Philosophical Basis

Sharon Beder

Economists have argued that external costs and benefits (externalities) that are not taken account of in market transactions should be 'internalised' by adjusting prices so that the firm producing the goods or services causing the external cost (and eventually the person buying those goods or services) is obliged to pay for it. This can be done by means of a tax or charge&emdash;for example, the firm discharging the waste into the river might be charged a fee to cover the cost of lost recreational amenity and fish life. Economic instruments, such as taxes and charges, are supposed to make external costs part of the polluter's decision.

Laws can also force the polluter to take notice of these external costs by prescribing limits to what can be discharged or emitted but economists tend to be ideologically opposed to the use of laws for this purpose, preferring the market to perform this function. Economic instruments advocate Thomas Schelling (1983, xiii) admits in his book Incentives for Environmental Protection that the "benefits from using well-designed pricing mechanisms can be obtained with sensible, well-designed regulatory standards." This is a rare admission. And whilst all parties agree that economic instruments cannot completely replace legislative instruments and that any environmental policy will have a mix of laws, standards and market-based instruments, most economics texts are quite savage about the abilities of legislative instruments to achieve environ-mental goals.

Most economists argue that the market is better able to find the optimal level of damage, the one that is most economically efficient. The idea that there should be an optimal level of pollution that is not zero is strange, and even repugnant, to many people. But it is a central assumption in the economic theory behind internalisation of costs using economic instruments.

The optimal level of pollution is supposed to be the level at which the costs to the company of cleaning up the pollution equal the cost of environmental damage caused by that pollution. If the pollution charge is equivalent to the cost of environmental damage then the theory says that the company will clean up its pollution until any further incremental reduction in pollution would cost more than the remaining charge, that is until it is cheaper to pay the charge than reduce the pollution. This is said to be economically efficient because if the polluter spends any more than this the costs (to the firm) of extra pollution control will outweigh the benefits (to those suffering the adverse affects of the pollution).

This might seem to be a less than optimal solution to the community but economists argue that the polluter is better off than if it had paid to eliminate the pollution altogether and the community is no worse off because it is being compensated by the firm for the damage through the payments to the government. In theory the payments made by firms in the form of charges can be used to correct the environmental damage they cause.

This is where theory and reality diverge because there is considerable doubt about whether money payments can correct environmental damage in many circumstances; and more importantly, money collected from pollution charges is seldom used to correct environmental damage. Economists argue that if the money is spent on something equally worthwhile then the community is still no worse off. A view that those who suffer from the pollution might find hard to accept. This also assumes that the benefits that arise from the environment can be substituted for other benefits that can be bought on the market. However, environmentalists and others would counter that environmental quality is not something that can be swapped for other goods without a loss of welfare (Goodin 1992). The assumption in internalising the costs is that environmental damage can be paid for and that this is as good as, or even preferable, to avoiding the damage in the first place.

A further assumption behind the theory that there is a point of optimal damage is that increasing pollution reduction are increasingly expensive (see the upward swing of the curve on the above graph) for smaller and smaller environmental gain (see the levelling off of the curve on the graph above). This premise is based on the idea that pollution reduction is achieved by pollution control equipment being added to production processes, whereas the aim of clean production processes is to change production processes so that the pollution is not generated. These changes in production processes may in fact end up saving a firm money over the long term.

All this supposes that the charges are in some way equivalent to the damage done but this cannot be so easily assumed. As Daly and Cobb (1989, 141) point out, "even when the physical consequences are not in dispute the evaluation of the economic loss is subject to wide disagreement and uncertainty." In practice governments and regulatory agencies do not attempt to relate charges or taxes to 'external costs'. Charges may be levied to raise revenue to cover the costs of programs to combat pollution effects but more usually the charges are aimed at providing an incentive for polluters to reduce their emissions.

Similarly the cost of tradeable pollution rights is determined by the market and does not have any direct relationship with the cost of environmental damage. This means that polluters are not paying the actual costs of the damage they cause. Accordingly, a major objective of the economic instrument&emdash;to internalise environmental costs so as to obtain the optimal level of pollution&emdash;is not achieved.

Internalisation of costs is a rhetorical argument. The presence of externalities challenges the claim of economists that the market provides the best means of allocating resources. Externalities are a much cited example of a way in which the market fails to protect the environment. Economists respond by calling for the adjustment of prices to internalise these externalities. Daly and Cobb argue that such adjustments to the market system are done to save face for economists and to avoid restructuring basic economic theory. The rhetoric of internalisation also reinforces the premise that the central environmental problem is the failure to value the environment and that markets can adequately deal with this problem by incorporating environmental costs into market prices.

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