do not require agreement between the diseconomy producer and each receiver on the amount of diseconomy that can be produced at a given price.

Yet government regulation often does not adequately recognise certain types of responses to regulation by individuals. Taking account of changes in averting behaviour should improve the quality of decisions about noise control. For example, strategic behaviour may enter if collective action is difficult to achieve. Imagine an uncoordinated community of individuals disturbed by traffic noise. The environmental authority is going to assess the losses imposed on the community by traffic and then regulate appropriately. No individual would gain from leaving his window open just to alter the authority total and therefore ultimately the traffic noise. If the community could organise itself, matters might be different. They could agree as a general policy to leave windows open. Each open-windowed resident would be contributing to a collective good: a higher marginal valuation of noise produced.

Both charging and regulation of externality-creating activities require large amounts of information in order to come anywhere close to achieving social efficiency. While charging requires considerably less information, a problem with the tax approach is that is difficult to apply differentially according to the location of the polluters and across time. A tax rate on truck movements that was sufficiently high to deal with noise at night would be far too restrictive during the day. This inflexibility resulting from uniform charges could be reduced by building variations into the schedule of fees itself. There is no reason in principle why an environmental authority cannot employ peak-load pricing techniques. The authority may adopt two schedules of noise pollution, one for during the day and a second with higher rates for the night hours. Yet the problem of measuring and monitoring the noise emitted remains, and may be impossible to solve given the current state of technology. Hence, it appears that the decision to simply ban truck movements in inner London at night may have been the most sensible one.



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